Government Budget and Fiscal Policy CHAPTER

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1 Government Budget and Fiscal Policy 11 CHAPTER

2 The National Budget The national budget is the annual statement of the government s 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. Gist: Using govt. purchases G and taxes T to control unemployment or inflation

3 The National Budget The federal government s budget balance equals tax revenue minus expenditure. If tax revenues exceed expenditures, the government has a budget surplus [T>G]. If expenditures exceed tax revenues, the government has a budget deficit [G>T]. If tax revenues equal expenditures, the government has a balanced budget [T=G].

4 The Federal Budget - USA

5 Budget Balance s a % of GDP Government Budget Balance - Bangladesh Source: (the Website has compiled the data from the World Bank)

6 Federal Receipts - USA Receipts This Figure shows receipts as a percentage of GDP.

7 Federal Receipts - USA Social Security tax The tax levied on both employers and employees used to fund the Social Security program. The Social Security tax pays for the retirement and disability benefits received by millions of Americans each year.

8 Government receipts - Bangladesh Source:

9 The Federal Outlays - USA Outlays This Figure shows outlays as a percentage of GDP.

10 Government Outlays - Bangladesh Source:

11 The National Budget Cyclical Deficits and Structural Deficits Suppose the budget is currently balanced, and then Real GDP in the economy drops. As Real GDP drops, the tax base of the economy falls, and, if tax rates are held constant, tax revenues will fall. Another result of the decline in Real GDP is that transfer payments (e.g., unemployment compensation) will rise. Thus, government expenditures will rise as tax revenues fall. As a result, a balanced budget turns into a budget deficit a result of the downturn in economic activity, not from current spending and taxing decisions by the government.

12 The National Budget Cyclical Deficits and Structural Deficits Economists use the term cyclical deficit to describe budget deficit that is a result of a downturn in economic activity. On the other hand deficit that would exist if the economy were operating at full employment is called the structural deficit.

13 The National Budget This Figure illustrates a cyclical deficit and a cyclical surplus. In part (a), potential GDP is $14 trillion. If real GDP is $13 trillion, the budget is in deficit and it is a cyclical deficit. If real GDP is $15 trillion, the budget is in surplus and it is a cyclical surplus.

14 The National Budget In part (b), if real GDP and potential GDP are $13 trillion, the budget is a deficit and the deficit is a structural deficit. If real GDP and potential GDP are $14 trillion, the budget is balanced. If real GDP and potential GDP are $15 trillion, the budget is a surplus and the surplus is a structural surplus.

15 The National Budget Budget Balance and Debt Government debt or Public debt is the total amount that the government has borrowed. It is the sum of past deficits minus past surpluses. This Figure shows the federal government s (in the U.S.) gross debt... and net debt.

16 Budget Deficit and the Crowding-Out Effect Government enters the loanable funds market when it has a budget surplus or deficit. A government budget surplus increases the supply of funds. A government budget deficit increases the demand for funds.

17 Budget Deficit and the Crowding-Out Effect This Figure illustrates the effect of a government budget surplus. A government budget surplus increases the supply of funds. The real interest rate falls. Private saving decreases. Investment increases.

18 Budget Deficit and the Crowding-Out Effect This Figure illustrates the effect of a government budget deficit. A government budget deficit increases the demand for funds. The real interest rate rises. Private saving increases. Investment decreases is crowded out.

19 Budget Deficit and the Crowding-Out Effect This Figure illustrates the Ricardo-Barro effect. A budget deficit increases the demand for funds. Rational taxpayers increase saving, which increases the supply of funds. Increased private saving finances the deficit. Crowding-out is avoided.

20 Fiscal Policy Multipliers Before we discuss fiscal policy and it s effect on real GDP and price level, we need to make the following assumptions: Economy is not self regulating when it is in a recessionary gap (similar to Keynesian assumption). Price is not constant in the short run, i.e., SRAS is upward sloping (similar to Classical view). So, we are somewhere in between the Classical and the Keynesian model.

