Chapter 12 - FISCAL POLICY

See opening quote, page 267.

We now look at Fiscal Policy. We assume that the money supply (MS) is fixed, monetary policy is held constant so we can isolate and focus on fiscal policy only.

Fiscal policy = Tax policy (T) and government spending (G) by the President and Congress, with the intention to affect the economy - promote growth, achieve low unemployment, etc.

Budget Deficits and Surpluses - Since fiscal policy involves a) setting tax policy to generate tax revenue (T), and b) federal spending (G), we start by discussing Budget Surpluses and Deficits.

Balanced budget = Govt. Revenue (taxes, tariffs, fees) = Govt. Spending,  (T = G)

Budget Deficit = Govt. Spending (G) > Govt. Tax Revenue (T)

Budget Surplus = Govt. Revenue (T) > Govt. Spending (G)

See back of book, From 1960-1997 we have had a deficit every year except 1960 (close to a balanced budget), and 1969 (surplus).  From 1998-2001 we had budget surpluses. Why?

Important distinction: Budget Deficit vs. National debt - Budget Deficits occur in years when G > T, have averaged between $100-200B per year in the 80s and 90s.  The National Debt is the accumulation of past budget deficits, which is now (2003) over $7000B or $7T.

The federal budget is the primary tool of fiscal policy - attempt at stabilization and fine-tuning. Budget deficits can change for two reasons:

1. Passive budget deficits - without a change in fiscal policy, deficits can reflect the current state of the economy.  Examples: deficit increases during recession. Tax receipts (T) are down during recession and govt. spending (G) increases. During an expansion, T goes up and G goes down due to the strong economy, leading to a smaller deficit, or a budget surplus which we currently have in U.S.

2. Active Budget deficits - result from deliberate, discretionary fiscal policy where policymakers plan the federal budget with the intention to spend more than they plan to take in (G > T, leading to a deficit)

U.S. budget deficits are mostly from discretionary fiscal policy, and when we talk about a "change in fiscal policy," we are referring to a change discretionary fiscal policy that affects the deficit or surplus.
 

KEYNESIAN VIEW OF FISCAL POLICY

Before Keynes (and up to the 1960s), balanced budgets were generally accepted by politicians and the public as the responsible thing. Keynes challenged the desirability of balanced budgets. Argued that federal budget should be used to promote AD/full employment, especially during a recession.

Fed Budget influences AD two ways:

1. Govt. spending on goods and services affects AD (G in C + I + G). National defense, highways, education, etc. Increases in federal spending increases G in GDP, cuts in federal spending decreases G.

2. Tax policy (T) influences AD. A tax cut increases disposable income, increases Consumption (C goes up in GDP). Bus tax cut increases business investment on equipment (I), etc.  Tax decreases will increase C and I, tax increases will decrease C and I.

Keynes argues that fluctuations in AD are the source of econ disturbances and create the bus cycle - "Animal Spirits."

Policy conclusion: stabilize the econ through fiscal policy. If economy is in recession, govt. should engage in Expansionary Fiscal Policy - increase govt. spending and/or reduce taxes, increase budget deficit. G > T (spending is greater than tax revenue), so the govt. has to borrow money from individuals, businesses or foreigners.

Example - page 270. Economy is in recession at e1  (Y1 < YF), due to animal spirits.  In the classical model, the weak economy would put downward pressure on prices and wages, and would shift SRAS1 to SRAS3.  Economy would adjust slowly from e1 to E3, back to YF.

In the Keynesian model, the classical adjustment process will be slow and uncertain, so he advocated expansionary fiscal policy (Increase G or Decrease T) as a more effective way to  move the economy back to YF.  Expansionary policy could increase from AD1 to AD2, and the economy goes back to full employment output at E2.  Expansionary fiscal policy (active budget deficit) would involve some combination of: i) cuts in personal income taxes, ii) cuts in corporate taxes, and iii) increased govt. spending, and a possible budget deficit.

Example: page 271. Now the economy expands beyond YF to e1 and Y1 > YF.  In the classical model, there will be upward pressure on prices, wages, and int. rates, which will eventually increase SRAS1 to SRAS3, and the economy will move back to YF (E3) at a higher price level (P3).   

OR Govt. can pursue Restrictive Fiscal Policy to reduce AD1 to AD2 by raising taxes or cutting govt. spending, running a smaller budget deficit or a budget surplus. Restrictive fiscal policy in response to an expansionary "overheating" will also combat inflation. 

