Federal Budgets: The Tools of Fiscal Policy

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1 Federal Budgets: The Tools of Fiscal Policy

2 Previously In the recent Great Recession, we experienced lower output and high unemployment. However, the Great Depression in the 1930s was much worse and lasted much longer. Classical economists believe the market to be self-correcting and focus on long-run growth aimed at expanding the LRAS. Keynesian economists believe that market corrections can take a long time due to sticky wages, and focus on policy aimed at AD.

3 Big Questions 1. How does the government spend? 2. How does the government tax? 3. What are government budget deficits, and how bad are they? 4. What is the relationship between government deficits and the national debt?

4 Big Picture 1. Gov. Saving = Income Spending 2. Gov. Deficit = Spending Income 3. National debt = total of all accumulated and unpaid deficits

5 Big Picture 1. The correct way to present deficit and debt: fraction of GDP. 2. This allows comparison across time and between countries.

6 Big Picture

7 Big Picture

8 Government Budgets Budget deficit averaged $300 billion per year Budget deficit averaged $700 billion per year 2009 Budget deficit was $1.4 trillion Questions: Is this dangerous? Is debt killing the economy? How did this happen? Will I be shackled with this debt?

9 Government Budgets A budget must have plans for both incoming and outgoing funds. Government budget is a plan for both spending and raising funds for the government. Sources of funds (income or revenue) Uses of funds (spending or outlays )

10 Outlays and Revenue U.S. government spends $3 trillion each year ($10,000 for every citizen!) Transfer payments Payments made to individuals when no good or service is received in return. Examples: Income assistance (welfare), Social security, Medicare and Medicaid, Food Stamps. Government outlays = Government consumption spending + Transfer payments

11 Outlays and Revenue Difference between government consumption expenditures and transfer payments? Spending is when the government buys something in the marketplace A transfer is when money is moved from one group to another Government revenues Generally raised through taxes Other small fees as well (national park admittance)

12 U.S. Government Outlays

13 Major Categories of National Government Spending Mandatory outlays Determined by ongoing programs such as Social Security and Medicare Cannot be altered during the budget process Altering requires long-run changes to existing laws Discretionary outlays Can be altered when the annual budget is set Bridges, roads, payments to government workers, defense spending

14 U.S. Government Outlays (2012)

15 Historical Outlay Shares

16 Social Security and Medicare Social Security Government-administered retirement program Set up in 1935 by FDR as part of the New Deal Requires workers to contribute a portion of their earnings to the Social Security Trust Fund Goal? Guarantee that no American worker retires without at least some retirement income

17 Social Security Historically Social Security in its infancy No retirees Lots of workers contributing to the trust fund Workers paid in 2% of wages (half paid by workers, half by employer) Social Security today Social security tax is now 12.4% Millions of baby boomers beginning to retire Fewer workers paying into the program

18 Medicare Medicare Federal program that funds health care for retirees Established in 1965 by Lyndon Johnson Law requires current workers to pay Medicare taxes (with promise of insurance upon retirement) Goal Ensure that all retired workers have some funding for their health care

19 Social Security and Medicare Demographic changes are the main reason why Social Security and Medicare currently make up such a large portion of the budget. 1. People are living longer today than ever before and draw post-retirement benefits longer. 2. Those who paid into the programs for many years are now retired and drawing benefits. 3. The baby-boom generation is now entering retirement age. Baby boomers were born in the years The oldest boomers reached 65 years old in 2011.

20 Aging Population, Fewer Workers, More Beneficiaries

21 The First S.S. Recipient The first Social Security recipient was Ida May Fuller. Received check in January Taxes and outlays Ida May Fuller worked for three years under the program, and was taxed a total of $ She lived to be 100 years old, and collected a total of $22, from the program! If this were a typical experience, the program would not be sustainable!

22 Spending and the Current Fiscal Issues Increased government spending began recently, due to a number of events. 1. Increased defense spending in the wake of September 11, Defense spending was 16.5% of the budget by By 2010, defense spending comprised 19.1% of the federal budget. 2. The increased spending on Social Security and Medicare 3. The government responses to the Great Recession, beginning with fiscal policy in $2.87 trillion outlay in 2007 $3.58 trillion outlay in 2009.

