I.          Introduction

A.  One major function of the government is to stabilize the economy (prevent unemployment or inflation).

B.   Stabilization can be achieved in part by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation.

C.   This chapter will examine a number of topics.

1.   It explores the tools of government fiscal stabilization policy using AD-AS model.

2.   Both discretionary and automatic fiscal adjustments are examined.

3.   The problems, criticisms, and complications of fiscal policy are addressed.

4.   The public debt and its effects on the economy, both real and imagined, are explored.

5.   Investigation of the long-run fiscal imbalances in the Social Security system conclude the chapter.

II.        Fiscal Policy and the AD/AS Model

A.  Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth.  “Discretionary” means the changes are at the option of the Federal government.

            B.   Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples                illustrated in Figure 14.1).

1.      Expansionary Policy needed: In Figure 14.1, a decline in investment has decreased AD from AD₁ to AD₂ so real GDP has fallen and also employment declined.  Possible fiscal policy solutions follow:

      a.   An increase in government spending (shifts AD back to the right).

      b.   A decrease in taxes (raises income and consumption; AD shifts right).

c.       A combination of increased spending and reduced taxes.

d.      If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.

      2.   Contractionary fiscal policy needed: When demand‑pull inflation occurs as illustrated by a shift from AD₃ to AD4 in the vertical range of aggregate supply in Figure 14.2.  Then contractionary policy is the remedy:

            a.   A decrease government spending shifts AD4 back to AD3.  Here price level returns to its preinflationary level P1.

      b.   An increase in taxes will reduce income and consumption and shift back to AD₃.

      c.   A combined spending decrease and tax increase could have the same effect with the right combination.

III.       Built-In Stabilizers

A.  Built‑in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending).  It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.  Figure 14.3 illustrates how the built-in stability system behaves.

1.   Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.

2.   Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.

B.   The strength of automatic stabilizers depends on responsiveness of changes in taxes to changes in GDP:  The more progressive the tax system, the greater the economy’s built‑in stability.  In Figure 14.3 line T is steepest with a progressive tax system.

C.     Automatic stabilizers reduce instability, but do not eliminate economic instability.

IV.       Evaluating Fiscal Policy

A.     A balanced standardized (full employment) budget in Year 1 is illustrated in Figure 14.4 because budget revenues equal expenditures when full-employment exists at GDP₁.

B.     At GDP₂ there is unemployment and assume no discretionary government action, so lines G and T remain as shown.

1.      Because of built‑in stability, the actual budget deficit will rise with decline of GDP; therefore, actual budget varies with GDP.

2.      The government is not engaging in expansionary policy since the budget is balanced at the full employment level of output.

3.      The standardized budget measures what the Federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full employment.

4.      Actual budget deficit or surplus may differ greatly from full‑employment budget deficit or surplus estimates.

            C.   Budget deficits may be either standardized or cyclical.

1.      Standardized deficits occur when there is a deficit in the full‑employment budget as well as the actual budget.

a.       Standardized deficits signal an expansionary fiscal policy.

b.      Standardized surpluses indicate contractionary fiscal policy.

2.      Cyclical deficits refer to when the standardized budget is balanced, but the actual budget is in deficit due to a recession.

D.  Global Snapshot 14.1 compares standardized budget deficits for selected countries.

E.   Applying the Analysis: Recent U.S. Fiscal Policy

      1.   Table 14.1 shows the U.S. budget experience from 1990 to 2004.

      2.   Actual and standardized deficits persisted through most of the 1990s.

      3.   Personal and corporate tax rate increases in 1993 reduced the standardized deficits.

      4.   The actual budget moved into surplus in 1998; the standardized in 1999.

      5.   Projected surpluses encouraged major tax rate reduction enacted in 2001.

            a.   Tax rate cuts helped soften the blow of the 2001 recession.

            b.   Tax cuts also turned the standardized surplus back into deficit in 2002.

      6.   Further tax cuts and increased spending have increased the deficit but provided stimulus.

      7.   Figure 14.5 shows actual and projected surpluses from 1992 to 2012.

V.        Problems, Criticisms and Complications

A.  Problems of timing

1.   Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.

2.   Administrative lag refers to the time taken to change policy once the problem has been recognized.

3.   Operational lag is the time elapsed between change in policy and its impact on the economy.

B.   Political considerations:  Government has other goals besides economic stability, and these may conflict with stabilization policy.

1.      A political business cycle may destabilize the economy:  Election years have been characterized by more expansionary policies regardless of economic conditions, as politicians attempt to maximize votes rather than pursue macroeconomic stability.

2.      If households expect a policy reversal, fiscal policy may be ineffective.  Households given a tax cut to encourage consumption, if they expect the cut to be rescinded, will save the extra disposable income instead of using it to stimulate total spending.

3.   State and local finance policies may offset federal stabilization policies.  They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse.  In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.

