Topic12-Fiscal Policy_AAPBW6_Rev

Topic12-Fiscal Policy_AAPBW6_Rev - Taxes Corp. Income The...

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Unformatted text preview: Taxes Corp. Income The Government and Fiscal Policy Social Security & Medicare Individual Income Federal Government Taxes, Budget Deficits, Traditional and Ricardian Traditional Ricardian Views of Government Debt, Fiscal Stimulus, Social Security Gov Purchases: Goods, Services, Labor Topic 12 (Text: 15.1-15.3; Pres Topics #6, 7 & 8) Excise and customs Interest Transfers: Social Security, Welfare, Medical, States 1 8 Overview Taxes • Government continuously enacts rules and laws that have revenue and tax implications for private firms • We think of these as incentive-related incentivepolicies, and they have mainly microeconomic implications microeconomic • The Federal government’s revenues come government’ from: We won’t deal with those types of policies, won’ even though they may be very important Individual income tax including interest, dividend & capital gains taxes including Corporate profit tax Excise and customs, and Social insurance levies SS & medicare The fiction of separateness 6 Fiscal Policy 9 Taxes (cnt.) cnt.) • The State governments’ revenues come governments’ from: • The government’s broad policies on government’ Individual income tax Corporate profits tax Property tax Sales tax Social insurance levies, and Federal aid expenditures, taxes, and therefore its borrowing is called fiscal policy • Current example: The “bailouts” bailouts” 7 10 Government Expenditures Again Taxes (cnt.) cnt.) • • Economists tend to analyze Two types of taxes: 1. Lump-sum taxes: The same amount of tax is Lumpamount of levied irrespective of income (or whatever criterion is used for taxation) These taxes do not skew incentives -- no matter what you do, you are taxed the same; i.e. they are non-distortionary non Except for fee-type taxes (some excise taxes) feeimpractical and politically infeasible One possible example is SS taxes (income cap) the incentive structures of the political process whether there is over or underproduction of public goods • Economists also analyze the “hidden costs” costs” of financing government expenditures Distortionary taxes All proportional taxes create distortions, i.e., inefficiencies Unacknowledged future costs SS is the best example • Hence the emphasis on gov. financing gov. 11 11 Increases in Gov Expenditures Taxes (cnt.) cnt.) • 17 Two types of taxes: 2. Proportional taxes: Tax depends on the amount or size of the activity e.g., certain fraction of income is taken by the government in income taxes practical to implement, but alter the behavior of individuals and firms therefore they are distortionary taxes distortionary In Full Employment • G means expenditures in goods & services, goods does not include transfers • If government uses more resources the private sector has to use fewer resources Private C, I, S will have to go down This does not mean that people are worse off, does if the increase in expenditures provide for if desirable public goods! It does mean that it is not a good way to does increase GDP or its growth rate GDP 12 18 Government Expenditures Increases in Gov Expenditures • Economists don’t have a lot to say about don’ the appropriate amount of government amount expenditures In Recession & Unemployment • Increased government demand may stimulate output and employment, because idle resources may be put to work Creation of public goods Outcome of the political process and the country’s country’ circumstances Defense, regulation, internal security (police, fire fighters, homeland security), legal system, funding of basic R&D, and many others Transfers At best a transient short-term fix shortThis kind of increase in GDP does not mean GDP that people are necessarily better off! Goes back to the short-term neutrality shortdiscussion Temporary reductions in output and employment may be optimal Fiscal policy is a