Chapter 11 - Modern Macroeconomics: Fiscal Policy

We now look at Fiscal Policy. We assume that MS is fixed. Hold monetary policy constant.

Fiscal policy = Tax and Spend by President and Congress.

Budget Deficits and Surpluses - Since fiscal policy involves tax and spend (inflow/outflow) we start by discussing Budget Surpluses and Deficits.

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

Budget Deficit = Gov Spending > Gov Rev

Budget Surplus = Gov Rev > Gov Spending 1958-1996 Deficit every year except 1969 (surplus). See back of book.

Deficit vs. National debt - Deficit is an annual concept (Income stmt). National debt is the accumulation of deficits.

Federal budget is the primary tool of fiscal policy - attempt at stabilization and fine-tuning. Budget deficits happen for two reasons:

1. Active Budget deficits - result from deliberate, discretionary fiscal policy where policymakers plan to spend more than is generated in revenue.

2. Passive budget deficit - without a change in fiscal policy, deficit increases during recession. Tax receipts are down during recession. Tax receipts go up during expansion, deficit shrinks.

Our deficits are mostly active.

Keynesian View of Fiscal Policy - Before Keynes balanced budgets were generally accepted by politicians and the public as the responsible thing. Keynesian view challenged the desirability of balanced budgets. Argued that federal budget should be used to promote AD/full employment.

Fed Budget influences AD two ways:

1. Gov spending on goods and services stimulates AD (G in C+I+G). National defense, highways, education, etc.

2. Tax policy influences AD. Tax cut increases disposable income, increases PCE - C goes up. Bus tax cut increases business investment on equipment, etc.

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, gov should engage in Expansionary Fiscal Policy - increase gov spending and/or reduce taxes, increase budget deficit. Borrow money (to finance the deficit) from individuals, businesses or foreigners.

Example - page 270. Economy is in recession at e1 due to animal spirits. Downward pressure on prices. Economy slowly adjusts from e1 to E3 in the classical model by SRAS going from SRAS1 to SRAS3. Or expansionary fiscal policy could increase AD1 back to AD2 and the economy goes back to E2.

Expansionary fiscal policy (active budget deficit) - some combination of i) cut personal income taxes, ii) cut corporate taxes, iii) increase gov spending.

Example: page 271. Economy expands due to increased AD/animal spirits. Upward pressure on prices, wages, int rates will eventually increase SRAS1 to SRAS3 at a higher price level. Animal spirits leading to inflation. Gov can pursue Restrictive Fiscal Policy to reduce AD1 to AD2.

Restrictive fiscal policy - Reduce Gov spending and/or increase in tax rates to help stabilize demand. Run a budget surplus (or smaller deficit).

Keynesian view - Gov should engage in activist, discretionary, Countercyclical Policy to stabilize economy. Run deficit during recession to stimulate (increase) AD. Run surplus during expansion to restrain (decrease) AD.

Since budget deficits are now permanent, restrictive policy now means a smaller deficit, NOT a surplus. If deficit goes from $200B to $100B, that is restrictive, even though there is still a deficit.


FISCAL POLICY AND CROWDING OUT -

There are secondary effects of countercyclical policy that weaken the potency of activist, discretionary policy - 1) "crowding out" effect and 2) foreign exchange effect.

1. Crowding Out:

Scenario I - econ is in recession. Government runs budget deficit to stimulate the econ back to full output. Deficit requires borrowing. Gov borrowing puts upward pressure on int rates. Gov competes for limited funds with businesses. At higher int rates, private investment gets "crowded out." Less private investment at higher interest rates, so 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 - econ is expanding. Government decreases spending and/or raises taxes and runs smaller budget deficit. Reduces demand for credit, putting downward pressure on int rates. Lower int rates stimulate the economy and may prevent the economy from returning to full output - econ will stay above full output.

2. If deficits raise int rates, the higher int rates attract foreign investment. Increased demand for investment in US increases demand for dollars. Dollar appreciates, foreign currency depreciates. Exports go down, Imports go up. Net exports fall. AD falls.

Crowding out and foreign exchange effect lessen 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.


TIMING PROBLEMS FOR FISCAL POLICY -

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. Due to the problems of LAGS, it is highly unlikely that fiscal policy will ever be effective. See page 393.

THREE LAGS that present major problems for effective fiscal policy:

1. Recognition lag - the 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 Jan!

2. Administrative/legislative Lag - time to implement a policy to correct the course of the economy. Pass legislation to increase/decrease taxes, increase/decrease the deficit, offer ITCs, etc. Both the House and Senate have to agree, has to be signed by the president, could be a veto, etc. Administrative lag could be measured in years.

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

Problem: for fiscal policy to really be effective, policymakers would have to know at least a year in advance what was going to happen to the economy.

For example, if we somehow knew now that there would be a recession in late 1998 and that the proper tax stimulus package would help the economy, we would have to start preparing legislation now that would get passed at the end of 1997 and would start to stimulate the economy in late 1998. 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 stabilize the economy, it will de- stabilize the economy. See page 279.  Like throwing gasoline on a fire.

Two possible scenarios:

1. Economy starts at AD0, goes into recession to 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. The anti- recession policies take effect when it is not needed, pushing the economy to an inflationary AD2 and e2 - policy then de-stabilizes the economy.

2. Economy is in expansion at AD2. Legislation is passed to slow econ down - restrictive fiscal policy - tax increases. Econ self-corrects to AD0 when the policy takes effect and causes a recession by pushing the economy to AD1 and e1 - policy then destabilizes the economy, doesn't stabilize.



AUTOMATIC STABILIZERS -

In terms of the problems that lags pose for fiscal policy, there are several fiscal programs that provide countercyclical policy and take effect automatically, without a change in legislation.

