Fiscal Policy, Incentives, and Secondary Effects

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Fiscal Policy, Incentives, and Secondary Effects312312

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Alternative Views of Fiscal PolicyKeynesians stress the potency of fiscal policy and its use to maintain AD at a level consistent with full employment. Others argue there are secondary effects of fiscal policy which undermine its effectiveness. Critics also argue that Keynesian analysis ignores important incentive effects of fiscal changes, including both changes in the composition of government spending and the supply-side effects of marginal tax rates. This chapter will consider these views.

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Alternative Views of Fiscal PolicyThe main difference between Keynes and modern economics is the focus on incentives. Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economists base all their analysis on incentives. –Luigi Zingales

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Fiscal Policy, Borrowing, and the Crowding-Out Effect

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The Crowding-out EffectThe Crowding-out effect: – theory that an increase in borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy The implications of the crowding-out analysis are symmetrical. Restrictive fiscal policy will reduce real interest rates and "crowd-in" private spending. Crowding-out effect in an open economy: Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

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Quantity of loanable fundsQ1Q2Loanable Funds MarketReal interest rater2 Other things constant, if the government borrows an additional $100 billion to finance its budget deficit, this borrowing will increase the demand for loanable funds (shift from D1 to D2) and lead to higher interest rates. How will higher interest rates influence aggregate demand?Deficits and Interest Rates: The Crowding-out View D1e1r1 Deficit = $100 billion

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AD1If government borrowing did not affect interest rates, the $100 billion increase in spending would increase aggregate demand to AD2.Deficits and Output: The Crowding-out ViewPrice LevelY1 Goods & Services (real GDP)SRAS1P1However, the increased borrowing will push up interest rates, which will crowd out private investment and consumption.

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AD1As a result aggregate demand will remain unchanged at AD1.Deficits and Output: The Crowding-out ViewPrice LevelY1 Goods & Services (real GDP)SRAS1P1The crowding-out effect indicates that expansionary fiscal policy will have little or no impact on aggregate demand.

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Crowding-Out in an Open EconomyAn increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. This retards private investment and aggregate demand. In an open economy, high interest rates attract foreign capital. As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. The appreciation of the dollar causes net exports to fall. Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which offset the expansionary impact of a budget deficit.

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Fiscal Policy, Future Taxes, and the New Classical Model

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The New Classical View of Fiscal PolicyThe New Classical view stresses that: debt financing merely substitutes higher future taxes for lower current taxes, and budget deficits affect the timing of taxes, but not their magnitude. New Classical economists argue that when debt is substituted for taxes: people save the increased income so they will be able to pay the higher future taxes, thus, the budget deficit does not stimulate aggregate demand.

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The New Classical View of Fiscal PolicySimilarly, New Classical economists believe that the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes. In the New Classical model, fiscal policy does not affect aggregate demand, output, employment, or real interest rates. While the explanation differs, both the Crowding-out and New Classical models argue that fiscal policy exerts little impact on either aggregate demand or output.

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AD1Expansionary Fiscal Policy: The New Classical view stresses that deficits merely substitute future taxes for current taxes.Fiscal Policy: New Classical ViewPrice LevelY1 Goods & Services (real GDP)SRAS1P1If households did not anticipate the higher future taxes, aggregate demand would increase (from AD1 to AD2). However, when households fully anticipate the future taxes and save for them, demand remains unchanged at AD1.

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Quantity of loanable fundsQ1S1Q2Loanable Funds MarketReal interest rater1 To finance the budget deficit, the government borrows from the loanable funds market, increasing the demand (to D2).Under the new classical view, people save to pay expected higher future taxes (raising the supply of loanable funds to S2.)This permits the government to borrow the funds to finance the deficit without pushing up the interest rate.Deficits: The New Classical View D1e1Deficit = $100 billion

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Questions for Thought:1. “When the federal government runs a budget deficit, it finances the deficit by issuing additional U.S. Treasury bonds.” -- Is this statement true? 2. When an economy is operating below its potential capacity, Keynesian economists argue that a. taxes should be raised if the government is currently running a budget deficit. b. the government should cut taxes and/or increase expenditures in order to stimulate aggregate demand. c. government spending should be cut and the budget shifted toward a surplus.

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Questions for Thought:3. The crowding out effect indicates that budget deficits … a. will stimulate aggregate demand and so exert a strong impact on both output & employment. b. will lead to additional borrowing and higher interest rates that will reduce the level of private spending.4. “New classical economists stress that an increase in government expenditures financed by borrowing rather than taxes will lead to higher interest rates.” -- Is this statement true?

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Political Incentives and the Effective Use of Discretionary Fiscal Policy

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Political Incentives and the Use of Discretionary Fiscal PolicyPublic choice analysis indicates that legislators are delighted to spend money on programs that directly benefit their own constituents but are reluctant to raise taxes because they impose a visible cost on voters. Given the political incentives, budget deficits will be far more attractive than surpluses. As a result, deficits will be far more common than surpluses and discretionary fiscal policy is unlikely to be instituted in a counter-cyclical manner.

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Fiscal Policy: Countercyclical versus Response during a Severe Recession

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Fiscal Policy: Countercyclical vs. Response during a Severe RecessionIt is important to distinguish between the use of discretionary fiscal policy to: promote economic stability and combat a severe recession Substantial agreement has emerged between the Keynesians and non-Keynesians on the first point, while spirited debate continues on the second.

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Areas of Agreement about Fiscal Policy as a Stabilization ToolProper timing of discretionary fiscal policy is both difficult to achieve and crucially important. Automatic stabilizers reduce fluctuations in AD and help direct the economy toward full employment. Fiscal policy is much less potent than the early Keynesian view implied.

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The Great Debate: Will Fiscal Stimulus Speed Recovery?Keynesians believe that increases in government spending financed by borrowing will speed recovery from a severe recession because: the expansion in government spending will offset reductions in private spending, interest rates will be extremely low during a severe recession and therefore crowding out of private spending will be minimal, and increased government spending will trigger a substantial multiplier effect when widespread unemployment is present.

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The Great DebateNon-Keynesian critics argue that increased government spending and expanded debt will adversely affect both recovery and long-term growth because: The expansion in government debt will mean higher future interest payments and tax rates that will retard future growth. Recessions reflect a coordination problem and increases in government spending are likely to worsen this problem, thereby slowing the recovery process. More politically directed spending will lead to more rent-seeking and less productive activity.

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Tax Cuts vs. Spending IncreasesSome argue that increases in government spending will expand GDP by more than tax reductions, because 100% of an increase in government purchases will be pumped into the economy, whereas part of the tax reduction will be saved or spent abroad. However, the issue is more complex than this simple multiplier analysis implies.

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Tax Cuts vs. Spending IncreasesThere are at least four reasons why a tax cut is likely to be more effective than a spending increase as a tool with which to promote recovery and long-term growth. A tax cut will stimulate AD more rapidly. Compared to an increase in government spending, a tax cut is less likely to increase structural unemployment and reduce the productivity of resources. A tax cut will be easier to reverse once the economy has recovered. A reduction in tax rates will increase the incentive to earn, invest, produce, and employ others.

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Paradoxes of Thrift and Spending

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Last Updated: 8th March 2018

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