Fiscal Policy, the Budget, and the National Debt

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Chapter 17: Fiscal Policy and the Federal Budget Fiscal Policy -- the Federal government changing its government budget position (G - T) in order to stabilize the economy. Fiscal Policy, by its nature, alters the Federal Budget. This chapter also examines the Federal Budget, what it’s made up of, and when budget deficits can be a problem in the economy.

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The Federal BudgetFederal Budget (or Budget) = Tax Revenues - Government Expenditure (over a given period). Federal Budget (or Budget) = Tax Revenues - (Government Purchases of Goods and Services + Transfer Payments + Interest on the National Debt).

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Budget DefinitionsBudget < 0 -- Budget Deficit Budget > 0 -- Budget Surplus Budget = 0 -- Balanced Budget Realistic Goal -- Balanced Budget when Y = YF.

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The US Federal Budget: 2003 (Billions of Dollars)Tax Revenues $1974.8 Government Expenditure $2381.3 Federal Budget -$406.5 Source: Economic Indicators, October 2005.

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Breakdown of Tax RevenuesPersonal Income Taxes = $801.8 Corporate Profits Taxes = $217.4 Taxes on Production and Imports (e.g. sales and excise taxes) = $94.0 Contributions for Social Insurance = $803.5 Other = $58.1

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Breakdown of Government ExpenditurePurchases of Goods and Services (G) = $725.7 Transfer Payments = $1391.2 Interest Payments = $221.5 Other = $42.9 Source: Economic Indicators, October 2005.

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The Budget: In Our NotationRecall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

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The Budget and The Budget PositionBudget = T - G Budget Position (or size of deficit) = G - T

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The National DebtThe National Debt -- The total accumulated stock of debt owed by the government to its lenders (holders of government bonds). Expanded by budget deficits, reduced by budget surpluses.

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National Debt -- Realistic GoalRealistic Goal -- consider the Debt-Income Ratio = (National Debt)/(GDP). For the US in 2004 = ($4295.5)/($11734.3) = 0.366. Source: Economic Indicators, October 2005.

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The Income Tax and Automatic StabilizationAutomatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (i.e. fiscal policy).

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The Income Tax as an Automatic StabilizerY* (maybe > YF)  Tax Revenues helps to cool the economy Y* (maybe < YF)  Tax Revenues helps to stimulate the economy Note -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

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The Income Tax and the Federal BudgetY*  Tax Revenues  T  (T - G) A strong and growing economy improves the budget. Y*  Tax Revenues  T  (T - G) A weak economy generates a lower budget.

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Strategy of Fiscal PolicyExpansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G or T. Contractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G or T.

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Specific Types of Fiscal PolicyChange Government Purchases of Goods and Services (G) -- Expansionary: G -- Contractionary: G Change Transfer Payments (TP) -- Expansionary: TP -- Contractionary: TP

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Tax Policy as Fiscal PolicyChange Marginal Tax Rates (t) -- Expansionary: t -- Contractionary: t Change Tax Deductions -- Expansionary: Bigger Deductions -- Contractionary: Smaller Deductions Change Indirect Business Taxes (e.g. Sales or Excise Taxes) -- Expansionary: Lower Taxes -- Contractionary: Raise Taxes

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Fiscal Policy in the AD-AS ModelExpansionary Fiscal Policy shifts the AD curve rightward, increases Y* and P*. Contractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*. Note -- like monetary policy, fiscal policy is justified only from a short-run perspective.

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Obstacles to Fiscal Policy EffectivenessDifficulties in getting the proper policy passed through Congress and the president. A tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*. Worries about the Federal Budget within a sluggish economy.

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The Crowding Out Effect -- An Adverse “Side Effect”The Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

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The Crowding Out Effect -- Fiscal Policy EffectivenessCrowding Out Effect -- makes fiscal policy less effective than would be otherwise. Decrease in investment to some extent offsets rise in (G - T). Smaller shift in AD curve than would be without the crowding out effect.

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The Crowding Out Effect – Impeding Economic GrowthCrowding Out Effect  loss of Investment (I). Decrease in Investment retards the buildup of the capital stock and possible implementation of new technology (i.e. Labor Productivity growth). Smaller shifts in LAS curve, smaller increases in YF.

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Ways to Avoid the Crowding Out EffectBottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs. -- expansionary monetary policy -- increased private saving -- increase in foreign capital inflows

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Distinctive Fiscal Policy Actions in the USWorld War II The Kennedy-Johnson Tax Cut of 1964 The Nixon Tax Increase of 1969 The Reagan Economic Recovery and Tax Act of 1981 Clinton Tax Increases of 1993 Bush Tax Cuts of 2001-03 Bush Tax Rebates of 2008 Obama Fiscal Stimulus Plan of 2009

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Last Updated: 8th March 2018