FISCAL POLICY

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FISCAL POLICY

• Dr. Fidel Gonzalez
• Department of Economics and Intl. Business
• Sam Houston State University

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Fiscal Policy

• Federal Budget the federal budget is the annual
  statement of the federal governments
  expenditures and tax revenues.

Fiscal policy is the use of the federal budget to
achieve macroeconomic objectives, such as full
employment, sustained long-term economic growth,
and price level stability.
Federal Budget is composed of the annual
government expenditures and revenue.
If Government Revenue gt Government Expenditure,
then we have a Budget Surplus
If Government Revenue lt Government Expenditure,
then we have a Budget Deficit
If Government Revenue Government Expenditure,
then we have a Balanced Budget
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Fiscal Policy Government Revenue
Tax Revenue Personal Income Taxes Social
Security Taxes Corporate Income Taxes
Indirect Taxes
Personal Income Taxes followed by Social Security
Taxes are two largest sources of revenue for the
government.
In 2004, government revenue was 1,955 billion
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Fiscal Policy Government Expenditure
Government Expenditure Transfer Payments
Purchases of Goods and Services Debt Interest
Paid
Transfer payments are money payments from the
government without any exchange of goods or
services. They represent by far the largest share
of government expenditures and they also continue
to grow.
Transfer payments includes Social Security
Payments to retirees, Unemployment Benefits,
In 2004, government expenditures were equal to
2,256 billion.
Hence, the government budget for 2004 was
Government Revenue 1,955 billion
Government Expenditures2,256 billion
Government Deficit 301 billion.
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Fiscal Policy Measurement of Government Budget
Most of the time we want to measure the
government budget, expenditures and revenue as
percentage of the GDP.
A surplus or deficit has to be compared with the
overall size of the economy to see if it is big
or small
When we compare the debt of a person we compare
the size of the debt with the income to see the
importance of this component.
A 2 million deficit for Bill Gates is not much
because his income is very high.
A 2 million deficit for a SHSU professor is a
lot because his income is not that high.
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The Federal Budget 1980-2004
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The Federal Budget Revenues and Expenditures
Government Revenue
Government Expenditures
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Fiscal Policy Government Debt
When the government has a budget deficit
(Revenues lt Expenditures), It has to borrow money
to cover the deficit.
Government debt is the total amount that the
government has borrowed, that the government
currently owes. It is the accumulation of all
past budget deficits.
The government debt can be observed as a bathtub
Water entering the bathtub is the current
government borrowing or government deficit
Bathtub
Water leaving the bathtub is the government
surplus used to pay off debt
The level of the bathtub is the government debt
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Government Debt

• Evolution of the debt as a percentage of GDP
  since 1942.

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International Government Deficits 2003

• The world as a whole that year had a government
  budget deficit of about 3.1 percent of world GDP.

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Government Fiscal Policy and the Economy
The governments fiscal policy have three
important implications on the economy
1) Government deficits increase the amount
borrowed in the market increasing the interest
rate. Higher interest rates reduce private
investment, this is called the crowding-out
effect.
2) Ricardo-Barro effect government deficit do
not affect interest rates because households save
an amount equal to the deficit and total savings
remain the same.
Note that the crowding-out and ricardo-barro
effect contradict each other. Each effect has
different assumptions about the effect of deficit
on private savings.
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1) Crowding-out Effect
A quick refresher of the national income
accounting equations is needed
The definition of GDP is the following
GDP C I G X M
Add and subtract taxes (T)
GDPC I G X MT-T

Move all terms to the left with exception of
investment (I)
(GDP C T) (M-X) (T-G)
I
Private Domestic Savings (PDS)
Private Foreign Savings (PFS)
Government Savings (GS)
That takes us to the main expression
I PDS PFS GS
(M-X) - NX - NCO -(Capital Outflows
Capital Inflows) Capital Inflows Capital
Outflows
Hence, (M-X) represents the net capital inflows
or the net amount foreign saving sent from
foreigners to the domestic country in form of
capital inflows.
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1) Crowding-out Effect
The equation I PDS PFS GS
Says that Investment (I) is financed through
private domestic savings (what domestic
households save), private foreign savings (saving
from households of foreign countries) and
government savings (government budget)
Call private savings (PS), so that PSPDSPFS
I PS (T-G)
Domestic Investment is equal to private savings
plus government savings
Total savings SPDS PFS GD
If taxes are less than government purchases, T lt
G, the government budget is in deficit and
government saving is negative.
Less savings means that there is less money
available to be borrowed
Total savings go down
Less money available brings an increase in the
real interest rate
Investment decreases as a result of higher real
interest rates
The tendency for a government budget deficit to
decrease investment is called a crowding-out
effect.
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1) Crowding-out Effect
SS is the supply of savings
ID is the demand for investment
A government deficit will increase the interest
rate and households want to save more to take
advantage of the interest rate.
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2) Ricardo-Barro Effect
If households believe that the government debt
will have to be paid in the near future by
raising taxes. Then, households will increase the
private savings to cover the deficit.
The Ricardo-Barro Effect government deficit
leads to an increase in the supply of private
saving that offsets the deficit, so that total
saving supply is unchanged. As a result, the real
interest does not change and investment is not
crowded out.
The Ricardo-Barro effect also predicts that a
tax-cut financed by issuing debt will have no
real effect in the economy.
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Business Cycle and Government Deficit
The ups and downs of the economy affect the
government deficit
Deficits increase during recessions because
income is higher so that the tax base decreases.
During recessions the government does not reduce
its expenditures.
Deficits decrease during periods of growth
because income is higher so the tax base
increases. The need for government spending is
lower, so the government can reduce spending.
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Business Cycle and Government Deficit

• The structural surplus or deficit is the surplus
  or deficit that would occur if the economy were
  at full employment and real GDP were equal to
  potential GDP.
• The cyclical surplus or deficit is the actual
  surplus or deficit minus the structural surplus
  or deficit that is, it is the surplus or deficit
  that occurs purely because real GDP does not
  equal potential GDP.

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Business Cycle and Government Deficit
Distinction between a structural and cyclical
surplus and deficit.
In part (a), as real GDP fluctuates around
potential GDP, a cyclical deficit or surplus
arises.
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Business Cycle and Government Deficit
In part (b), as potential GDP grows, a structural
deficit becomes a structural surplus.
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Laffer Curve
The Laffer curve summarizes the relationship
between the tax rate and tax revenue

• Tax Revenues and the Laffer Curve
• An increase in the tax rate decreases employment.
• If the decrease in employment is large, the total
  amount collected in taxes might decrease when the
  tax rate increases.

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Laffer Curve
Bush Jr. believes that the economy of the US is
on the right-side of the laffer curve. Why? A
tax-cut on the right side, brings more revenue.
Tax Revenue Tax Rate x Tax Base
On the right side, a tax cut decreases the tax
rate but increases the tax base more producing an
increase in tax revenue.
On the left side, a tax increase, increases the
tax rate more than decreases the tax base
producing an increase in tax revenue.