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Ch. 10: The Federal Ch. 10: The Federal Budget and Fiscal Budget and Fiscal PolicyPolicy

James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts UniversityUniversity©2005 Thomson Business & Professional Publishing, A Division of Thomson ©2005 Thomson Business & Professional Publishing, A Division of Thomson LearningLearning

22

Government Spending as Government Spending as a Percentage of GDP, a Percentage of GDP, 20032003

19.2

18.618.4

18.6

19.4

19.9

17.5

18

18.5

19

19.5

20

20.5

1998 1999 2000 2001 2002 2003

Year

Per

cen

t

33

Dollar Amounts Spent in Dollar Amounts Spent in Various Spending Programs, Various Spending Programs, 20032003

Spending Program Category Billions of Dollars

National Defense $404

Social Security $471

Medicare $274

Medicaid $161

Unemployment Compensation $55

Food Stamps $25

Family Support $26

Child Nutrition $12

Veterans' Benefits $29

Federal Civilian Retirement Benefits $58

Administration of Justice $35

Science, space and technology $20

Agriculture $22

Net Interest on the Public Debt $153

44

Government Tax Revenues Government Tax Revenues as a Percentage of GDP, as a Percentage of GDP, 20032003

20.0 20.0 20.919.8

17.916.5

0.0

5.0

10.0

15.0

20.0

25.0

1998 1999 2000 2001 2002 2003

Year

Per

cen

t

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Government Tax Government Tax Revenues by Type of Tax, Revenues by Type of Tax, 20032003

Tax Billions of DollarsPercentage of 2003

GDP

Individual Income Tax $794 7.3

Corporate Income Tax $132 1.2

Social Security Taxes $713 6.6

Other $143 1.3

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Government Tax Revenues Government Tax Revenues in Billions of Dollars, 2000-in Billions of Dollars, 2000-20032003

YearIndividual Income

TaxCorporate Income

TaxSocial

Security

2000 $1,004 $207 $653

2001 $994 $151 $694

2002 $858 $148 $700

2003 $794 $132 $713

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Income Tax StructureIncome Tax Structure

Progressive Income TaxProgressive Income Tax: the tax rate : the tax rate increases as a person’s taxable income increases as a person’s taxable income level rises. A progressive tax is usually level rises. A progressive tax is usually capped at some tax rate.capped at some tax rate.

Proportionate Income TaxProportionate Income Tax: the same : the same tax rate is used for all levels. This is tax rate is used for all levels. This is sometimes called a flat tax.sometimes called a flat tax.

Regressive Income TaxRegressive Income Tax: the tax rate : the tax rate decreases as a person’s taxable income decreases as a person’s taxable income level rises.level rises.

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Exhibit 1: Three Exhibit 1: Three Income Tax StructuresIncome Tax Structures

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Who Pays the Tax?Who Pays the Tax?

Income Group

Group's Share of Total Income

Group's Share of Federal Income Taxes

Top 1 % 17.5% 33.9%

Top 5 % 32.0% 53.3%

Top 10 % 43.1% 64.9%

Top 25 % 65.2% 82.9%

Top 50 % 86.2% 96.1%

Bottom 50 % 13.8% 3.9%

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The Federal BudgetThe Federal Budget

Budget DeficitBudget Deficit: government : government expenditures > tax revenues.expenditures > tax revenues.

Budget SurplusBudget Surplus: government : government expenditures < tax revenues.expenditures < tax revenues.

Balanced BudgetBalanced Budget: : government expenditures = government expenditures = tax revenuestax revenues

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Projected U.S Budget Projected U.S Budget DeficitsDeficits

YearProjected Budget Deficit

(billions of dollars)

2005 348

2006 298

2007 308

2008 318

2009 312

2010 298

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Deficits and the Public Deficits and the Public DebtDebt

Cyclical deficitCyclical deficit: the part of the budget : the part of the budget deficit that is a result of a downturn in deficit that is a result of a downturn in economic activity.economic activity.