Keynesian view - Gov. should engage in activist, discretionary, Countercyclical Policy to "fine-tune" and stabilize the economy over the business cycle (adapt a policy that runs "counter" to the change in AD).  Run a budget deficit during a recession to stimulate (increase) AD.  Run budget surplus during expansion to restrain (decrease) AD.
 

FISCAL POLICY AND CROWDING OUT -

By the 1960s, most economists and policymakers favored the Keynesian approach - activist, discretionary, countercyclical fiscal policy to attempt to constantly "fine-tune" and stabilize the economy. However, economists started to recognize that there are several secondary effects of countercyclical policy that weaken the potency of activist, discretionary policy.

1. Crowding Out Effect

Scenario I - Economy is in recession. Government pursues expansionary fiscal policy and runs a budget deficit to stimulate the econ back to full output (tax cuts and/or spending increases). Deficit requires borrowing. Gov. borrowing puts upward pressure on int. rates, since the govt. competes for limited funds with the private sector. At higher int. rates, private borrowing gets "crowded out" by the public sector, and there will a reduction in private borrowing by consumers and businesses, so that AD may not shift all the back to full employment output. Also, less private investment has negative effect on output in future periods due to lower supply of capital equipment.

Scenario II - Economy is in a strong expansion. Government decreases spending and/or raises taxes and runs budget surplus to slow down the economy. G Reduces demand for credit, putting downward pressure on int. rates. Now the lower int. rates stimulate the economy (increase C and I) and may prevent the economy from returning to full output - economy may stay above full output.

Point: Crowding out effect counteracts / neutralizes discretionary fiscal policy.  Fiscal policy will be weakened or completely offset by crowding out.

2. Crowding out in the Global Economy.  If deficits raise int. rates, the higher int. rates attract foreign investment to the U.S.  Increased demand for investment in US increases demand for dollars. Dollar appreciates, foreign currency depreciates. Exports (X) go down, Imports (M) go up. Net exports fall. AD falls since the strong dollars encourages foreign production over domestic production.

Crowding out and foreign exchange effect weaken (neutralize) the effect of countercyclical policy. Deficit spending may first increases AD, but the crowding out and exchange rate effect later lower AD, or prevent AD from increasing in the first place.  See Exhibit 3 on page 273.
 

TIMING PROBLEMS FOR FISCAL POLICY -

Another shortcoming of Keynesian approach: For fiscal policy to be effective, and reduce econ instability, it must stimulate the econ during a recession and restrain it during an inflationary expansion. For fiscal policy to work, timing is critical.  Due to the problems of LAGS, it is highly unlikely that fiscal policy will ever be effective.

THREE LAGS that present major problems for effective fiscal policy:

1. Recognition lag - time to recognize that there is a problem that needs correction. Recession is two consecutive quarters of neg. real GDP growth. Suppose growth in the first quarter (Jan - Mar) is neg., and growth in the second quarter (Apr - June) is negative. But there is a three month lag period to get the final statistics. So final est. of real GDP in second quarter isn't released until October 1. We don't know until October that the economy was in recession back in January.

2. Administrative/legislative Lag - time to enact a policy to correct the course of the economy. Fiscal policymakers have to pass legislation to increase/decrease taxes, increase/decrease the deficit, etc. Both the House and Senate have to agree, has to be signed by the president, could be a veto, etc. Might take more than a year for fiscal policy to be enacted.

3. Impact lag - time for a change in fiscal policy to affect the economy. Even after the legislation is passed, there may be a 6-12 month period before the legislation actually affects the economy.

Problem: for fiscal policy to really be effective, policymakers would have to know more than a year in advance what was going to happen to the economy.  If we somehow knew now that there would be a recession in early 2004 and that the proper tax stimulus package would help the economy, we would have to start preparing legislation now that would pass in the middle of 2003 and would start to stimulate the economy in early 2004. How likely is that? Economic conditions are very hard to forecast accurately.

Danger: because of the problems with lags, and because fiscal policy does not work instantly, expansionary fiscal policy may take effect when the economy has already self corrected, and instead of stabilizing the economy, it will de-stabilize the economy. See page 277.  If policy is mis-timed, it will still affect the economy, but it will be the wrong effect at the wrong time and will hurt the economy.

Two possible scenarios: (page 277)

1. Economy is in a recession at AD1. Policymakers eventually recognize the problem, prepare and pass legislation, but by the time it starts to take effect, the economy has already gone back to AD0 on its own The anti- recession policies take effect when it is not needed, pushing the economy to an inflationary AD2 and e2 - fiscal policy then de-stabilizes the economy.

