Chapter 15

FISCAL POLICY

Introduction

  • Fiscal policy is the most powerful tool of economic policy available to the government because it mobilizes billions of dollars in expenditure and taxation.
  • So far we have studied its impact on aggregate demand but we haven't analyzed the fine details of its practical implementation and side-effects.
  • In this chapter we are going to study:

-What are the specific components of fiscal policy (types of expenditures and taxes)

-What are the major drawbacks of employing fiscal policy to stabilize the business cycle.

-What are the implications of issuing debt to finance budget deficits.

15.1 The Budget.

  • The budget is composed of outlays and tax revenues.

Outlays

  • Government outlays are the government’s total spending during a period of time:

-Government purchases (G): purchases of goods and services for either consumption (16%) or investment (83%) purposes. This is the largest component of total outlays.

-Transfer payments (TR): social welfare, pensions, unemployment insurance… unilateral transfers of income to individuals. This chapter is the fastest growing one.

-Net interest payments (INT): net difference between interest payments to holders of government bonds and interest received from federal and state loans. Growing and decreasing.

  • Total expenditure is around one-third of real GDP and has increased dramatically during war times. It has changed in composition over time as the role of government has evolved from provider of public goods to provider of public services and income re-distributor.

(See Figure 15.1)

  • Compared to other developed countries, the US has the lowest ratio of government expenditure to real GDP due to the relative small size of social welfare programs and public services provided.

(See Table 15.1)

Tax Revenues

  • The main source of government revenue are receipts from different types of taxes:

-Personal taxes: tax on personal income and property. The highest grossing of all taxes was introduced in 1913. These are the fairest taxes because they are proportional and progressive (the tax burden increases with the level of income.)

-Corporate profit taxes: tax on corporate profit. Recently increasing in value.

-Indirect business taxes: sales tax. Very stable in value and not very fair because even though they are proportional they are not progressive (everybody pays the same.)

-Social security taxes: taxes directly levied on workers’ income and specifically geared towards the Social Security trust fund that finances retirement pensions and other transfers.

(See Figure 15.2)

  • The budget composition varies greatly from federal to state and local governments. Some programs (defense, social security) are federal while some taxes are mostly local (sales tax.)

(See Table 15.2)

Deficits and Surpluses

-When outlays exceed revenue (G>T) there is a budget deficit.

-When revenue exceeds outlays (T>G) there is a budget surplus

  • For matters of clarity it is helpful to distinguish between a budget deficit and a primary budget deficit (the difference between revenue and outlays that don't include interest payments on outstanding debt.)

(See Figure 15.4)

15.2 Fiscal Policy and the Macroeconomy

  • Fiscal policy has a large impact on aggregate demand due to the multiplier effect.
  • However it is not very flexible due to the lengthy political process involved in its formulation.
  • There are also large time lags between the moment a discretionary change in fiscal policy is decided and the moment when aggregate demand actually reflects that change.
  • Most of the time fiscal policy stabilizes real output in an automatic way. Many components of the federal budget change with the phase of the business cycle acting as automatic stabilizers (e.g. personal income tax and unemployment insurance.)
  • Partisan initiatives such as the "Balanced Budget Act" of the early 1990s would destroy that critical quality of the budget, undermining the basic workings of fiscal policy.
  • From a microeconomic perspective, taxes induce distortions on consumption and saving by reducing consumer and producer surpluses and incurring in a deadweight loss of welfare:

-If the average tax rate (% of all earned income that goes to taxes) is high, the tax code will provide a positive stimulus for people to work and earn more money (but also to avoid taxes!)

-If the marginal tax rate (% of each additionally earned dollar that goes to taxes) is high, the tax code will provide a negative stimulus for people to work and earn more money.

15.3 Government Deficits and Debt.

  • Each government deficit has to be financed by issuing government-backed securities (short-term Treasury Bills or long-term Federal Bonds) that constitute the federal debt.
  • Observe that for the US economy, the negative economic impact of the growing budget deficits of the 1960s-90s (see Figure 15.4) was ameliorated by the impressive growth in GDP.
  • Compared to other countries’, the level of US debt is average.

(See Figure 15.6)

  • Budget deficits create a burden for future generations because they compromise future outlays to the repayment of outstanding debt.

-We may argue that since the debt is held by US citizens there is actually no outflow of wealth out of the US. But most of this debt is held by the wealthiest so there is an actual transfer of income across social groups.

-There are also large debt holdings by non-nationals, as part of investment portfolios. This makes deficits easier to finance, but it also represents a net outflow of resources.

-Overall, a large debt volume reduces national saving and the standard of living of future generations, that will commit a large fraction of their taxes to pay off previous deficits.

  • Budget deficits also have an effect on the current state of the economy through the Ricardian equivalence proposition.

-Rational tax payers would expect any current budget deficit to be re-paid with higher future taxes so that an actual lowering of taxes does to increase current consumption, but saving.

-This proposition requires households to be both forward-looking and to care about the future.