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ECN 253---Fiscal Policy

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Yuanyuan Chen

on 31 October 2012

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Transcript of ECN 253---Fiscal Policy

What is Fiscal Policy? Obstacle:
The Limits of Using Fiscal Policy to Stabilize the Economy Obstacle:Deficits, Surpluses, and Federal Government Debt Start Structure of this Chapter The Long-Run Effects of Tax Policy Catherine Chen, Ph.D. Chapter 16 Fiscal Policy The Government Purchases Crowding Out Long run Effects Limits What is Fiscal Policy and its effects? Deficits, Surplus, and Debts Government Purchases & Tax Multipliers (cc) image by nuonsolarteam on Flickr Fiscal Policy What Fiscal Policy Is and What It Isn’t Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. Economists typically use the term fiscal policy to refer only to the actions of the federal government. State and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy. Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle. With discretionary fiscal policy, the government takes actions to change spending or taxes. An Overview of Government Spending and Taxes Federal government expenditures include purchases plus all other federal government spending:
Interest on the national debt,
Grants to state and local governments, and
Transfer payments The Effects of Fiscal Policy on Real GDP and the Price Level Expansionary fiscal policy involves increasing government purchases or decreasing taxes. Cutting the individual income tax will increase household disposable income,the income households have available to spend after they have paid their taxes, and consumption spending. Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation. A Summary of How Fiscal Policy Affects Aggregate Demand The table isolates the effect of fiscal policy by holding constant monetary policy and all other factors affecting the variables involved. Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures. The Effect of Changes in Tax Rates Government purchases multiplier Tax multiplier The higher the tax rate, the smaller the multiplier effect. A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending.
A cut in tax rates increases the size of the multiplier effect. Taking into Account the Effects of Aggregate Supply The Multipliers Work in Both Directions Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP.
Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case, the effect is negative. Crowding out A decline in private expenditures as a result of an increase in government purchases. Crowding Out in the Short Run Crowding Out in the Long Run The long-run effect of a permanent increase in government spending is complete crowding out, where the decline in investment, consumption, and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. In the long run, the economy returns to potential GDP. Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue. How the Federal Budget Can Serve as an Automatic Stabilizer Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking any action, but is instead due to the effects of the automatic stabilizers. Deficits occur automatically during recessions for two reasons:
During a recession, wages and profits fall, causing government tax revenues to fall.
The government automatically increases its spending on transfer payments when the economy moves into recession. Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP. Is Government Debt a Problem? If an increasing debt drives up interest rates, crowding out of investment spending may occur, which means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. This effect is somewhat offset if some of the government debt was incurred to finance improvements in infrastructure, such as bridges, highways, and ports; to finance education; or to finance research and development. The Effects of Fiscal Policy in the Long Run Tax wedge The difference between the pretax and posttax return to an economic activity The tax wedge applies to the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. Individual income tax. Sole proprietorships’ profits and households’ returns from saving are taxed at the individual income tax rates. Cutting these rates not only reduces the tax wedge faced by workers, thereby increasing the quantity of labor supplied, but also raises the return to entrepreneurship, encouraging the opening of new businesses, and increases the return to saving. Corporate income tax. The federal government taxes the profits earned by corporations under the corporate income tax. Cutting the marginal corporate income tax rate would encourage investment spending by increasing the return corporations receive from new investment goods, potentially increasing the pace of technological change if innovations are embodied in these goods. Taxes on dividends and capital gains. Lowering the tax rates on dividends and capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate. Tax Simplification In addition to the potential gains from cutting individual taxes, there are also gains from tax simplification. The Economic Effect of Tax Reform http://www.bloomberg.com/news/2012-10-30/hurricane-sandy-may-slow-economy-as-workers-stay-at-home.html
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