blunt and broad weapon! Also outcome of the political process Some have the character of a public good 16 19 “Multipliers” Budget Debt and Deficits • Question: • A term that has come back into use with the current situation • If you spend $1 government, by how much does GDP go up? It depends on the economics situation and where and how firmly you fit in the conviction spectrum Are deficits a good thing? Should we worry? • Deficit financing is one of the three BIG issues in fiscal policy • The Others? Social Security, Medicare/Aid Social Is SS going bankrupt? Do we have to change the system? Can we sustain Medicare/Aid? 20 23 “Multipliers” Budget Deficits • At “full employment” mult = 0 or mult < 0! • If you spend the $1 in transfers the multiplier ought to be less than if you spend it directly • Barro in a recent article claims that over WWII, the government spending multiplier was 0.82 • A lot of the discussion before passing Obama’s relief package was about multipliers Different assumptions give different answers • Government outlays (spending): Government purchases (G) Transfer payments (TR), and Net interest payments (INT) • The budget deficit is then defined as: deficit = outlays - tax revenues Deficit = (G + TR + INT) - T TR INT • Primary deficit excludes net interest from government outlays = (G + TR) - T TR 21 24 Example #1 Budget Debt and Deficits • Governments all over the world borrow to finance a shortfall of revenue compared to expenses; some of reasons: Don’t have to raise taxes now Don’ Taxpayers can postpone payment Finance capital projects Finance large transient expenditures Unable to collect taxes • Let Gov. purchases SS payments Welfare payments Interest on Debt Income taxes Corp taxes SS & Medicare levies = 300 = 200 = 100 = 30 = 220 = 40 = 140 • What are government spending and receipts? • They borrow in their own currency and they borrow in foreign currency 22 Gov Spending = Gov Receipts = 25 Debt Example #1 • The accumulated budget deficit is the accumulated national debt. Deficit is a flow, debt is a stock • Let Gov. purchases SS payments Welfare payments Interest on Debt Income taxes Corp taxes SS & Medicare levies = 300 = 200 = 100 = 30 = 220 = 40 = 140 Not all government borrowing shows up in the “unified” budget unified” Differences between state & Fed budget processes • A useful measure is the Debt-GDP ratio Debt From the 1980s until recently, federal government spending far outstripped revenue, causing the debt to double from its 1980 level and the Debt-GDP ratio to climb Debt- • What are the budget deficit and the primary deficit? Def = Def(Prim) = Def(Prim) Does it matter? 28 28 35 Example #1 gov. purchases gov. SS payments Welfare payments Interest on Debt Income taxes Corp taxes SS & Medicare levies Debt (cnt.) cnt.) = 300 = 200 = 100 = 30 = 220 = 40 = 140 • Dynamics of debt Dt+1 – Dt = Deft Def Dt+1 – Dt = Primary Deficitt + it-1 Dt Primary where it = nominal interest rate Deficits add to the government’s debt government’ • What are the government transfers? TR = TR • The Debt/GDP ratio is a reasonable measure Debt of the impact of debt 31 36 How Indebted Are the World’s Governments? Actual & Projected Deficits Country Debt to GDP ratio in 1998 Belgium 125% Italy -0 8 -0 6 ar 65 65 65 United Kingdom M -0 4 ar ar M M -0 0 -0 2 -9 8 ar ar M ar M M -9 4 -9 6 -9 2 ar ar M M -9 0 ar M ar M M ar -8 8 -8 6 -8 4 ar ar M -8 0 -8 2 M ar ar M -7 6 ar -7 4 ar ar -7 8 M M M -7 0 -7 2 66 United States 34 67 France -10.0% 67 Portugal FED DEFICIT CBO PROJECTED 73 Germany M ar ar M M -8.0% 73 Denmark -6.0% 74 Netherlands Ireland -4.0% 76 Spain Austria -2.0% 93 Sweden 0.0% 94 Japan 2.0% 103 Canada 4.0% 123 Greece Actual and Projected Federal Deficits 60 Source: Mankiw 2000 37 The Debate on Budget Deficits The Traditional View (cnt.) cnt.) • Government levies taxes to finance its spending • According to the traditional view, the reduction in the future standard of living is the true burden of government debt • The argument crucially depends on how consumers behave in response to such a tax cut (through Spvt) • “If some of the debt is held by foreigners, then the future generations will also have to pay interest to them.” them.” It can levy taxes equal to G1 T1 = G1 It can tax T1 < G1 (current scenario) and borrow borrow (G1 - T1) to finance spending; i.e. run a deficit and sell debt • Is this “good” or “bad” for the economy? good” bad” Current generations? Future generations? This is true but irrelevant, as long as the debt is in home currency 39 39 The Traditional View of Deficits 42 The Traditional View (cnt.) cnt.) Traditional view: • A tax cut of $1 • Notice that the issue is NOT: how will our NOT children pay all this back? disposable income by $1 What it is about paying back the debt? Is it optimal to ever do that? ever part is consumed and the rest saved Spvt by < $1, while deficit Sgov by $1 As a result, Spriv + Sgov (total saving), S, Equilibrium real interest rate Investment 40 43 Example #2 (Traditional View) The Traditional View (cnt.) cnt.) • With persistent deficits, accumulation of domestic capital slows down future generations will experience a lower standard of living Solow model predicts a lower steady state level of capital and per capita income when the saving rate decreases 41 • Suppose private consumption is given by C = C0 + (Y – T) ; = 0.60 (Keynesian consumption function) C0 = 100, Y = 2,000, T = 600, G = 600 600, 600 What is Current Consumption, Priv. Saving, Current Priv. Nat’l Savings? Nat’ C SPriv SNatl 44 Example #2 (Traditional View) The Ricardian View of Deficits • Gov. decreases taxes to 400 without decreasing spending C = C0 + (Y – T) ; = 0.60 C0 = 100, Y = 2,000, T = 400, G = 600 400, 600 What is Consumption, Priv. Sav, Nat’l Sav? ’ Consumption Priv. Nat C = SPriv = SNatl = The Ricardian conclusion is that consumers will save all such tax cuts, and national savings will save national not change Private savings will offset the government deficit We’ll show this in a simple model We’ • Assume government cuts taxes and runs a deficit, while holding current and future while government expenditures fixed Taxes are lump-sum lump- 48 48 Brief Review 54 The Ricardian View of Deficits • Deficit = (G + TR + INT) - T TR INT Debt/GDP is the usual way we compare deficits over time and across countries • What is the traditional “burden of the debt”? debt” Lower std of living; not the interest payments not • The “thought experiment” is: experiment” Gov cuts taxes while holding spending the same Bush policy (also the old Reagan policy) Does this change private behavior? “Traditional View” YES! Reduces Nat’l View” Nat’ Savings, k, and therefore steady state y • The budget constraint for a consumer in the 2-period model is (discussed in T.6) PV(consumption) = PV(net income) (consumption) PV C1 C2 Y T Y1 2 T1 2 1 r 1 r 1 r Recall that the PV of a series of cash receipts over PV time is: PV X 0 , X 1 , X 2 , X 3 X 0 X1 X2 X3 1 r 1 r 2 1 r 3 51 The Ricardian View of Deficits 55 Ricardian View (cnt.) cnt.) • Ricardian view: postulates a forwardforwardlooking consumer and examines if a tax cut will consumption Simple logic of government’s budget constraint: government’ PV(Gov Spending) = PV(Tax Revenue) Otherwise no one would lend to government Current deficits (& therefore lower taxes) lower imply future higher taxes higher Conclusion: the “tax cut” is not a tax cut in PV cut” in 53 • The government’s government’ constraint, is: intertemporal budget PV (Gov. Expenditures) = PV (Taxes) PV PV G G1 G2 T T1 2 PV T 1 r 1 R 56 Ricardian View (cnt.) cnt.) Ricardian View (cnt.) cnt.) • If planned government expenditures do not change (Fix G1 and G2 ) change • In algebraic terms Government decreases taxes by T today and finances this tax cut by borrowing, In the next period it needs to increase taxes by (1+r) (1+ T, to repay the debt and the accumulated interest PV G T1 T T2 T 1 r PV T 1 r Consumer’s budget constraint with