1. 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 imposed on businesses will decrease because of the reduction in employment. Gov spend goes up, Gov Tax Receipts go down, pushing the budget toward a deficit during a recession, supplying the expansionary fiscal policy at the right time.

During an expansion, Un comp pmts go down, Un comp taxes go up. Gov spending fall, gov receipts rise, so the budget moves toward a surplus (restrictive fiscal policy) at the right time.

2. Corporate profit tax receipts are highly sensitive to econ conditions and thus highly cyclical, going up during an expansion and falling during a recession. By going down during a recession, falling corp taxes help move the budget toward a deficit during a contraction.

3. Progressive inc 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. When incomes are falling, people move to lower tax brackets, reducing inc tax receipts and moving the econ toward a deficit.

Conclusion, during a recession, budget automatically moves toward a deficit, due to: increased un payments, decreased un taxes, corp taxes and personal inc taxes.

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


NEW CLASSICAL VIEW OF FISCAL POLICY

Conclusion: Fiscal policy is completely impotent. Expansionary fiscal policy (budget deficits) won't work at all.

Keynesian assumption: Econ in recession, Stimulate with $50B tax cut financed by $50 new debt, run budget deficit, increase AD, econ goes back to full output. Main assumption: tax cut of $50B will be spent by consumers, C goes up by $50B, AD goes up by $50B.

New Classical View - People are rational and forward looking and have "rational expectations" of the future and financial markets are efficient. People will figure out that a $50B tax cut now will mean a $50B tax increase later, and they wont be fooled by the illusion of a "tax cut" now for a tax increase later. 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.

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

Example: Your income is $100, taxes are 10, disposable income is $90, C=90, S=0. You get a $5 tax cut, financed by gov debt, so your disp inc is now $95. New classical says that: C=90, S=5, C has not changed. You save the entire tax cut. If all households do this, AD is the same.

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 it doesn't hold, there is still crowding out, which dampens the effect of fiscal policy.

The combined problems of 1) lags, 2) crowding out/foreign exchange effect and 3) the possibility that some of tax cuts are saved all present very serious challenges for discretionary fiscal policy to have the desired effect of 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 does the tax cut go to? For child care, education, charitable contributions, etc??


MODERN VIEW OF FISCAL POLICY
(Accepted by most Keynesian and non-Keynesians)
1. When substantial unused capacity is present during a recession, expansionary fiscal policy may be able to help stimulate the economy back to full employment.

2. During normal econ times, fiscal policy is relatively ineffective at stimulating AD, due to the secondary effects of crowding out, exports declining and/or people saving tax cuts.

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 econ 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 econ looks at how incentives change.

Conclusion: High marginal income tax rates reduce output. Lower marginal tax rates will stimulate the economy by increasing the incentive to work, save and invest.

Three reasons that high marginal inc tax rates reduce output:

1. High INCOME tax rates discourage work effort. Faced with high marginal tax rates, like 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. They will not work two jobs. Why work part-time on Sat if taxes take more than half your pay?

One spouse may quit work or not bother to work at all. Married couple, one works and is in the 90% tax bracket, the other spouse only gets to keep 10% of income.

People will take more vacation. Europe - take a month off. Higher tax rates make vacations less expensive.

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 disincentive, higher INCOME tax rates will reduce output.

2. High tax rates on capital investment, Cap Gains taxes, discourage investment in productive activities. High cap gains taxes discourage foreign investment, and may encourage a capital outflow. Domestic investors look overseas for more favorable tax treatment.

Investors try to avoid taxes and invest in tax-shelters, regardless of whether the project is productive. Investment is made, based on tax consequences, not the economic value. "Malinvestment" results in less output, less efficient use of scarce capital.

3. High marginal tax rates encourage spending on tax-deductible goods, resulting in inefficient use of resources. Companies and individuals (self- employed) may spend money on frivolous or unnecessary items, because they are tax-deductible. 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.

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. More 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.

See page 282. In response to tax cuts, either income and/or cap gains, LRAS1 goes to LRAS2. SRAS1 to SRAS2. AD1 to AD2. Yf to Yf'.

Point: permanent shift 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: Mixed. Hard to isolate effects of tax cuts. There was almost a ten year econ expansion after the tax cuts of the early 80s. Didn't stop until Bush raised taxes around 1990. Tax revenues for people in top inc brackets actually did go up in the 80s. If rates went down and rev went up, it had to be because they were working more and/or reporting more.

Top 1% paid 25% of tax revenues in 1990, top 5% paid 50%, as a group paid over 40% more in revenue in 1990 compared to 1980.

See page 285 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 page 286. 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.

Note: deficit spending has resulted in G spending as a percent of GDP to increase from about 18% in 1960 to 22% in 1995. See page 299.

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

3. There is little evidence linking higher deficits to higher int rates in US. Some reasons:

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.

See page 289. There is some evidence that deficits of the mid-80s were associated with high real int rates. But deficits remained high in the 90s, and int rates fell to the same level as during the early 60s. Note: graphical analysis is very crude.

4. The dollar appreciated and got very strong in the mid 80s - appreciated by 50% between 1980 and 1985. There was some crowding out due to the exchange rate effect. High deficits led to high real int rates, attracting foreign capital, which appreciated the dollar, which stimulated imports and decreased exports, and reduced AD. High deficits of the 1980s result in "crowding out" from the appreciation of the dollar.

Political View: Deficits cause higher int rates, so lower deficits will benefit everyone. Benefit of a balanced budget is lower int rates? Not necessarily the case. Weak link between int rates and deficits.

Possible danger of persistent or increasing deficits as a percentage of GDP: at some point the debt is so large that the government's creditworthiness is questioned, leading to possible risk premiums on government debt - higher interest rates. If this happens, fiscal policy is severely weakened as an effective policy tool.