CH 14 - Fiscal Policy The use of government spending and...

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Unformatted text preview: Fiscal Policy The use of government spending and taxation to influence the size of economic fluctuations. Setting the Annual Budget Federal budget: a summary of the federal government's proposals for spending, taxes, and the deficit. Setting the Annual Budget The fiscal year runs from October to October. For example, the Budget of the United States: Fiscal Year 2009 is applied from October 1, 2008, to September 30, 2009. A Typical Budget Cycle: Fiscal Year 2009 Setting the Annual Budget In early 2008, the president will send the proposed budget for 2009 to Congress. This budget will be debated and revised by Congress. After modifications, it will be passed by Congress and sent back to the president to sign and enact as law. The enacted budget is usually slightly different from the proposed budget. Proposed vs. Actual Budget The proposed budget may differ from actual spending and tax revenues received for two reasons: 1. Congress modifies the budget, adding some programs and deleting others. 2. Unanticipated events such as wars and natural disasters may change the budget for a given year. Definitions Balanced budget: a budget in which tax revenues equal government spending. Budget surplus: the amount by which tax revenues exceed government spending. Budget deficit: the amount by which government spending exceeds tax revenues. A Look at the Federal Budget Table 1 summarizes the federal budget for fiscal year 2008. The full budget, which is more than 2000 pages long, gives much more detail. A Look at the Federal Budget Table 1 shows that expenditures exceed tax revenues, so the budget is in deficit. Since 1970, the U.S. government has managed to have a budget surplus only from 1997 to 2001. All other years brought a deficit. As shown in Table 1, the largest source of federal tax revenues is personal income taxes, followed by payroll taxes and corporate income taxes. Sales taxes (under the category "Other") are the smallest component of tax revenues for the federal government. A Look at the Federal Budget The expenditure side of the budget can be broken into two categories: 1. Purchases of goods and services (e.g., defense) 2. Transfer payments (e.g., Medicare and social security) Only purchases are included in government spending (G). A Look at the Federal Budget Purchases of goods and services: the part of government expenditures that involves new production. Transfer payments: the part of government expenditures that does not involve new production, but rather transfers of funds from the government to individuals, for which the government does not receive anything in exchange. A Look at the Federal Budget A very large part of federal expenditures (nearly 50 percent of the budget) consists of payments under the Medicare, Medicaid, and social security programs. These entitlements are projected to grow very rapidly under current law. If Congress and the president do not change the law, the federal deficit could eventually be as high as 20 percent of GDP. WakeUp Call: Federal Revenue and Expenditure Projections The Federal Debt Federal debt: the total amount of outstanding loans owed by the federal government. If the government incurs a surplus, the federal debt decreases by the amount of the surplus. If the government incurs a deficit, the federal debt increases by the amount of the deficit. Figure 3: The Rise and Fall of Government Debt The Federal Debt Debt to GDP ratio: the total amount of outstanding loans the federal government owes divided by nominal GDP. Figure 4 illustrates the debt to GDP ratio of the United States from 1950 to the present. While the total debt of the government is at its highest level ever, the debt to GDP ratio is much lower now than it was in 1995. Figure 4: Debt as a Percentage of GDP Fiscal Policy The use of government spending and taxation to influence the size of economic fluctuations. Impacts of the Instruments of Fiscal Policy: Spending Policy The objective of fiscal policy is to get the economy back to potential GDP. Fiscal policy requires spending to Increase when the economy is below the potential GDP Decrease when the economy is above the potential GDP. Figure 5: Effect of a Change in Government Purchases Impacts of the Instruments of Fiscal Policy: Tax Policy Tax policy requires that taxes Be decreased when the economy is below the potential GDP. Be increased when the economy is above the potential GDP. Figure 6: Effects of a Change in Taxes Countercyclical Fiscal Policy Countercyclical policy: a policy designed to offset the fluctuations in the business cycle. Recessions can be countered with tax cuts and increased spending. Overexpansion can be countered with tax hikes and decreased spending. Figure 8: Analysis of a WellTimed Countercyclical Fiscal Policy Effect of a WellTimed (Ideal) Countercyclical Fiscal Policy Countercyclical Fiscal Policy Figure 9 illustrates the effect of a poorly timed countercyclical policy. In the figure, if the fiscal stimulus is enacted while the economy is on its way to recovery, the fiscal policy will increase the size of the fluctuation and may send the economy into another recession before it eventually heads back to potential GDP. Figure 9: Effect of a Poorly Timed Fiscal Policy Discretionary Fiscal Policy Discretionary fiscal policy: changes in taxes or spending policy requiring legislative or administrative action by the president or Congress. Examples of discretionary fiscal policies: The 1968 temporary income tax surcharge during the Vietnam War The Reagan tax cuts in the early 1980s The Economic Growth and Tax Relief Reconciliation Act of 2001, which lowered income tax rates and increased tax exemptions for married couples and for children Automatic Changes in the Instruments of Fiscal Policy Automatic stabilizer: automatic tax spending that occurs over the course of the business cycle and tends to stabilize fluctuations in real GDP. A tax on income is an automatic stabilizer: When the economy is in recession, the tax receipts that the government collects will decrease. In a growing economy, the tax receipts will increase. Rules vs. Discretion Debate for Fiscal Policy There is debate among economists on the usefulness of automatic and discretionary fiscal policy. Critics of discretionary fiscal policy emphasize that three types of lags occur in the economy, making a discretionary policy harmful: Recognition lag Implementation lag Impact lag Rules vs. Discretion Debate for Fiscal Policy Recognition lag: the time between the need for a policy and the recognition of the need. Implementation lag: the time between the recognition of the need for a policy and when the policy is implemented. Impact lag: the time between the implementation of a policy and when its impacts are seen in the real GDP. The Structural vs. the Cyclical Surplus Structural surplus: the level of the government budget surplus under the scenario where real GDP is equal to potential GDP; also called the full employment surplus. The Structural vs. the Cyclical Surplus Figure 10 illustrates the effects of the level of real GDP and the level of the government budget surplus/deficit. The upwardsloping line shows the effect of automatic stabilizers. Higher real GDP results in higher revenues, lower spending, and a larger surplus. Figure 10: The Effect of Real GDP on the Budget The Structural vs. the Cyclical Surplus Figure 11 illustrates how the structural surplus is determined. The structural surplus is the surplus that would occur when the economy is at potential. The Structural vs. the Cyclical Surplus Figure 11 also illustrates the difference between the structural surplus and the actual surplus in a given year. A structural surplus can occur in a recession year even though the economy is experiencing an actual deficit. Figure 11: The Structural Surplus versus the Actual Surplus in a Recession Year Key Terms federal budget balanced budget budget surplus budget deficit federal debt debt to GDP ratio countercyclical policy discretionary fiscal policy automatic stabilizers structural surplus ...
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This note was uploaded on 06/01/2010 for the course ECONOMICS STA2012 taught by Professor Fan during the Spring '10 term at A.T. Still University.

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