21 Fiscal Policy Multipliers Automatic fiscal policy is a change in fiscal policy triggered automatically by the state of the economy. To illustrate, suppose Real GDP in the economy turns down, causing more people to become unemployed and, as a result, automatically receive unemployment benefits. These added unemployment benefits automatically boost government spending. Discretionary fiscal policy is a policy action that is initiated by an act of the Government, taken deliberately. To enable us to focus on the principles of fiscal policy multipliers, we first study discretionary fiscal policy in a model economy that has only lump-sum taxes. Lump-sum taxes are taxes that do not vary with real GDP; actual examples would be a head tax or property taxes.

22 Fiscal Policy Multipliers The Government Purchases Multiplier The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on equilibrium aggregate expenditure and real GDP. A multiplier exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

23 Fiscal Policy Multipliers This Figure illustrates the government purchases multiplier in the aggregate expenditure diagram. The government purchases multiplier is 1/(1 MPC) where MPC is the marginal propensity to consume (absent induced taxes and imports).

24 Fiscal Policy Multipliers The Lump-Sum Tax Multiplier The lump-sum tax multiplier is the magnification effect a change in lump-sum taxes has on equilibrium aggregate expenditure and real GDP. An increase in lump-sum taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.

25 Fiscal Policy Multipliers The amount by which a tax increase lowers consumption expenditure is determined by the MPC. A $1 tax increase lowers consumption expenditure by $1 MPC, and this amount gets multiplied by the standard autonomous expenditures multiplier. The lump-sum tax multiplier is therefore -[MPC/(1 MPC)]. It is negative because an increase in lump-sum taxes decreases equilibrium expenditure.

26 Fiscal Policy Multipliers This Figure illustrates the effect of an increase in lump-sum taxes. The lump-sum transfer payments multiplier and the lump-sum tax multiplier are the same except for their signs the transfer payments multiplier is positive.

27 Fiscal Policy Multipliers Induced Taxes and Entitlement Spending Taxes that vary with real GDP are called induced taxes. Most transfer payments are part of entitlement spending, and they vary with real GDP they are induced, too. During a recession, induced taxes fall and entitlement spending rises; and during an expansion, induced taxes rise and entitlement spending falls. For this reason, they are called automatic stabilizers. Both effects also diminish the size of the government purchases and lump-sum tax multipliers.

28 Fiscal Policy Multipliers International Trade and Fiscal Policy Multipliers Imports also decrease the fiscal policy multipliers. The larger the marginal propensity to import, the smaller is the magnitude of the government purchases and lumpsum tax multipliers. The reason? If a bigger fraction of any change in aggregate income is spent on imports, a smaller fraction is spent on domestically-produced output so generates less GDP and income. Remember the multiplier formula with imports? Multiplier = 1 1 b 1 t m

29 Fiscal Policy Multipliers Fiscal Policy and Aggregate Demand This Figure illustrates the effects of fiscal policy on aggregate demand. An increase in government purchases shifts the AE curve upward and shifts the AD curve rightward.

30 Fiscal Policy Multipliers The magnitude of the shift in the AD curve equals the government purchases multiplier times the increase in government purchases. When lump-sum taxes decrease, the rightward shift in the AD curve equals the lump-sum tax multiplier times the reduction in taxes.

31 Fiscal Policy Expansionary fiscal policy, an increase in government expenditures (G) or a decrease in taxes (T), shifts the AD curve to the right. The target of an expansionary fiscal policy is to increase production and reduce unemployment. The underlying assumption is that the economy is in a recessionary gap. Contractionary fiscal policy, a decrease in government expenditures (G) or an increase in taxes (T), shifts the AD curve to the left. The target of an contractionary fiscal policy is to decrease production and reduce inflation. The underlying assumption is that the economy is in an inflationary gap.

32 Fiscal Policy Graphical Illustration of Fiscal Stimulus This Figure shows how fiscal policy is supposed to work to close a recessionary gap. An increase in government expenditure or a tax cut increases aggregate expenditure. The multiplier process increases aggregate demand. If no supply side effect is present, then T would need be larger than G to get GDP to potential GDP.

