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1 FISCAL POLICY**
3
Answers to the Review Quizzes
Page 328 (page 736 in Economics)
1. What is fiscal policy, who makes it, and what is it designed to influence?
Fiscal policy is the use of the federal budget to achieve macroeconomic objectives.
Fiscal policy is made by the president and Congress. It is designed to influence
employment, economic growth, and price level stability.
2. What special role does the president play in creating fiscal policy?
Each year the president proposes the budget that Congress amends and enacts.
3. What special roles do the Budget Committees of the House of Representatives
and the Senate play in creating fiscal policy?
Each year the Budget Committees of the House of Representatives and the Senate
consider the budget proposed by the president, and develop their own ideas of
how it should be modified. Eventually, formal conferences between the two houses
resolve the differences between them and a series of spending acts and an overall
budget act passed.
4. What is the timeline for the U.S. federal budget each year? When does a fiscal
year begin and end?
Consider the budget for 2015 as an example in answering this question. In
February 2014 the president proposes a budget to Congress. Then, from February
until October 1, 2014, the Congress debates the budget, amends it, and eventually
passes the necessary budget bills. The president then signs or vetoes the budget
bills that were presented to him. When the president vetoes bills, the Congress
may over-ride the veto or pass other bills acceptable to the president. Fiscal year
2015 begins on October 1, 2014 and runs until September 30, 2015. During this
year the Congress may passand the president may signsupplementary bills.
Then, after the fiscal year ends, accounts are prepared and the official amounts
of outlays, receipts, and budget deficit or surplus are reported.
5. Is the federal government budget today in surplus or deficit?
Currently, the U.S. federal government is running a (large) budget deficit.
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supply of labor. That is, for each before-tax wage rate, workers provide a lower
quantity of labor when faced with a tax that lowers their after-tax wage. The
decrease in labor supply raises the before-tax wage rate, even though the after-tax
wage rate received by workers falls. The decrease in labor supply also means that
the quantity of employment at full employment (i.e., equilibrium employment in
the labor market) falls.
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2. How does the tax wedge influence potential GDP?
By decreasing employment, the tax wedge lowers potential GDP.
3. Why are consumption taxes relevant for measuring the tax wedge?
A tax on consumption raises the price paid for consumption goods and services
and so is equivalent to a cut in the real wage rate from the perspective of workers.
4. Why are income taxes on capital income more powerful than those on labor
income?
Given positive inflation, what appears to be a moderate tax on interest income
dramatically decreases the real after-tax interest rate, which is the interest rate
that influences investment and saving plans. In particular, by driving a wedge
between the real interest rate savers receive and firms pay, the tax on interest
income decreases the supply of loanable funds, which lowers investment and
saving in the economy.
5. What is the Laffer curve and why is it unlikely that the United States is on the
wrong side of it?
The Laffer curve is the relationship between the tax rate and the amount of tax
revenue collected. The amount of tax revenue collected increases with the tax rate
only up to a certain tax rate, after which, further increases in the tax rate cause
tax revenue to fall. When tax rates are higher than the tax rate that maximizes tax
revenue, a country is said to be on the wrong side of the Laffer curve. It is unlikely
that the United States is on the wrong side of the Laffer curve because U.S. tax
rates are among the lowest in the industrial world and past changes in U.S. tax
rates have produced changes in tax revenues in the same direction.
Automatic fiscal policy is triggered by the state of the economy with no need for
any government action. Discretionary fiscal policy, however, requires an act of
Congress to either change government spending and/or change taxes.
2. How do taxes and needs-tested spending programs work as automatic fiscal
policy to dampen the business cycle?
Taxes, such as income taxes, and needs-tested spending programs both work as
automatic fiscal policy because they decrease the effect a change in income has
on aggregate expenditure. For instance, when income decreases, consumption
expenditure and aggregate expenditure decrease. But with the fall in income,
income taxes decrease and needs-tested spending increase so that disposable
income does not fall as much as does income. The smaller fall in disposable
income means that the fall in consumption expenditure is smaller, so that the fall
in aggregate expenditure is likewise smaller.
3. How do we tell whether a budget deficit needs discretionary action to remove
it?
A budget deficit needs discretionary government action to remove it when the
deficit is a structural deficit. If the deficit is a structural deficit, then even when the
economy is at full employment, the deficit will remain. However, if the deficit is a
cyclical deficit, then when the economy returns to full employment, the deficit will
disappear.
4. How can the federal government use discretionary fiscal policy to stimulate
the economy?
If the economy has a recessionary gap, the government can increase its
expenditure or lower taxes to increase aggregate demand and move the economy
back toward potential GDP.
5. Why might fiscal stimulus crowd out investment?
Fiscal stimulus, such as an increase in government expenditure or a decrease in
taxes, increases the budget deficit. The increase in the budget deficit increases the
(governments) demand for loanable funds, thereby raising the real interest. The
higher real interest rate decreasescrowds outinvestment.
f. Potential GDP?
Potential GDP decreases. The equilibrium
level of employment is full employment.
So as full employment decreases,
potential GDP decreases along the
aggregate production function. Figure
13.2 shows this change as the
movement along the aggregate
production function, PF, from point A,
with 310 billion hours of employment
and potential GDP of $16.2 trillion, to
point B, with 300 billion hours of
employment and potential GDP $16.1
trillion.