2. Economy is in an overheating, inflationary expansion at AD2.  Legislation is passed to slow economy down, restrictive fiscal policy - tax increases or cuts in govt. spending.  Economy self-corrects to AD0 by itself when the policy takes effect and causes a recession by pushing the economy to AD1 and e1 - the activist policy destabilizes the economy, makes it worse because of improper timing.

POINT: Proper timing is critical for fiscal policy to be effective, and the problems of lags almost guarantees that proper timing will be impossible.
 

AUTOMATIC STABILIZERS

Lags pose serious problems for fiscal policy, but there are several fiscal programs that provide countercyclical policy automatically, without a change in legislation, and may overcome some of the problems with lags since there is no delay.  Automatic stabilizers automatically promote a budget deficit during recession and budget surplus during an expansion.

1. Unemployment (Un) compensation - when econ is in recession, people are laid off. Un compensation spending goes up (G increases) to pay unemployed workers and Un comp taxes (T) imposed on businesses will decrease because of the reduction in employment. Govt. spending (G) goes up, Govt. Tax Receipts (T) go down, pushing the budget toward a deficit during a recession, supplying the expansionary fiscal policy at the right time.

During an expansion, Un compensation pmts (G) go down, Un comp taxes (T) go up. Govt. spending falls, govt. receipts rise, so the budget moves toward a surplus (restrictive fiscal policy) at the right time.

2. Corporate tax receipts on profits are highly sensitive to econ conditions and are thus highly cyclical, going up during an expansion and falling during a recession. By falling during a recession, corp. taxes help move the budget toward a deficit during a contraction.  By rising during an expansion, corp. taxes help move the budget toward a surplus during an expansion (like now).

3. Progressive income tax system provides auto stabilizer. When incomes are rising, econ is expanding, people get forced into higher tax brackets, raising inc. tax receipts, moving the budget toward a surplus.  During a recession when incomes are falling, people move to lower tax brackets, reducing inc. tax receipts and moving the econ toward a deficit.

Conclusion: 1. During a recession, budget automatically moves toward a deficit, due to: increased unemployment payments, decreased unemployment taxes, corporate taxes and personal income taxes.

2. During an expansion, budgets automatically moves toward surplus due to: reduced un pmts, increased un taxes, corp. taxes and personal taxes.

Automatic stabilizers provides the appropriate fiscal policy at the proper time, may provide some countercyclical stabilization without legislative action.
 

NEW CLASSICAL VIEW OF FISCAL POLICY

Another challenge to the activist Keynesian view of the potency of fiscal policy, the New Classical view leads to the extreme conclusion that active fiscal policy is completely impotent and that expansionary fiscal policy (budget deficits), for example, won't work at all.

Keynesian assumption: Economy is in recession, so policymakers should stimulate economy with a $50B income tax cut financed by $50B new debt, run a budget deficit, increase AD (tax cut raises C), econ goes back to full output. Main assumption: tax cut of $50B will be spent by consumers, so that C goes up by $50B, AD goes up by $50B.

New Classical View - Assumes that people are forward looking and have "rational expectations" of the future, and financial markets are efficient. People will figure out that a $50B tax cut now financed with a $50B deficit implies a $50B tax increase later, and they won't be fooled by the illusion of a "tax cut" now for a tax increase later. "Budget deficits merely substitute future taxes for current taxes." People will save the entire $50B to pay for taxes at a later date. Consumption will be unaffected, AD will not change, real int. rates will not change, output/employment will not change, fiscal policy will be totally ineffective/impotent. A budget deficit (of $50B) just substitutes higher future taxes (of $50B) for lower taxes today ($50B).

Policy conclusion of new classical: don't rely on fiscal policy to stabilize the economy, rely on the self-correcting mechanisms of the market.  See graph on page 275.

New Classical view of fiscal policy in its pure form is controversial. Assumes that people are forward looking and that they care about future generations - "intergenerational altruism." If new classical view holds, fiscal policy is completely ineffective. If at least some of the people save their tax cut, the potency of activist policy will be reduced.

SUMMARY

The combined problems of 1) lags, 2) crowding out/foreign exchange effect, and 3) the possibility that some portion of tax cuts are saved, ALL present very serious challenges for discretionary fiscal policy to have the desired effect of economic stabilization. Even the best intended fiscal policy may not ever work. And we haven't assumed that much of fiscal policy may be very politically motivated to please special interest groups and get re-elected. For example, who gets the tax? For child care, education, charitable contributions, etc.??
 