23 U.S. Government Outlays

24 How do Federal Governments Raise Revenue? Generally, government revenue comes from taxes. Most people probably don t enjoy paying taxes, but government activity must be paid for. Payroll taxes (deducted from paychecks) Income tax, Social Security tax, and Medicare tax combined for 81% of all federal tax revenue in Other tax revenue sources Corporate taxes, estate and gift taxes, excise taxes, and custom taxes

25 Social Insurance Taxes Social Security and Medicare are paid for with taxes on employees pay. Benefits received at retirement depend on taxes paid while in the labor force. Tax is 15.3% of the worker s pay. Typically, the worker and the firm split this tax bill, each paying 7.65%. Tax is applicable on first $110,100 a person earns. Revenue goes into the SSI and Medicare trust funds that serve to provide income and healthcare assistance to retirees.

26 U.S. Federal Tax Revenue Sources, 2012

27 The Mechanics of Payroll Taxes Progressive tax system Higher-income individuals pay a larger fraction of their incomes in taxes. Marginal tax rate The tax rate paid on the next dollar of income Marginal tax rates increase with higher earnings with a progressive tax system. Average tax rate Total tax paid divided by taxable income Will be less than the marginal tax rate due to progressive tax system

28 U.S. Federal Tax Rates, 2012

29 Historical Income Tax Rates The income tax is 100 years old in the United States. Prior to 1913, most taxes were generated by import tariffs. The highest marginal tax rate in was 6%. This applied to earnings over $500,000 (equivalent to $11 million today) Rates rose quickly. In 1918, the top marginal rate was 77%! It applied to income over $2 million. Highest top marginal rates occurred in 1945, at 94%.

30 Government Deficit: Tax Policies Source:

31 Key Dates for Income Tax Changes 1930s During the Great Depression, Presidents Hoover and Roosevelt, in attempts to balance the budget, increased top marginal rates to 80% With top marginal rates over 90%, President JFK lowered the top rate to 70%. 1980s President Reagan lowered marginal tax rates further, and by the end of the decade, the top marginal rate was 28% President Clinton proposed higher rates, and the top rate rose to 39% Rates fell to their recent levels (35%) as a result of urging by President George W. Bush.

32 Historical Top U.S. Marginal Tax Rates

33 Tax Form in 1913

34 Who Pays for Government?

35 Outlays and Revenues Budget deficit Occurs when outlays exceed revenues More funds flowing out than in 2009: $1.4 trillion budget deficit, largest in U.S. history, even bigger than WWII deficits However, these do not exceed WWII deficits when they are examined as a portion of GDP. Budget surplus Occurs when revenues exceed outlays More funds flowing in than out

36 U.S. Federal Budget Data

37 U.S. Federal Outlays and Revenue as a Portion of GDP

38 Outlays and Revenue Three general observations 1. Deficits grow when outlays increase, or revenues decrease (or both). 2. Deficits tend to grow during recessionary periods. 3. Recent U.S. budget deficits are large in a historic context.

39 Deficits versus Debt Deficit debt Deficit: a shortfall in revenue for a particular year s budget National debt: total of all accumulated and unpaid deficits The national debt Part of the debt is owed to the public. Part of the debt is owed to government agencies (one branch of government can owe another branch).

40 U.S. National Debt

41 Debt to GDP Ratio, 2010

42 Foreign Ownership of U.S. Debt Fear: foreign control of our government through debt 70% of national debt held domestically 30% held internationally Major international holders of U.S. debt include China, Japan, and the United Kingdom.

43 Foreign and Domestic Ownership of U.S. Debt

44 Conclusion Outlays are government spending. Revenues are gathered by taxes. The debt is the cumulative sum of all yearly deficits. Social Security and Medicare make up the largest portion of outlays, and this share has increased due to demographic changes. The U.S. income tax system is progressive.

45 Practice What You Know Which of the following is true? a. The United States generally has a budget surplus. b. National debt is the same as deficit. c. The national debt is the sum of yearly budget deficits. d. A deficit will occur when revenues exceed outlays.

46 Practice What You Know Which of the following is FALSE regarding deficits? a. Deficits grow when outlays increase. b. Deficits tend to grow during recessions. c. Deficits grow when revenues increase. d. Recent U.S. budget deficits are large in a historical context.

47 Practice What You Know Which of the following is part of mandatory outlays? a. Social Security b. defense spending c. government employee salaries d. infrastructure maintenance

48 Practice What You Know Income taxes in the United States can be described as a. progressive. b. regressive. c. flat. d. U-shaped.

49 Practice What You Know Social Security and Medicare outlays a. are funded by income tax. b. have increased in size recently. c. are used to make sure working-age adults stay healthy. d. are part of discretionary spending.

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