33 Fiscal Policy Fiscal Expansion at Potential GDP This Figure illustrates the effects of an expansionary fiscal policy starting from a position of full employment.

34 Fiscal Policy So, if the economy was at potential GDP to begin with, then in the long run, fiscal policy multipliers are zero because real GDP equals potential GDP and a change in aggregate demand changes the money wage rate, the SAS curve, and the price level.

35 Limitations of Fiscal Policy Because the short-run fiscal policy multipliers are not zero, fiscal policy can be used to help stabilize the economy, and frequently is in countries with parliamentary systems of government [or other systems that allow the executive to control the budget]. But in practice, fiscal policy is always hard to use, and in the US usually not feasible, because: The legislative process is too slow to permit fiscal policy actions to be implemented when they are needed. Potential GDP is very hard to estimate, so the wrong fiscal stimulus or restraint may be enacted.

36 Limitations of Fiscal Policy Fiscal Policy May Destabilize the Economy In this scenario, the SRAS curve is shifting rightward (healing the economy of its recessionary gap), but this information is unknown to policy makers. Policy makers implement expansionary fiscal policy, and the AD curve ends up intersecting SRAS 2 at point 2 instead of intersecting SRAS 1 at point 1. Policy makers thereby move the economy into an inflationary gap, thus destabilizing the economy.

37 Supply-Side Effects of Fiscal Policy Fiscal Policy and Aggregate Supply Production depends on the quantity of labor, which in turn is influenced by the income tax. Figure on the next slide illustrates the effect of the income tax in the labor market.

38 Supply-Side Effects of Fiscal Policy The income tax decreases the aggregate supply of labor because it decreases the aftertax wage rate. Because the income tax decreases the aggregate supply of labor, it raises the equilibrium wage rate, decreases employment, and decreases aggregate supply.

39 Supply-Side Effects of Fiscal Policy This supply-side effect of the income tax means that a cut in the income tax rate may increase aggregate supply.

40 Supply Side Effects of Fiscal Policy This Figure illustrates two views about the effects of a tax cut on real GDP and the price level (assuming the economy is in a recessionary gap). A tax cut increases aggregate demand and the AD curve shifts rightward.

41 Supply-Side Effects of Fiscal Policy Most economists believe that a tax cut has a small effect on aggregate supply [SAS 0 to SAS 1 ]. So GDP increases and the price level rises.

42 Supply-Side Effects of Fiscal Policy Supply-side economists think that a tax cut may increase aggregate supply by a large amount [SAS 0 to SAS 2 ] so that GDP can increase and the price level does not change much (or maybe even fall).

43 Tax Rates and Tax Revenues Laffer Curve The curve, named after Arthur Laffer, that shows the relationship between tax rates and tax revenues. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall with further increases in tax rates.

44 Tax Rates and Tax Revenues Laffer Curve Tax revenues = Tax base Average Tax rate As tax rate increases: Direct effect: Upward pressure on tax revenues Indirect effect: Downward pressure on tax base Downward pressure on tax revenues Tax base is a direct function of Real GDP. An increase in tax rate puts downward pressure on tax base because: increased tax rate both demand and supply curve (according to supply-side economists) shift leftward Real GDP falls Tax base falls.

45 Tax Rates and Tax Revenues Laffer Curve Between point A and point B, the direct effect dominates, so, tax revenues increase. Between point B and point C, the indirect effect dominates. Rationale: The greater the proportion of one s income is taken away in taxes, the lesser the incentive for working. At point B, tax revenues are maximized.

46 Tax rates in Bangladesh According to a National Board of Revenue (NBR), Bangladesh circular, in : Tax free Income For men less than 65 years of age: Tk. 20,333/month For women and people over 65 years of age: Tk. 25,000/month For people with disability: Tk. 31,250/month

47 Tax rates in Bangladesh Tax rates Total Income (Yearly) Tax rate First 2,50,000 Tk. 0% Next 4,00,000 Tk. 10% Next 5,00,000 Tk. 15% Next 6,00,000 Tk. 20% Next 30,00,000 Tk. 25% Any remaining income 30%

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