•Keynesian view•Discretionary versus non-discretionary fiscal policy•The automatic stabilizers•Fiscal policy to close a contractionary gap.•Fiscal policy to close an expansionary gap.•Problems with fiscal policy•Principles of taxation•The Federal Deficit and the National Debt

The use of the taxing and spending powers of government to regulate aggregate expenditure, and thereby to stabilize the economy

The use of the taxing and spending powers of government to regulate aggregate expenditure, and thereby to stabilize the economy

The economy needs to be stabilized. The economy

can be stabilized. The economy should be

stabilized. This is the Keynesian view

This legislation established a

responsibility for the federal government to

promote “maximum employment,

production, and purchasing power.”

Discretionary fiscal policy is the deliberate manipulation of government purchases, taxation, and transfer payments to pursue macroeconomic goals such as full employment and price stability.

The Bush tax stimulus package of 2008 and the Obama stimulus

package of 2009 are examples of discretionary fiscal policy

3

4

5

6

7

2.0

2.2

2.4

2.6

2.8

90 92 94 96 98 00 02 04 06

Defense Spending Non-Defense Spending

Federal Spending as a Percent of GDP, 1990-2007

Source: Bureau of Economic Analysis

Non-discretionary or “built-in” features of government spending and taxation that reduce fluctuations in disposable income, and thus consumption, over the business cycle.

Non-discretionary or “built-in” features of government spending and taxation that reduce fluctuations in disposable income, and thus consumption, over the business cycle.

•Tax rates for various types of income are set by elected officials. Tax collections depend on the employment levels/incomes, profits, capital gains, retails sales, . . .•Elected officials establish eligibility requirements and support levels for needs-tested transfer payments—e.g., TANF, food stamps, and unemployment compensation. Actual government outlays for needs-tested transfer payments depend on (1) the number of persons eligible; and (2) the number of those eligible that actually file claims.

As the economy enters a recession, federal revenues tend to decline while at the same time transfer payments rise. Thus recession

brings about an automatic decline of net taxes (NT)

DINTY

Remember that: DI = Y - NT

DINTY

Real GDP0

G, T Potential GDP

G

T = TX - TR

Y1

DeficitBalanced budget at full-employment

If a lack of aggregate expenditure is the problem, why not use the

spending and taxing powers of the federal government to stimulate

aggregate expenditure

How Fiscal Policy WorksMTRMPMMPC

GGDPY

1

1

AE

Real GDP0 Y1

AE1

YFE

Full employment GDP

AE2

G

The preceding slide illustrates the type of

expansionary fiscal policy that Keynesians

recommend for recession. We will now use the AS-AD

framework to illustrate contractionary fiscal policy.

Potential GDP

AS

AD1

Real GDP

Price Level

0

AD2

Modeling Contractionary Fiscal Policy

Y1

)( MXGIbNTa

AEAEAE’

Real GDP (Y)Y YF

YF is full-employment (potential) GDP.

Contractionary gap

•Increase in G•Decrease in NT

1. Policy lags2. Permanent income

•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.

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

Principles of Taxation

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

Gross Income: $35,000

Minus: Standard deduction

7,050

Equals: Taxable income

$27,950

•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.

•Progressive tax: The proportion of taxable income taken in taxes increases as taxable income increases.

•Regressive tax: The proportion of taxable income taken in taxes decreases as taxable income increases.

•Proportional tax: The proportion of taxable income taken in taxes remains constant as taxable income increases.

AffluentNeedy

By making the tax structure

“progressive,” governments can

make the after-tax distribution of income

more equitable (or even).

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)

Income Tax Ave. Tax Rate Marginal Tax Rate$10,000 $0 0% 0%20,000 272 1.4 1530,000 1,766 5.9 1550,000 4,766 9.5 1575,000 10,315 13.8 28

150,000 32,140 21.4 31250,000 66,802 26.7 36400,000 128,710 32.2 39.6

Average and Marginal Tax Rates under the Tax Reform Act of 1993 (for a couple with 2 children)

2003 Taxable Income Marginal Tax Rate

$0-$12,000 10.0%

$12,000-$47,500 15.0

$47,500-$114,650 27.0

$114,650-$174,700 30.0

$174,700-$311,950 35.0

Over $311,950 38.6

Tax Brackets for 2003 under the 2001 Tax Reform Act

Source : Wall Street Journal

Quick Facts about President Bush’s Tax Bill

•The 39.6% tax rate reduced to 33%

•The 36% tax rate reduced to 33%

•The 31% rate reduced to 25%

•The 28% rate reduced to 25%

•The current 15% bracket is retained over most of its range

•A new 10% bracket applies to the lowest ¼ of 15% range.

•Maximum rate on capital gains reduced from 28 to 15 percent. President Bush comments (wav)

Fun Fact: Of the $477 billion in federal tax cuts over 10 years, 52 percent go to the top 1 percent of households (average income: $343,000). Source: Center for Tax Justice

The Bush tax cuts are scheduled to expire in 2010. Senator

McCain favors renewing them—even though he voted against

the Bush tax bill in 2001. Senators Clinton and Obama support raising marginal rates

on capital gains and also for high income families.

Family

(1)

Income

(2)Spending for items subject to excise tax

(3)=

(2)/(1)

(4)

Excise Tax Paid

(5)=(4)/(1)

ATR

Greens $27,000 $16,200 .60 $1,188 4.4%

Jones 64,000 25,600 .40 1,871 2.9

Lemons 270,000 40,500 .15 2,961 1.0

Assume a 7.13 percent excise tax on groceries, gasoline, cigarettes, and liquor

Moral of the story: Low income families tend to spend a greater proportion of their income on items subject to excise taxes. Hence excise taxes tend to be regressive.

The Arkansas state sales tax on groceries was

reduced from 6 percent to 3 percent effective July

1, 2007

In the case of a federal deficit, the Treasury must borrow. The national debt

is the accumulated borrowing of thefederal government in all previous

fiscal years, minus what has been repaid

For updated information, check the National Debt Clock

Is a large national debt a bad thing?

Arguments against a large national debt include:

•The “burden on future generations” argument.

•A large national debt means that a significant share of federal spending must be allocated for interest payments—leaving less for other priorities.

•A large national debt makes the U.S. too dependent on foreign financial inflows.

•Federal borrowing “crowds out” private sector borrowing units—i.e., firms and households.

“[W]e (the U.S.) owe $5.7 trillion in debt and if we don’t pay it off, our children and our grandchildren are going to have to.”

Congressman Marion Berry, in a speech to the Jonesboro Lions Club on April 16, 2001.

Interest payments as a Percent of Federal Expenditures (Annual)

www.economagic.com

As long as the debt grows by the same percentage as nominal GDP, the ratios of debt to GDP will remain constant. In this case, the government can continue to pay interest on its rising debt without increasing the average tax rate in the economy.

National Debt Graph (2007 Budget data) Click image below to enlarge.

Who Owns the National Debt?

Source: Federal Reserve

3342 / 48%

463 / 7%

1271 / 18%

1814 / 26%

Privately Owned

Fed. Reserve Banks

Foreign Investors

Agencies and Trusts