Episode 6


PURPOSE To show that a key element of Keynes’ contribution is that, at least in theory, the government can fine-tune tax and spending policies to reduce the severity of business cycle fluctuations.

1. Government spending on goods and services is an injection into the circular flow of the economy. As government purchases rise the demand for GNP rises and, assuming that the economy is below full capacity, GNP produced will rise. The rise in GNP is larger than the rise in government spending. In fact, it is equal to the rise in government spending times the multiplier.

2. Taxes have a similar but opposite effect on GNP. Moreover, the impact of taxes is indirect. A tax cut results in an increase in disposable or after-tax income. This additional income can either be saved or spent. Only that portion of the tax cut which is spent is considered an injection into the circular flow. Consequently, a tax cut of the same magnitude as a spending increase will usually have a smaller impact on GNP than the spending increase. Rises in transfer payments such as social security and welfare payments have the same impact on GNP as a tax cut.

3. Generally speaking, the larger the government deficit (taxes less spending) the larger will be the net injections into the circular flow and the larger will be the volume of the flow (GNP). The opposite is true for surpluses. Thus by changing the spending and tax policies the government can, in the abstract, stimulate growth in the economy or slow the economy down.

4. The U.S. economy also has a number of built-in stabilizers which raise the deficit (lower the surplus) in recessions and lower the deficit (raise the surplus) in recoveries. These include unemployment benefits and welfare payments which rise when GNP is falling and vice versa. The progressive structure of the U.S. tax structure also serves as a stabilizer. In a recession tax receipts are lower because of higher unemployment. This means that the deficit is larger. The reverse is true in periods of high growth.

aggregate demand management, budget surplus and deficit, lump-sum tax, proportional tax
progressive tax, recessionary and inflationary gaps, automatic stabilizers, balanced budget multiplier, government purchases, government transfers.

Contemporary Issues
Fiscal Policy

The 2001 recession in the U.S. was one of the mildest in the post-war period. The mildness of this downturn was in part due to aggressive interest rate cuts by the Fed. However, fiscal policy also played a big role. Tax cuts that took effect in mid-2001 helped, as the did the increase in spending on defense and homeland security in the wake of the terrorist attacks of September 11 of that year. How do tax cuts and increases in defense spending boost GDP? Dollar-for-dollar which has a bigger impact on the economy?

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Full Employment
The lessons of the depression and war convinced economists and politicians alike that the government could prevent hardship and promote prosperity by manipulating taxes and spending.

Ultimately it was the war that put an end to the Depression. By 1944, twelve million men and women were in uniform, and 66 million more had jobs supporting the mightiest war machine. After WWII there was a fear that the economy could slip back into a Depression if the government’s spending used to maintain full employment for the war effort was removed. FDR introduced a second Bill of Rights which included the right to a useful and remunerative job in the industries, or shops, or farms, or mines throughout the nation. Out of this came the Full Employment Bill. Before the bill was passed FDR died, and Vice President Harry S. Truman took over the office of the President. As President Truman signed the Employment Act of 1946 which no longer referred to full-employment instructing the government instead to promote maximum employment, production, and purchasing power. The passage of the Employment Act of 1946 marked the commitment of the government to use its considerable power to insure that prosperity continued.

Comment and Analysis by Richard Gill
The rational for using fiscal policy to maintain economic stability was very much influenced by the ideas of John Maynard Keynes who stated that total private spending on consumer goods and business investment might be insufficient to sustain national income at the full employment level. The solution was to increase government spending to fill the gap.
Dwight Eisenhower and Automatic Stabilizers
Dwight Eisenhower, known as Ike was swept to victory in 1952, the first Republican president since Herbert Hoover. Like Hoover, Eisenhower inherited a prosperous economy. And like Hoover, Eisenhower was forced to watch as that economy slid into a recession. Hoover responded with a large tax increase that deepened the depression. However, Ike did not make changes in taxes rates. He believed that if you just keep the tax rate stable, revenues will automatically fall when the economy falls because people will have less income. The revenue will rise when the economy rises because people will have more income and that exercises a certain stabilizing effect on the economy. Ike took advantages of these stabilizer to bring America out of the recession of 1954.

Comment and Analysis by Richard Gill
In 1954 when GNP began to fall, federal tax revenues also began to fall. Not because of any plan but simply because there was less taxable income. This meant relatively more money in the hands of consumers, which, in turn, meant that private spending did not have to fall as much. Instead of the economy spiraling down into a Great Depression, private spending was maintained at a relatively high level and the fall in the national income was cushioned.
The Kennedy Tax Cut John F. Kennedy took office as the country was already beginning its recovery from the Recession of 1960, but unemployment remained high. Kennedy’s advisors realized the government would soon be taking in ore than it was spending. That surplus would stop economic growth, well short of full employment. That could be corrected in two ways: by tax cuts or increased expenditures. Kennedy was committed to tax cuts despite calls from John Kenneth Galbraith, a long-time friend, who lobbied that social programs on the behalf of the poor were in need of more support. The Treasury Department was dubious about a big tax-cut and wanted only a 4 billion cut. Kennedy advisor and chairman of the Council of Economic Advisors Walter Heller was pushing for a 12 billion cut. Kennedy tried to sell the $12 billion tax-cut to a reluctant congress. Congress passed the Kennedy tax program following his death. The economy immediately took off in a burst of prosperity.

Comment and Analysis by Richard Gill.
What the tax cut did was simply give more disposable income to consumers. It shifted private spending up. The gap between spending and full employment was eradicated.. The apparent success of the tax-cut of 1964 was hailed by many as a total vindication of Keynesian ideas.