Fixing an
Economy’s Health:
Fiscal Policy
Taxes, Entitlement
Programs (Transfer Payments),
and Government
Spending
CHAPTERS 14 & 15
The 3 “tools” of Fiscal Policy:
1. Government Purchases/Spending
2. Entitlement Programs (also called Transfer Payments)
3. Taxes
…and how these three affect macroeconomic variables
such as real GDP, employment, the price level, and
economic growth.
The basics of Fiscal Policy - 2 Min (website) Cash for Gold Spoof -3 Min (Personal File)
How just a little Fiscal Policy can
effect our economy in a BIG way.
$150 $150
$200
$400 $50 (already in
his pocket)
$200 already in
his pocket)
Multiplier Effect: each dollar spent will tend to
generate more than 1 dollar added to GDP.
When does the government use fiscal policy?
It is pretty simple.
1. When the economy is in a slump
(recession or depression) the economy
has contracted.
Sothe government will enact an
Expansionary Fiscal Policy to
help boost the economy.
2. When the economy is booming (peak) the
economy has expanded.
So the government will enact an
Contractionary Fiscal Policy to help slow
down the economy.
Closing a Contractionary Gap
This is where
using Fiscal Policy we should be!
Potential
aggregate
Begin with a aggregate supply output
curve (AS) and the CPI turns out
Price level
AS
to be 2300, the economy will
produce its potential output at e*
2300 e*
e
Suppose that AD intersects 2250
AS at point e, therefore a
Contractionary Gap of
$1 trillion exists.
AD
So unemployment
exceeds the natural rate 0 Real GDP
(4%-5%)! 14.0 15.0
(trillions of dollars)
Contractionary gap
Closing a Contractionary Gap
This is where
using Fiscal Policy we should be!
Potential
aggregate
A $0.5 trillion increase in output
government purchases reflects
Price level
AS
an Expansionary Fiscal Policy
that increases AD (as shown by
the rightward shift from AD to AD*)
In the long-run the price 2300 e*
level will rise until AD equals
AS at e* where the price 2250
e e'
level is 2300 and the nation is
at its potential GDP. AD*
AD
0
15.0 16.0 Real GDP
14.0
(trillions of dollars)
Contractionary gap
Notice that the government only increased spending by $0.5 trillion and yet
GDP increased by $1 trillion. This is known as the multiplier effect.
Closing a Contractionary Gap
This is where
using Fiscal Policy we should be!
Potential
aggregate
output
Price level
AS
A $0.5 trillion decrease in taxes
reflects an expansionary fiscal
policy that increases AD, as
shown by the rightward shift
from AD to AD* 2300 e*
e e'
2250
Also, a $0.5 trillion increase in AD*
Social Progams reflects an
expansionary fiscal policy that AD
increases AD, as shown by the
rightward shift from AD to AD* 0
14.0 15.0 16.0 Real GDP
(trillions of dollars)
Contractionary gap
Transfer payments are those payments
Closing an Contractionary Gap
given to help the needy and unemployed.
through fiscal policy results in a higher
price level and lower unemployment .
Closing an Expansionary Gap using
Contractionary Fiscal Policy
Potential aggregate
output
Price level
Suppose that aggregate
AS
demand exceeds
potential output and
inflation results (we
2400 e
could be in an economic
boom).
AD
As a result, output is
$16.0 trillion and an
expansionary gap of $1
trillion exists.
0
Real GDP
15.0 16.0
(trillions of
Expansionary gap dollars)
Closing an Expansionary Gap using
Contractionary Fiscal Policy
Potential aggregate
If left alone, this gap output
Price level
could be closed by a AS
leftward shift of the AS e”
curve, returning the
economy to the
2400 e
potential level of output
but at a higher price
level, shown by point e" 2300 e* AD
By decreasing
Government Spending, AD*
increasing Taxes, or
decreasing Social
Program spending, the 0
Real GDP
government can 15.0 16.0
(trillions of
implement a Expansionary gap dollars)
Contractionary Fiscal
Closing an expansionary gap through
Policy designed to
fiscal policy results in a lower price level,
reduce AD
but higher unemployment .