this tax cut: Consumer’ Y2 T 1 r T T1 T 2 1 r 1 r Y2 G 2 Y1 G1 1 r PV Y1 57 57 Ricardian View (cnt.) cnt.) 60 Ricardian View (cnt.) cnt.) • What happens to the consumer’s budget constraint? consumer’ She gets a tax break of T, so her first period income is T She knows that the government has to go out and borrow T to finance its expenses She also foresees that the government will have to repay its debt debt and it will have to increase her taxes by (1 + r) T to finance repayments (1 nd period after tax income to be She expects her 2 (1 + r) T T 1 r 0 The PV of this = 0! T 1 r • The net effect is to leave the present value of her income, and therefore her consumption plan, unchanged unchanged • Implication: A balanced budget every year is not necessarily good. For instance, during a war instead of raising taxes on an already overburdened public, it might be welfare improving to run a deficit; it does not SNat’l Nat’ this is because taxes have distortionary costs distortions increase exponentially with taxes 58 62 Government Cuts Taxes by $1 by $1 and Borrows $1 Ricardian View (cnt.) cnt.) • The key is: Consumers care about the Present Value of their Present tax obligations SNatl Spriv Sgov by < $1 by < $1 by $1 by $1 by $1 Straight from the Permanent Income idea Government’s reducing taxes now and having to Government’ increase them later doesn’t change the PV of taxes doesn’ PV It is a shell game Therefore, the consumer is neither better or worse off Doesn’t change her consumption plan! Doesn’ The tax cut becomes additional saving Traditional View View Ricardian Unchanged View It’ll be used to pay the future higher taxes It’ 59 63 63 Example #3 (Ricardian View) (Ricardian Example #3 (Ricardian View) (Ricardian • Government reduces current taxes by 200 without changing expenditures. What happens to Current Current Consumption, Priv. Saving, Nat’l Savings? Priv. Nat’ • Suppose private consumption is given by 1 PV Net Inc 2 Y1 = 1,600, Y2 = 1,100, T1 = 400, G1 = 600, G2 = 660, 600, r = 10% Y1 = 1,600, Y2 = 1,100, T1 = 600, T2 = 660, 600, G1 = 600, G2 = 660 (balanced budget each period), r = 10% 600, 660 C SPriv SNatl = = = 64 64 69 Example #3 (Ricardian View) (Ricardian Empirical Evidence for the U.S. • Suppose private consumption is given by 1 PV Net Inc 2 Federal Deficits & the Real Rate 10.0% FED DEFICIT 10Y Real Rate CAB/GDP 8.0% Y1 = 1,600, Y2 = 1,100, T1 = 600, T2 = 660, 600, G1 = 600, G2 = 660 (balanced budget each period), r = 10% 600, 660 6.0% 4.0% 2.0% What is Perm. Inc., and the PVs of G, T? Perm. G, Perm Inc = PV(G) = PV PV(T) = -0 6 -0 8 -4.0% -6.0% -8.0% -10.0% 65 73 The “Burden” of Debt in a Nutshell Burden” Example #3 (Ricardian View) (Ricardian C ar ar M M ar -0 2 -0 4 -0 0 -9 8 ar ar M -9 6 ar M M -9 4 -9 2 ar ar ar M M M -8 8 -9 0 ar M -8 6 -8 4 ar ar M M -8 2 ar M -8 0 -7 8 ar ar M M -7 6 ar M -7 4 ar -7 2 ar ar M ar M M -7 0 0.0% -2.0% M C M C 1 PV Net Inc 2 • Gov takes resources from the economy now now but borrows to pay for them! Y1 = 1,600, Y2 = 1,100, T1 = 600, T2 = 660, 600, G1 = 600, G2 = 660, r = 10% 600, 660, What is Current Consumption, Priv. Saving, Current Priv. Nat’l Savings? Nat’ C = SPriv = SNatl = 67 If this tricks consumers into thinking their tricks income is high, they will save less and k will grow more slowly equilibrium k will be lower The issue is the empirical relevance of Ricardian empirical equivalence 74 The “Burden” of Debt (Concl.) Concl.) Burden” Do We Have to Pay Back the Debt or Not? Even if the world is Ricardian • Higher future taxes mean higher future tax distortions • Indefinitely-lived entities have to “show” evidence to the markets that they can pay back their debt Increases the distortionary wedge between wages paid and wages received Distortions increase non-linearly with taxes nonWage elasticity of labor supply is substantial Lump-sum taxes are infeasible Lump- Corporations by being solvent Governments through their taxing capacity orderly and lawful society