MODERN SYNTHESIS VIEW OF FISCAL POLICY
(Accepted by most Keynesian and non-Keynesians, but open to debate)

1. Automatic stabilizers help to smooth out fluctuations / business cycle, by automatically moving the federal budget toward a deficit during recession and toward a surplus during an expansion, and thereby directing the economy toward full employment.

2. During normal econ times, activist Keynesian fiscal policy is relatively ineffective at stimulating AD, due to the secondary effects (side effects) resulting from deficits: crowding out, exports declining and/or people saving tax cuts. Crowding Out and New Classical models say that Keynesian fiscal policy will not affect output and employment during normal economic contractions/expansions.

3. Proper timing of discretionary policy is both extremely difficult to achieve and extremely crucial if it is to help the econ. Because of this, most economists favor active, discretionary fiscal policy only in response to a major recession.
 

SUPPLY-SIDE EFFECTS OF FISCAL POLICY

So far we have concentrated on the demand-side effects of fiscal policy. But when taxes change, incentives change, and this then effects supply. Taxes are always distortionary, meaning that they cause people to change behavior. Only a lump sum, or head tax, is neutral. Supply side economists argue that looking at dynamic change, dynamic adjustment is more accurate than static policy. Supply side economics looks at how incentives change when tax policy changes, and how changes in taxes and incentives affect Aggregate Supply (AS), especially LRAS.

Supply side economics emphasizes marginal income tax rates.  Marginal tax rates determine how much of your marginal (additional) income goes to taxes and how much you get to keep.  Example:  You are an accountant working for a salary and you have an opportunity to do some consulting work for $100/hour on Saturdays.  If your marginal tax rate is 90%, you pay $90 in tax and keep $10, not a very attractive opportunity on an after-tax basis.  If you tax rate is 10%, you keep $90 and pay only $10 in tax, much better outcome on an after-tax basis.  Point: people make decisions on an after-tax basis, based on their marginal income tax rate.  Taxes affect incentives and affect the attractiveness of productive activity compared to leisure and tax avoidance.

Conclusions: changes in taxes will affect the LRAS.  High marginal income tax rates reduce output and decrease SRAS and LRAS. Lower marginal tax rates will stimulate the economy by increasing the incentive to work, save and invest, and increase SRAS and LRAS.  See graph page 280.

Three reasons that high marginal income tax rates reduce output:

1. High INCOME tax rates discourage work effort. Faced with high marginal tax rates, above 50% for example, many workers will work less or not work at all.

For example, they will not work overtime, or will work less overtime, or they will work fewer hours. Substitute leisure for work. Higher tax rates make leisure more desirable and affordable. They will not work two jobs. Why work part-time on Sat if taxes take more than half your pay?

For married couples facing high marginal taxes, they may decide that one spouse will only work part time instead of full time, or maybe not work at all.  If a married couple is in the 90% marginal tax bracket with just one spouse working, then the couple will only get to keep 10% of the other spouse's income.  The high marginal tax rates will provide disincentives to work, for a household deciding on the number of hours the household will provide to the economy.

Faced with high tax rates, people will take more vacation time. Higher tax rates make vacations less expensive. Vacation results in foregone income - the opportunity cost of vacation is the lost income.  If you make $10,000 / month, a vacation will "cost" you only $1000 of foregone income at the 90% tax rate, but will cost you $9000 at the 10% tax rate.

People will leave the country if tax rates are too high. And it will usually be the highest paid, most talented people that leave. Brain drain.

Because fewer hours are worked as a result of disincentives, higher INCOME tax rates will reduce output, decrease SRAS and LRAS.

2. High tax rates on capital investment (Cap Gains taxes) discourage investment in productive activities, and result in investment disincentives, the same as the income disincentives above.  High cap gains taxes here will discourage foreign investment in U.S., and may encourage a capital outflow. Domestic investors look overseas for more favorable tax treatment.

In addition to the quantity of investment, investors trying to avoid taxes will change investment strategy and invest in tax-shelters, regardless of whether the project is productive. In high tax environments, investments are made based on tax considerations, not on whether it is a productive, economic investment. "Malinvestment" in tax shelters results in less output, less efficient use of scarce capital, LRAS decreases.