Problems with Fiscal Policy
Other concerns also caused economists and policy makers
to question the effectiveness of discretionary fiscal policy.
1. The difficulty of estimating the natural rate
of unemployment. natural rate of unemployment
(4% to 5%)
• Before adopting discretionary policies, public
officials must correctly estimate this natural rate
of unemployment.
2. The time lags involved in implementing
fiscal policy (takes the government a long time to do
anything).
3. Various government agencies can
somehow coordinate their fiscal efforts.
4. Possible feedback effects of fiscal policy on
aggregate supply by effecting labor.
Problems with Fiscal Policy
Policy makers sometimes question the effectiveness of
Discretionary Fiscal Policy.
The government experiences a budget
deficit during Expansionary Fiscal Policy.
If the deficit continues, it is likely that
public debt will rise.
ANNUAL
GOV. + TAXES = BUDGET
(Revenue for
SPENDING Gov.)
DEFICIT
(negative)
Solving Deficits with very little sacrifice does not work -3 Min (Personal File)
Problems with Fiscal Policy:
Closing a Contractionary Gap
What if policy makers
overshoot the mark and
stimulate aggregate demand
more than needed to achieve
potential GDP?
Whoops…
When Discretionary Fiscal Policy
Suppose that the economy Overshoots the Mark
is producing its potential
output of $15 trillion where
the natural rate of Potential output
unemployment is 4%.
However, suppose that
public officials mistakenly
believe the rate is predicted AS
to increase to 7% and they
attempt to increase output a
2400
and employment.
AD*
Cut Taxes & Increase 2200
Government Spending:
Aggregate demand shifts
AD to AD*. AD
In the short-run, this policy
increases GDP and reduces 0
unemployment, but causes 15.0 15.5
(trillions of dollars)
inflation in the long-run.
Real GDP
When Discretionary Fiscal Policy
However, this shift in AD Overshoots the Mark
creates an expansionary
gap, which pushes up
prices. Potential output
AS*
Suppliers will react and in
the short-run and produce
more, but in the long run
(due to high prices for 2600 b AS
resources) suppliers will
c
limit the amount supplied 2400 a
causing a leftward shift in AD*
AS to AS*.
Lay-offs would occur in 2200
the workforce and AD*
would decrease to AD** as AD**
income falls.
0
15.0 15.5
(trillions of dollars)
This could cause prices to increase then GDP to decline.
Real GDP
Fiscal Policy’s
Effects on Labor
Fiscal Policy’s Effects on Labor
What about Fiscal policy’s effect on
the labor supply?
If the government does anything to
pump money into the economy, then
the labor supply should increase along
with the number of jobs available.
However, the unemployed, who benefit
from increased transfer payments
(Expansionary Fiscal Policy), may have
less incentive to find work.
Fiscal Policy’s Effects on Labor
Inversely, during Contractionary Fiscal
Policy, workers who find their wage
reduced by the higher tax rates may be
less willing to work.
The supply of labor could decrease as a
result of increased tax rates or increased
transfer payments resulting in aggregate
supply declining.
Which will cause an economy’s GDP to
decline.
Simply, there is not enough workers so
wages increase. (Let’s see this graphically...)
Fiscal Policy’s Effects on Labor
The dangers of INCREASING transfer payments.
Increased Transfer Payments
Wages $ Demand for workers
Supply of workers
Shortage of $7.50
workers
$5.15
50 Quantity of Workers
(in millions)
What would higher wages do to EMPLOYERS?
FINAL FISCAL TOPICS
Automatic Stabilizers
&
Types of Taxes
&
Who Should Pay Taxes?