sustainable borrowing • When these criteria are not met, there is a crisis 75 75 The “Laffer” Curve! Laffer” 78 Do We Have to Pay Back the Debt or Not? • What is “sustainable borrowing” for a government? • That debt doesn’t “grow too fast” relative to the economy Gov Revenue Basically it means that Debt/GDP cannot be expected to rise indefinitely Short-term rises are OK, as long as the market expects them to stop Tax Rate Stopping Debt/GDP ↑ doesn’t mean running surpluses (paying back the debt) It means growing the deficits at less than GDP growth 76 Do We Have to Pay Back the Debt or Not? • In the 2-period model, government definitely has to pay back the debt • In the real world, mortal entities (consumers) also definitely have to pay back their debt Exceptions are bankruptcies • Entities with indefinite lives have different rules Corporations, governments 77 79 Fiscal Stimulus • Passive countercyclical fiscal policy Gov revenues automatically fall in a recession Rise in a recovery That means deficits rise in a recession What to do? NOTHING! NOTHING In the past, governments worried about the rising deficits and proceeded to raise taxes In a recession! Nixon 1972, Roosevelt in 1936, Japan in the 1990s 82 Fiscal Stimulus Example #4 Problem #5 at chapter end –Taxes Distort • Active countercyclical fiscal policy Temporary tax cuts in recessions and/or tax and/or increases in government spending government • Workers value their leisure at 90 units of goods. The production function is Y = 250L – 0.5L2. MPL = 250 - L MPL 1. No taxes: What are the equilibrium wage, L, & Y ? wage to stimulate consumption spending See: “market failure or optimal response?” response?” Also Tax cut may be saved (Ricardian view) no in C (Ricardian Particularly if it a temporary tax cut temporary Huge lags between need for policy and enactment enactment of policy and effect on the economy Even for “shovel-ready” projects as we are finding out shovel- ready” 83 83 91 91 Fiscal Stimulus (concl.) concl.) Example #4 • Increase government expenditures on goods and services, G, to spend on infrastructure, create jobs, etc. Increase in G on a permanent basis reduces goods and services available to the private sector Problem #5 at chapter end –Taxes Distort Problem • Workers value their leisure at 90 units of goods. The production function is Y = 250L – 0.5L2. MPL = 250 - L MPL 1. No taxes: What are the equilibrium wage, L, & Y ? wage In equilibrium, workers will give up 1 unit (hour, day) of leisure for 90 units of goods. This, then will be the wage rate! Therefore, w= There is a tradeoff (public vs. private goods) Since Keynesians believe deficits are bad, they would increase taxes to make up for G Problems: Y= Distortionary income taxes decrease labor supply! Distortionary taxes decrease capital formation 84 92 “Good” Fiscal Policy Good” Example #4 • Choose an “optimal” level of G and TR optimal” TR Problem #5 at chapter end –Taxes Distort Problem Cost-benefit, political equilibrium Cost- • Workers value their leisure at 90 units of goods. The production function is Y = 250L – 0.5L2. MPL = 250 - L MPL 2. Wage tax 25%: What are the equilibrium wage, L, & 25%: wage Y ? What is the distortion cost of the tax in terms of output? w= • Steady tax rates Lowest marginal rates possible Avoid double taxation Profit taxes? Finance deficit fluctuations • In a growing economy, keep Debt/GDP Debt constant on average This implied a steady-state deficit steady- Y= ~$14T GDP, $10T debt ~71% ratio GDP 5.0% $growth implies $ ~500B steady-state deficit! steady85 94 Glossary G Government expenditure S C National Saving = Spvt (private saving) + Sgov (govt. saving) Consumption of households T T r Y PV(X) Perm.Inc. Perm.Inc. Taxes (T1, T2, in two-period setup) twoChange in taxes Real interest rate Real income (GDP) Present Value of X Permanent Income (G1, G2, in a 2-period setup) 2- (C1, C2, in 2-period setup) 2- 96 96 THE END 97 ...
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