      4.   The crowding‑out effect may be caused by fiscal policy.

      a.   “Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy. 

      b.   Some economists argue that little crowding out will occur during a recession.

      c.   Economists agree that government deficits should not occur at full employment.

            C.   Current thinking on fiscal policy

                  1.   Some economists argue that the economy is self-correcting and fiscal policy is                                                    unnecessary.  However,

                  2.   Most economists believe that fiscal policy is an important policy tool for pushing the                                          economy in a particular direction, but not for “fine tuning” it.  Monetary policy is                                               generally preferred for month-to-month adjustments.

                  3.   In addition to its effects on AD, the productivity (AS) effects of a fiscal policy need to                                       be considered.  The effect of fiscal policy is not simply a matter of how many dollars are                                         spent (or collected in tax revenue), but also how they are spent (or from whom they are                                      collected).

a.       Lower taxes could increase saving and investment.

            b.   Lower personal taxes may increase effort, productivity and, therefore, shift aggregate     supply to the right.

     c.     Lower personal taxes may also increase risk‑taking and, therefore, shift supply to                             the right.

A.  The public debt is the total amount of money owed by the Federal government to owners of government securities; equal to the sum of past budget deficits less surpluses.

B.   The public debt in 2004 was $7.4 trillion.  This is a large number.  One million seconds ago was 12 days back.  One trillion seconds ago was around 30,000 B.C.

C.   Causes of the expansion in debt:

1.   National defense and military spending have soared, especially during wartime.  During World Wars I and II, debt grew rapidly. 

2.   Recessions cause a decline in revenues and growth in government spending on programs for income maintenance.  Such periods included 1974-75, 1980-82, 1990-91, and 2001.

3.   Tax cuts are another cause.  Tax cuts in the 1980s without equivalent spending cuts led to increasing debt.  The Clinton administration in 1993 is an example of how politically difficult it is to reduce spending and raise taxes to reduce the deficit.  An unpopular deficit reduction act was passed in that year and many Democrats lost elections later.

            D.  Ownership of the debt (Figure 14.6)

                  1.   Public debt is held in the form of U.S. securities: Treasury bills, Treasury notes,                                                  Treasury bonds, and U.S. savings bonds.

                  2.   Ownership of the debt is an important question in terms of who the Federal government                                     is obligated to repay, and has implications for whether U.S. assets remain in the country.

                  3.   The public held 58 percent in 2004; the Federal government 42 percent.

                  4.   Foreign interests hold 26 percent of the U.S. public debt, meaning most of the public                                          debt is held (and owed) internally.

            E.   Debt and GDP

1.   Comparing the debt to GDP is more meaningful than the absolute level of debt by itself.  Use the example of a family or corporate borrowing.  For a prosperous family or firm, $100,000 worth of debt may be a small fraction of their income; for others, $100,000 worth of debt may mean they’re unable to make payments on the debt.  The amount is not as important as the amount relative to the ability to pay.  Also, most borrowing is made to purchase physical assets such as buildings, equipment, etc.  Another way to judge government debt is to compare it to an estimate of public assets.

2.   Figure 14.7 reveals that as a percentage of GDP, Federal debt held by the public is increasing, but lower than it was in the 1990s.

3.   International comparisons show that other nations have relative public debts as great or greater than that of the U.S. when compared to their GDPs.  See Global Snapshot 14.2.

4.   Interest charges as a percentage of GDP (1.4 percent in 2004) represent the primary burden of the debt today.

F.   False concerns about the public debt include several popular misconceptions:

1.   Can the federal government go bankrupt?  There are reasons why it cannot.

a.   The government does not need to raise taxes to pay back the debt, and it can borrow more (i.e. sell new bonds) to refinance bonds when they mature.  Corporations use similar methods—they almost always have outstanding debt.

b.   The government has the power to tax, which businesses and individuals do not have when they are in debt.

2.   Does the debt impose a burden on future generations?  In 2004 the per capita public debt in the U.S. was $25,200.  But the public debt is a public credit—your grandmother may own the bonds on which taxpayers are paying interest.  Some day you may inherit those bonds that are assets to those who have them.  The true burden is borne by those who pay taxes or loan government money today to finance government spending.  If the spending is for productive purposes, it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline.  Borrowing allows growth to occur when it is invested in productive capital.

G.  Substantive issues do exist.

1.   Repayment of the debt affects income distribution.  If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality.

2.   Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.

3.   A higher proportion of the debt is owed to foreigners (about 26 percent) than in the past, and this can increase the burden since payments leave the country.  But Americans also own foreign bonds and this offsets the concern.

4.   Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear (see Figure 14.8).

5.   There are some positive aspects of borrowing even with crowding out.

a.   If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.

b.   Public investment makes private investment more attractive.  For example, new federal buildings generate private business; good highways help private shipping, etc.