3. High marginal tax rates encourage spending on less-desired tax-deductible goods, resulting in an inefficient use of resources. Companies and individuals (self-employed) may spend money on frivolous or unnecessary items, just because they are tax-deductible and result in tax savings. As business expenses, they are fully tax-deductible, so they reduce tax liability. You don't have to bear the full cost.

For example, at the 90% tax bracket, spending $1000 on a tax-deductible item, saves $900 in taxes if it was reported as income, so that you only have to pay 10% of the cost of the item, out of pocket. You have an incentive to spend money on plush offices, Hawaiian bus conferences, fringe benefits (luxury cars, limousine rides, airplanes, corp. yachts, etc.). Even though the spending is beneficial, some of it may be wasteful or inefficient, resulting in less output. Taxes are distorting the allocation of resources, reducing LRAS.

Policy conclusion: reduce marginal income tax rates and/or cap gains tax rates to stimulate the economy. More people will work, people will work harder, people will have more of an incentive to start businesses, save money, invest in businesses. Lower taxes will result in more capital investment and capital formation. People will shift away from leisure to work, away from income tax avoidance, away from inefficient investing for tax avoidance to efficient investing for econ reasons, away from inefficient spending for tax consequences to spending for what is really beneficial.

These increased incentives for productive behavior/activity - working, saving and investing - will lead to increased output, increased LRAS.  Point: there will be a permanent shift of LRAS due to increased productivity and increased efficiency leading to permanently higher output. Long-run growth oriented strategy. Cut taxes on productive activity, and then get out of the way. More market oriented approach. Provide the correct incentives and let the econ grow.

Evidence of Supply Side Effects: See graph, page 282, which looks at the share of total taxes paid by the richest 1/2 of 1% of U.S. taxpayers over time.  There were three major income tax reductions over the last 40 years, 1964-65, 1981 and 1986, and a cut in the capital gains tax (1997), and after each tax cut, the share of taxes paid by the "super-rich" went up, confirming the prediction of the Supply Side model.  Notice also that the super-rich paid a much larger percentage of all taxes paid when the top marginal income tax rate was less than 40% (1986-1998) compared to the 1960s and 1970s when the top tax rate was 70-91%!   

See page 283 for a Thumbnail Sketch comparison of expansionary fiscal policy according to the four models.
 

FISCAL POLICY - EMPIRICAL EVIDENCE

1. Automatic stabilizers do increase the budget during a recession and reduce the deficit during an expansion, provide some countercyclical fiscal policy. See graph page 284. During recessions, yellow shaded areas, the deficit increased. Between recessions, during expansions, the deficit decreased. There is little evidence that it was discretionary fiscal policy that provided stabilization, it was more from automatic stabilizers.

2. Evidence of a Laffer curve effect. Tax cuts of the early 1980s did raise Tax Revenues overall during the 1980s. Tax increases in 1990 lowered tax revenues.

3. There is some evidence linking higher deficits to higher int. rates in U.S. over long periods of time, but limited evidence on a yearly basis.   The majority of studies find no evidence of crowding out (deficits raise int rates), providing more support for the new classical model.

a. Empirical testing issues - deficits raise which int. rate? 1 year, or 30 year? Nominal or real int. rate? Real or nominal deficit, or deficit as a percentage of GDP?

b. Capital inflow from abroad keeps int. rates low by providing supply of capital. Open economy vs. closed economy.

c. Hard to separate the effects of passive vs. active budget deficits. Passive deficits wouldn't be expected to raise int. rates as much as active deficits. During a recession, demand for credit is weak, putting downward pressure on int. rates, resulting in LOWER int. rates. Recessions generate both DEFICITS and LOWER INT RATES. We would expect discretionary active deficits to generate higher int. rates when they are stimulating the economy and competing with private borrowing. We can't always accurately distinguish between active and passive deficits.

 

CURRENT VIEW OF FISCAL POLICY

We started this century with the Classical Model as the prevailing view of the economy, which fell out of favor in the 1930s during the Great Depression.  Keynesian view of the importance of fiscal policy emerged in the 1930s, and by the 1960s economists and politicians had embraced the Keynesian view of fiscal policy.  Starting in the 70s with stagflation, the Keynesian view was discredited, leading to a revival of the Classical Model as the New Classical Model (Rational Expectations Revolution).  As the book says, we have come full circle, back to the classical model, economists have very little confidence in the effectiveness of activist fiscal policy.   May take a while for politicians to agree.... Also elevates the role of monetary policy.