Structural deficitStructural deficit: the part of the budget : the part of the budget deficit that would exist even if the economy deficit that would exist even if the economy were operating at full employment.were operating at full employment.

Total Budget DeficitTotal Budget Deficit = Cyclical Deficit = Cyclical Deficit + + Structural DeficitStructural Deficit

Public debtPublic debt: the total amount the federal : the total amount the federal government owes its creditors. government owes its creditors.

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Fiscal PolicyFiscal Policy

Fiscal PolicyFiscal Policy: changes in : changes in government expenditures government expenditures and/or taxes to achieve and/or taxes to achieve particular economic goals, such particular economic goals, such as low unemployment, price as low unemployment, price stability, and economic growth.stability, and economic growth.

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Fiscal Policy Fiscal Policy DefinitionsDefinitions

Expansionary Fiscal Expansionary Fiscal PolicyPolicy: Increases in : Increases in government expenditures government expenditures and/or decreases in taxes to and/or decreases in taxes to achieve particular economic achieve particular economic goals.goals.

Contractionary Fiscal Contractionary Fiscal PolicyPolicy: Decreases in : Decreases in government expenditures government expenditures and/or increases in taxes to and/or increases in taxes to achieve macroeconomic achieve macroeconomic goals.goals.

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Fiscal Policy Fiscal Policy DefinitionsDefinitions

Discretionary Fiscal Discretionary Fiscal PolicyPolicy: deliberate : deliberate changes of government changes of government expenditures and/or taxes expenditures and/or taxes to achieve particular to achieve particular economic goals.economic goals.

Automatic Fiscal PolicyAutomatic Fiscal Policy: : changes in government changes in government expenditures and/or taxes expenditures and/or taxes that occur automatically that occur automatically without (additional) without (additional) congressional action.congressional action.

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Two Key AssumptionsTwo Key Assumptions

Only deal with discretionary fiscal Only deal with discretionary fiscal policy.policy.

Any change in government Any change in government spending is due to a change in spending is due to a change in government purchases and not to government purchases and not to a change in transfer payments.a change in transfer payments.

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Demand-Side Fiscal Demand-Side Fiscal PolicyPolicy A change in consumption, A change in consumption,

investment, government purchases, investment, government purchases, or net exports can change aggregate or net exports can change aggregate demand and therefore shift the AD demand and therefore shift the AD curve.curve.

A change in taxes can affect A change in taxes can affect consumption or investment or both consumption or investment or both and therefore can affect aggregate and therefore can affect aggregate demand.demand.

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Exhibit 2: Fiscal Policy in Keynesian Exhibit 2: Fiscal Policy in Keynesian Theory: Ridding the Economy of Theory: Ridding the Economy of Recessionary and Inflationary GapsRecessionary and Inflationary Gaps

1919

Crowding OutCrowding Out

Refers to a decrease in private Refers to a decrease in private expenditures that occurs as a consequence expenditures that occurs as a consequence of increased government spending or the of increased government spending or the financing needs of a budget deficit.financing needs of a budget deficit.

– Direct substitution of public spending for Direct substitution of public spending for private spending.private spending.

– A drop in investment due to a higher A drop in investment due to a higher interest rate from financing the deficit.interest rate from financing the deficit.

2020

Crowding OutCrowding Out

Complete Crowding OutComplete Crowding Out: a : a decrease in one or more components decrease in one or more components of private spending completely offsets of private spending completely offsets the increase in government spending.the increase in government spending.

Incomplete Crowding OutIncomplete Crowding Out: the : the decrease in one or more components decrease in one or more components of private spending only partially of private spending only partially offsets the increase in government offsets the increase in government spending.spending.

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Exhibit 3: Zero (No), Incomplete, and Complete Crowding Out

2222

Exhibit 4: Expansionary Fiscal Policy (Government Spending Increases), Crowing Out, and Changes in Real GDP and the Unemployment Rate

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The New Classical View of The New Classical View of Fiscal PolicyFiscal Policy

Current consumption will fall as a Current consumption will fall as a result of expansionary fiscal policy.result of expansionary fiscal policy.