Automatic Stabilizers
Automatic Stabilizers will smooth the fluctuations
in disposable income over the business cycle:
…thereby boosting aggregate demand
during periods of recession and…
…reducing aggregate demand during
periods of expansion
Examples of automatic stabilizers:
1. Progressive Income Tax
2. Unemployment Compensation (social spending)
Let’s look at the vocab then let’s see a graphic example…
1.) Progressive Income Tax Table
Single filers Married filing jointly Head of household Tax Rate
Up to
Up to $7,150
$14,300
Up to $10,200 10%
$7,151 - $29,050 $14,301 - $58,100 $10,201 - $38,900 15%
$29,051 - $70,350 $58,101 - $117,250 $38,901 - $100,500 25%
$70,351 - $146,750 $117,251 - $178,650 $100,501 - $162,700 28%
$146,751 - $319,100 $178,651 - $319,100 $162,701 - $319,100 33%
$319,101 $319,101 $319,101
or more or more or more 35%
NOTE: A small % is added on top of the lowest income in each range.
1. ) Progressive Income Tax
The Progressive Income Tax relieves some
of the expansionary pressures that arise
when demand increases and causes GDP to
rise too much.
It stabilizes the expansion so that aggregate
demand does not increase TOO much
On the other hand, when the economy is in a
recession, taxes decline automatically, so
disposable income does not fall too much.
It stabilizes the contraction so that aggregate
demand does not decline TOO much
2.) Unemployment Insurance
One thing to remember, when taxes are taken out of your
paycheck, some of that money goes into a government savings
account so it can be used on the unemployed.
UNEMPLOYMENT INSURANCE FUND
During an economic EXPANSION, MORE money
from taxes flow INTO the unemployment
insurance fund, thereby stabilizing aggregate
demand.
Taking MONEY OUT of the economy.
During a RECESSION, unemployment payments
automatically flow OUT of the unemployment
insurance fund to those who have become
unemployed (thereby stabilizing aggregate
demand).
Thus, putting money INTO the economy
Progressive Income Tax
How it works.
DURING A PEAK:
INCOME = INCOME = GDP & AD
TAXES
DURING A RECESSION:
INCOME = INCOME = GDP & AD
TAXES
Unemployment Insurance & Taxes
GRAPHIC EXAMPLE
STATE & FEDERAL
UNEMPLOYMENT
FUND
MORE MORE LESS MONEY TO THE
SPENDING TAXES UNEMPLOYED
IN COME
ECONOMY OUT AS
PRICE
LEVEL
AD
GDP
Unemployment Insurance & Taxes
GRAPHIC EXAMPLE
STATE & FEDERAL
UNEMPLOYMENT
FUND
LESS LESS
MORE MONEY TO THE
SPENDING TAXES
UNEMPLOYED
IN COME
ECONOMY OUT AS
PRICE
LEVEL
AD
GDP
SPEAKING OF PAYING
TAXES??
Property Taxes
These help pay for
schools in Cherokee
County.
What is one argument
you can think of
AGAINST this type of
taxation?
TWO THEORIES ON WHO
SHOULD PAY TAXES
1. Benefits-Received Principle
Only those who receive benefits should pay taxes.
EXAMPLE: City of Canton is building a new parkway to
limit the amount of traffic so a tax is raised to pay for it.
ONLY those who use the parkway should pay (the citizen of
Canton, NOT the citizens of Hickory Flat)
EXAMPLE: Gasoline Sales Tax goes toward road
construction (you ride on them, you pay for them)
2. Ability-to-Pay Principle
Only those with the ability to pay should pay MORE of
the tax.
EXAMPLE: Same Canton situation, but those who pay
more of the tax should be the wealthy.
Benefits-Received Principle
QUESTION TO PONDER???
Why isn’t it smart for the US Government
to try to pay for a Welfare program by
imposing a benefits-received principle
tax?
Those who would pay would have to be those
who receive Welfare. (making them pay more,
when they have little money to begin with is
stupid)
TAX APPLICATIONS:
Identify whether progressive, regressive, or proportional
1. Personal Income Tax
Progressive
2. Sales Tax
Regressive & Proportional
3. Corporate Income Tax (28% for all corporations)
Regressive & Proportional
4. Property Taxes (based on value of property)
Regressive & Proportional