4. What fiscal policy action might increase investment and speed economic
growth? Explain how the policy action would work.
A decrease in the tax on capital income will increase investment and thereby
increase economic growth. A decrease in the tax on capital income increases the
supply of loanable funds. The real interest rate falls and investment increases. The
increase in investment increases economic growth.
5. Suppose that instead of taxing nominal capital income, the government taxed
real capital income. Use appropriate graphs to explain and illustrate the effect
that this change would have on:
a. The tax rate on capital income.
The nominal interest rate is the (nominal) income from capital. If the government
changes the tax code to subtract the inflation rate from the (nominal) interest rate
before taxes are imposed, the true tax
rate on capital income falls because the
part of the capital incomethe inflation
ratethat is received in compensation
for inflation is no longer taxed.
b. The supply of and demand for
loanable funds.
With a lower tax rate on capital income,
the supply of loanable funds increases
as the after-tax real interest rate rises.
This change is illustrated in Figure 13.3
by the rightward shift of the supply of
loanable funds curve from the initial
supply of loanable funds curve, SLF0, to
SLF1.
The demand for loanable funds
generally remains the same because it
However, some of the budget deficit might be a structural deficit. The structural
deficit is the deficit that would exist if real GDP equaled potential GDP and the
economy was at full employment.
b. Explain how automatic fiscal policy is changing the output gap?
Automatic fiscal policy is decreasing the output gap relative to what it would be
otherwise in a recession because they increase aggregate demand relative to what
it would be otherwise in a recession. That is, aggregate demand decreases in a
recession, but it would decrease by more without the increase in needs-tested
spending and the decrease in tax revenue that produce the cyclical deficit.
c. If the government increases its discretionary expenditure, explain how the
structural deficit might change.
A discretionary increase in government expenditure, if not reversed following the
end of the recession, moves the budget balance toward a structural deficit.
Use the following news clip and fact to work Problems 9 to 11.
Senate Approves Obama Tax Cut Plan
The U.S. Senate has passed legislation extending Bush-era tax cuts for high-income
earners to middle-class Americans earning up to $250,000 per year.
Source: Financial Times, July 26, 2012
Fact: Middle and low-income earners spend almost all their disposable incomes.
High-income earners save a significant part of their disposable incomes.
9. a. Explain the intended effect of
extending tax cuts for middle-class
Americans but not for high-income
families. Draw a graph to illustrate
the intended effect.
The goal of extending the tax cuts for
middle-class Americans has an
intended effect of increasing
consumption expenditure, which
increases aggregate demand. Figure
13.4 shows the intended effect of this
policy where, including the multiplier
effect, the aggregate demand curve
shifts rightward from AD0 to AD1. As a
result real GDP increases, in the figure
from $15.7 trillion to $15.9 trillion. In
the figure real GDP remains below
potential GDP but the recessionary gap
becomes smaller.
b. Explain why the effect of tax cuts depends on who receives them.
The effect of this fiscal policy depends on the size of the impact on aggregate
demand. The more of the tax cut that is spent (which means the less that is saved)
the larger the magnitude of the effect on aggregate demand. If the tax rebates go
to people who spend more of the rebate, that is, middle and low-income earners,
the effect of this fiscal policy is larger.
10. What would have a larger effect on aggregate demand: extending the Bush-
era tax cuts to everyone; extending them for middle-class only; or extending
them for high-income earners only? How would each alternative compare with
no tax cuts but an equivalent increase in government expenditure?
Extending the income tax cuts to everyone will have the largest effect on
aggregate demand. Middle-income tax payers will spend most of the tax cut and
high-income tax payers, while spending only a small fraction of their income, still
spend some. In general, tax cuts have a larger effect on real GDP than do
increases in government expenditure because the tax cuts have stronger supply-
side effects. So whichever tax cut policyextending the tax cuts to everyone, to
only middle-class taxpayers, or to only high-income tax payershas the largest
supply-side effect also has the largest effect on real GDP.
11. Compare the impact on equilibrium real GDP of a same-sized decrease in taxes
and increase in government expenditure on goods and services.
According to the aggregate demand/aggregate supply model, the government
expenditure multiplier exceeds the tax multiplier, so government expenditure has
a larger impact on real GDP. Some economists, such as Robert Barro and Harald
Uhlig disagree and assert that the tax multiplier exceeds the government
expenditure multiplier because taxes affect aggregate demand and aggregate
supply. In this case the decrease in taxes has a larger impact on real GDP.
b. Explain the potential supply-side effects of the fiscal policy actions in part (a).
Compared to the situation of allowing these policies to expire, extending
emergency unemployment benefits increases job search by making unemployed
workers less likely to accept employment offers, thereby reducing employment.
Allowing the Social Security payroll tax cuts to continue continues the decreases
the income tax on labor, which means that the supply of labor will not decrease
and hence employment will not decrease.
25. Why might a stimulus come too late? What are the potential consequences of
a stimulus coming too late?
Stimulus might come too late because forecasters predictions that the slowdown
in Chinas growth will be slight might prove incorrect. So stimulus might be
delayed until the economy was actually in a recession. If this outcome occurred,
the unemployment rate would already have risen and real GDP already have
decreased because of the delay in implementing the program. Additionally, if the
program is implemented too late, then GDP might already be rising and
unemployment falling when the programs impacts occur, which could result in a
significantly higher price level.