| UNIT FOUR |
CHAPTER 12
Fiscal Policy
I. Budget
Deficits and Surpluses
A.
Budget deficit: Present when total government spending exceeds total
revenue from all sources.
1.
When the money supply is constant, deficits must be covered with
borrowing
2.
U.S. Treasury borrows funds by issuing bonds.
B.
Budget surplus: Present when total government spending is less than total
revenue from all sources.
1.
Surpluses reduce the size of the government’s outstanding debt.
C.
Changes in the size of the federal deficit or surplus are often used to
gauge whether fiscal policy is adding additional demand stimulus or imposing
additional demand restraint.
D.
Changes in the size of the budget deficit or surplus may arise for either
of two sources:
1.
A change in the state of the economy
2.
A change in discretionary fiscal policy: Government spending and/or
taxation
II.
Keynesian View of Fiscal Policy
A.
Keynesian theory highlights the potential of fiscal policy as a tool
capable of reducing fluctuations in demand.
B.
When an economy is operating below its potential output, the Keynesian
model suggests that government should institute expansionary fiscal policy--it
should either increase its purchases of goods and services and/or cut taxes.
C.
When inflation is a potential problem, the Keynesian analysis suggests
that a shift toward a more restrictive fiscal policy—reduce government
spending and/or raise taxes.
D.
Keynesian revolution challenged the view that the government should
always balance its budget.
1.
Rather than balancing the budget annually, Keynesians argued that
countercyclical policy should be used to offset fluctuations in aggregate demand.
III. Fiscal Policy and
the Crowding-out Effect
A.
Crowding-out Effect indicates that the increased borrowing to finance a
budget deficit will increase real interest rates and thereby retard private
spending. Thus, fiscal policy is not very potent.
B. The
implications of the crowding out analysis are symmetrical. Restrictive fiscal
policy will reduce real interest rates and "crowd in" private
spending.
C.
Crowding-out Effect in an open economy: Larger budget deficits and higher
real interest rates may also lead to an inflow of capital, appreciation in the
dollar, and a decline in net exports.
IV.
New Classical View of Fiscal Policy
A. The new
classical view stresses that debt financing merely substitutes higher future
taxes for lower current taxes. Thus, budget deficits affect the timing of taxes,
but not their magnitude.
B.
Argues that when debt is substituted for taxes, people will save the
increased income so they will be able to pay the higher future taxes. Thus, the
budget deficit does not stimulate aggregate demand.
C.
Similarly, the real interest rate is unaffected by deficits since people
will save more in order to pay the higher future taxes.
D.
According to the new classical view, fiscal policy is completely
impotent.
V.
Fiscal Policy: Problems of Proper Timing
A.
Various time lags make proper timing of changes in
discretionary fiscal policy difficult.
1.
Discretionary fiscal policy is like a two-edged sword; it can both harm
and help. If timed correctly, it may reduce economic instability. If timed
incorrectly, however, it may increase rather than reduce economic instability.
B.
Automatic Stabilizers: without any new legislative action, they tend to
increase the budget deficit (or reduce the surplus) during a recession and
increase the surplus (or reduce the deficit) during an economic boom.
C.
Examples of Automatic Stabilizers
1.
Unemployment Compensation
2.
Corporate Profit Tax
3.
Progressive Income Tax
VI.
Fiscal Policy as a Stabilization Tool: A Modern Synthesis
A.
Proper timing of discretionary fiscal policy is both difficult to achieve
and of crucial importance.
B.
Automatic stabilizers reduce the fluctuation of aggregate demand and help
to direct the economy toward full employment.
C.
Fiscal policy is much less potent than the early Keynesian view
implied.
VII. Supply-Side Effects
of Fiscal Policy
A.
From a supply-side viewpoint, the marginal tax rate is of crucial
importance. A reduction in marginal tax rates increases the reward derived from
added work, investment, saving, and other activities that become less heavily
taxed.
B.
High marginal tax rates will tend to retard total output because they
will:
1.
Discourage work effort and reduce the productive efficiency of
labor.
2.
Adversely affect the rate of capital formation and the efficiency of
its
use.
3.
Encourage individuals to substitute less desired tax‑deductible
goods for more desired nondeductible goods.
C.
Thus, changes in marginal tax rates, particularly high marginal rates,
may exert an impact on aggregate supply because the changes will influence the
relative attractiveness of productive activity in comparison to leisure and tax
avoidance.
D.
Impact of Supply-Side Effects
1.
Are likely to take place over a lengthy time period.
2.
Some evidence that countries with high taxes grow more slowly—France
and Germany versus United Kingdom
3.
While significance of supply-side effects are controversial, there is
evidence they are important for taxpayers facing extremely high rate, say rates
of 40 percent and above.
VIII. Empirical Evidence
on the Impact of Fiscal Policy
A.
Fiscal Policy During the Last Four Decades
B.
Budget Deficits and Interest Rates
1.
Year-to-year relationship is weak
2.
However, interest rates were high as size of deficits increased in the
early 1980s.
C.
Deficits, Consumption, and Investment
C.
Deficits and Appreciation of the Dollar, Capital Inflow, and Net
Exports.
IX.
Current View of Fiscal Policy
A.
Compared to two decades ago, there is now greater
awareness of both political and economic factors that make the proper
timing of fiscal policy changes
difficult.
B.
There is now more concern about the impact of budget deficits on interest
rates and capital formation.
