Fiscal Policy and Public

Expenditure
Module 10
 Fiscal Policy

• Deliberate changes in:

• Government spending
• Taxes
• Designed to:
• Achieve full-employment
• Control inflation
• Encourage economic growth

LO1 31-2
 Expansionary Fiscal Policy

• Use during a recession

• Increase government spending
• Decrease taxes
• Combination of both
• Create a deficit

LO1 31-3
 Contractionary Fiscal Policy

• Use during demand-pull inflation

• Decrease government spending
• Increase taxes
• Combination of both
• Create a surplus

LO1 31-4
 Policy Options: G or T?

• To expand the size of government

• If recession, then increase government
spending
• If inflation, then increase taxes
• To reduce the size of government
• If recession, then decrease taxes
• If inflation, then decrease government
spending

LO1 31-5
 Built-In Stability

• Automatic stabilizers
• Taxes vary directly with GDP
• Transfers vary inversely with GDP
• Reduces severity of business fluctuations
• Tax progressivity
• Progressive tax system
• Proportional tax system
• Regressive tax system
31-6
 Evaluating Fiscal Policy

• Is the fiscal policy…

• Expansionary?
• Neutral?
• Contractionary?
• Use the cyclically adjusted budget to evaluate

LO3 31-7
 Cyclically Adjusted Budgets

Government expenditures, G, and

tax revenues, T (billions)

b a
$500 G

450 c

GDP2 GDP1
(year 2) (year 1)
LO3 31-8
Real domestic output, GDP
 Cyclically Adjusted Budgets

T1

Government expenditures, G, and T2

tax revenues, T (billions)

e d
$500 G
475 h
450 f
425 g

GDP4 GDP3
(year 4) (year 3)
LO3 31-9
Real domestic output, GDP
 Fiscal Policy: The Great Recession

• Financial market problems began in 2007

• Credit market freeze
• Pessimism spreads to the overall
economy
• Recession officially began December
2007 and lasted 18 months

LO4 31-10
 Problems, Criticisms, & Complications

• Problems of Timing
• Recognition lag
• Administrative lag
• Operational lag
• Political business cycles
• Future policy reversals
• Off-setting state and local finance
• Crowding-out effect
LO5 31-11
 Current Thinking on Fiscal Policy

• Let the Federal Reserve handle short-term

fluctuations
• Fiscal policy should be evaluated in terms of
long-term effects
• Use tax cuts to enhance work effort,
investment, and innovation
• Use government spending on public capital
projects

LO5 31-12
 The U.S. Public Debt

• $16.4 trillion in 2012

• The accumulation of years of federal deficits
and surpluses
• Owed to the holders of U.S. securities
• Treasury bills
• Treasury notes
• Treasury bonds
• U.S. savings bonds

LO5 31-13
 The U.S. Public Debt

LO5 31-14
 The U.S. Public Debt

• Interest charges on debt

• Largest burden of the debt
• 2.3% of GDP in 2012
• False Concerns
• Bankruptcy
• Refinancing
• Taxation
• Burdening future generations
LO5 31-15
 Substantive Issues

• Income distribution
• Incentives
• Foreign-owned public debt
• Crowding-out effect revisited
• Future generations
• Public investment

LO6 31-16
 Crowding-Out Effect

16

Real interest rate (percent)

14
Increase in
12 investment
b c demand
10

8
a
6
Crowding-out
4 effect
ID2
2
ID1
0 5 10 15 20 25 30 35 40
Investment (billions of dollars)

LO6 31-17
Social Security, Medicare Shortfalls

• More Americans will be receiving benefits as

they age
• Social security shortfalls
• Income during retirement
• Funds will be depleted by 2033
• Medicare shortfalls
• Medical care during retirement
• Funds will be depleted by 2024

31-18
Social Security, Medicare Shortfalls

• Possible options “to fix” include:

• Increasing the retirement age
• Increasing the portion of earnings subject
to the social security tax
• Disqualifying wealthy individuals
• Redirecting low-skilled immigrants to
higher-skilled, higher paying work
• Defined contribution plans owned by
individuals
31-19
 Government and the Circular Flow
(1) Costs

(2) Resources RESOURCE (2) Land, labor, capital

MARKET
Entrepreneurial Ability
(7) (8)
Expenditures Resources

(10) (9)
Goods and services Goods and services

BUSINESSES GOVERNMENT HOUSEHOLDS

Net taxes Net taxes
(11) (12)

(5) Expenditures (6) Goods and services

(4) (4)
Goods and services Goods and services
PRODUCT
MARKET
(3) Revenues (3) Consumption expenditures
18-20
LO1
 Government Finance

• Government purchases
• Exhaustive
• Transfer payments
• Nonexhaustive
• Borrowing and deficit spending
• Opportunity cost is low during recession; high during growth

18-21
LO2
 Government Finance
Government purchases, transfers, and total spending as
percentages of U.S. output, 1960 and 2012
40

35
Government
Percentage of U.S. output
30 transfer payments
15.3%
25 5%
20

15

10 22% Government 19.6%

Purchases
5

0
1960 2012
Year
18-22
LO2
 Federal Expenditures

18-23
LO3
 Federal Tax Revenues

• Personal income tax

• Progressive tax
• Marginal tax rate
• Payroll taxes
• Corporate income tax
• Excise taxes

18-24
LO3
 Federal Tax Revenues
Federal Personal Tax Rates, 2013*
(3)
(4)
(1) (2) Total Tax
Average Tax Rate on
Total Taxable Marginal Tax on Highest
Highest Income in
Income Rate, % Income in
Bracket % (3) / (1)
Bracket

$1-$17,850 10 $ 1785 10
$17,851-$72,500 15 9983 14
$72,501-$146,400 25 28,458 19
$146,401-$223,050 28 49,920 22
$223,051-$398,350 33 107,769 27
$398,351-$450,000 35 125,847 28
$450,001 and above 39.6

LO3 * For a married couple filing a joint return 18-25

 State Finances

18-26
LO4
 Local Finances

18-27
LO4
 Local, State, and Federal Employment

18-28
LO5
 Apportioning the Tax Burden

• Size, distribution, and impact of the costs that taxes impose on

society
• Benefits-received principle
• Ability-to-pay principle

18-29
LO6
 Apportioning the Tax Burden

• Progressive tax – average tax rates increase as income

increases
• Regressive tax – average tax rate declines as income
increases
• Proportional tax – average rate stays the same as income
increases

18-30
LO6
 Tax Incidence and Efficiency Loss

• Tax incidence
• Who really pays the tax?
• Excise tax
• Tax burden depends on elasticity
• Inelastic vs. elastic
• Efficiency loss/deadweight loss
• Transfer of surplus to government

18-31
LO7