Fiscal policy refers to the use of the spending and taxing powers of the federal government to manage aggregate demand, and thereby to stabilize the level of output, employment, and prices.

Under the Employment Act of1946, the Federal government is

to promote “maximum production, employment ,and purchasing power.”

AE AE = Y

Y

AE1

AE2

Y* Yf

G

Here weillustrate theuse of G to

stimulate AE andpush the economy to full-employment

Yf is potential GDP

Y

Y = G 1

1 - c + m

•Horizontal equity: Tax code should be written so that those in the same economic circumstances pay the same amount in taxes.

•Vertical equity: Tax code should be written so that those in different economic circumstances should pay an unequal amount in taxes.

•Ability to pay principle: Those with greater ability to pay taxes should pay more.

•Benefits received principle: Those who derive more benefits from government programs should pay more taxes.

If Madonna or Bill Gates paid the same amount

in taxes as an accountantor government employee,that would be vertically

inequitable

•Taxable income: Gross income - income exempt from taxes. Example: For single filers who use the 1040EZ:

Gross Income: $30,000

Minus:Standard deduction

6,250

Equals:Taxable income

$23,750

•Average tax rate (ATR): Tax payments as a percent of taxable income.

•Marginal tax rate (MTR): The tax rate applied to the last dollar of taxable income.

Family Taxable income ($) Taxes ATR

Smiths $17,500 $2,655 15%

Cunninghams 54,000 10,322.72 19.12

Zappas 158,000 41,313.49 26.15

Note that ATR and taxable income move in same direction

A progressive tax, such as thefederal personal income tax upon which this

example is based, is generally consistent with the principle of vertical equity

Family Taxableincome($)

Taxes ($) ATR

Smiths $17,500 $5,075 29%

Cunninghams 54,000 14,040 26

Zappas 158,000 37,920 24

Payroll and sales taxes on groceryitems, beer, and

cigarettes areregressive

Total TaxableIncome

Marginal TaxRate (%)

$0 0%

0-36,900 1536,901-89,150 28

89,151-140,000 31

140,001-250,000 36

250,000 and up 39.6

Federal personal Income Tax rates Under the 1993 Tax Reform Act (Married couple filing jointly)

Taxes (TX) and Transfer Payments (TR) are called “automatic stabilizers” because they react to changes in national income in a way that increases the federal deficit (or reduces the surplus) in the event of an economic contraction or reduces the deficit (increases the surplus) when the economy is expanding.

The automaticstabilizers make sure

that YD does notfall too much

when national incomeis falling

Remember that the federaldeficit or surplus is

equal to the differencebetween G and Net Tax Receipts,

where Net Taxes are equal toTX - TR

YTX, for example

YTX, and vice versa

YTR, for example

YTR, and vice versa

Note that claims for unemployment compensation and other assistance surges when unemployment rises.

National Income0

G, T Full-employment

G

T = TX - TR

YR

Deficit

YR is the recession-level of national income

Let:

• AE denote aggregate demand

• Y is real GDP

•TX is tax payments

•TR is transfer payments

•YD is personal disposable income

Thus, in a closed economy we have:

AE = C + I + G [1]

It is also true that:

YD = Y - TX + TR [2]

The full-employment model suggests that an increase in G must result in a compensating decrease in C or I--this is the “crowding out” effect

Government can increase YD by decreasing TX or increasing TR (reverse also holds true). Economists call transfer payments “negative taxes.”

Increased government spending crowds out investment

Investment function

Allow for an increase in G finance by increased taxes (TX). Note that:

YD = Y - TX + TR

Interest rate (r)

0

r1

r2

S function shifts left due to decrease in YD

I2I1 S, I

Crowding out