Deficits do not necessarily bring Deficits do not necessarily bring higher interest rates.higher interest rates.

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Exhibit 5: The New Classical View of Expansionary Fiscal Policy

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Lags And Fiscal PolicyLags And Fiscal Policy

1.1. The Data LagThe Data Lag

2.2. The Wait-And-See LagThe Wait-And-See Lag

3.3. The Legislative LagThe Legislative Lag

4.4. The Transmission LagThe Transmission Lag

5.5. The Effectiveness LagThe Effectiveness Lag

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Exhibit 6: Fiscal Policy Exhibit 6: Fiscal Policy May Destabilize the May Destabilize the EconomyEconomy

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Self-TestSelf-Test

How does crowding out question the How does crowding out question the effectiveness of expansionary demand-effectiveness of expansionary demand-side fiscal policy?side fiscal policy?

According to new classical economists, According to new classical economists, how do individuals respond to larger how do individuals respond to larger deficits? What changes do they deficits? What changes do they anticipate in the credit or loanable funds anticipate in the credit or loanable funds market as a result of a larger deficit?market as a result of a larger deficit?

How might lags reduce the effectiveness How might lags reduce the effectiveness of fiscal policy?of fiscal policy?

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Supply-Side Fiscal Supply-Side Fiscal PolicyPolicy Ceteris Paribus, lower marginal tax rates Ceteris Paribus, lower marginal tax rates

increase the incentive to engage in increase the incentive to engage in productive activities relative to leisure productive activities relative to leisure and tax avoidance activities.and tax avoidance activities.

Marginal Tax Rate = (Marginal Tax Rate = (Δ Tax payment)Δ Tax payment) (Δ Taxable Income)(Δ Taxable Income)

Average Tax Rate = Total tax paymentAverage Tax Rate = Total tax payment Taxable IncomeTaxable Income

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Exhibit 7: The Predicted Effect of a Exhibit 7: The Predicted Effect of a Permanent Marginal Tax Rate Cut on Permanent Marginal Tax Rate Cut on Aggregate SupplyAggregate Supply

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The Laffer Curve: Tax The Laffer Curve: Tax Rates and Tax Rates and Tax ReturnsReturns

If income tax rates were lowered, would If income tax rates were lowered, would it increase or decrease tax revenue?it increase or decrease tax revenue?

There are two tax rates at which zero tax There are two tax rates at which zero tax revenues will be collected – 0 and 100%.revenues will be collected – 0 and 100%.

An increase in tax rates could cause tax An increase in tax rates could cause tax revenues to increase.revenues to increase.

A decrease in tax rates could cause tax A decrease in tax rates could cause tax revenues to increase.revenues to increase.

Tax revenues = (Tax base) x (the Tax revenues = (Tax base) x (the average Tax rate)average Tax rate)

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Exhibit 8: The Laffer Exhibit 8: The Laffer CurveCurve

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Exhibit 9: Tax Rates, the Exhibit 9: Tax Rates, the Tax Base, and Tax RevenuesTax Base, and Tax Revenues

3333

Macroeconomics Macroeconomics IntermissionIntermission

How Does the How Does the Economy Work?Economy Work?

1.1. Is it Self-Is it Self-regulating?regulating?

2.2. Is it Inherently Is it Inherently unstable?unstable?

3.3. Will a fiscal policy Will a fiscal policy have its intended have its intended effect?effect?

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Self-TestSelf-Test

Give an arithmetical example to Give an arithmetical example to illustrate the difference between illustrate the difference between the marginal and average tax the marginal and average tax rates.rates.

If income tax rates rise, will If income tax rates rise, will income tax revenue rise as well?income tax revenue rise as well?

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Exhibit 10: Macroeconomists’ Views on Two Issues: How the Economy Works and the Effectiveness of Fiscal Policy

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Coming Up (Ch. 11): More on Coming Up (Ch. 11): More on Government Spending and Taxes: Government Spending and Taxes: Beyond Fiscal PolicyBeyond Fiscal Policy