Fiscal Policy & the Federal budjeg
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The federal government is composed of two, not necessarily equal, parts:
- government expenditures
- tax revenues
Goverment expenditures (sometimes called government spending) include:
- government purchases
- government transfer payments
the bulk of government tax revenues comes from three taxes:
- individual income tax
- corporate income tax
- social security tax
an income tax structure can be: (3)
progressive income tax:
the tax rate increases as a person's taxable income level rises
proportional income tax
the same tax rate is used for all income levels
regressive income tax
the tax rate decreases as a person's taxable income level rises.
government expenditures are greater than tax revenues
tax revenues are greater than government expenditures
government expenditures equal tax revenues
the part of the budget deficit that is a result of a downturn in economic activity
part of the deficit taht would exist if the economy were operating at full employment
total budget deficit equation
total budget deficit = structural deficit + cyclical deficit
the TOTAL amount of federal government owes its creditors
One of the major ways government can influence the economy is through:
its fiscal policy
consists of changes in government expenditures and or taxes to achieve particular economic goals, such as low unemployment, price stability, and economic growth
Expansionary fiscal policy
consists of increases in government expenditures and/or decreases in taxes to achieve macroeconomic goals
Contractionary fiscal policy
implemented through decreases in government expenditures and / or increases in taxes to achieve these goals
when deliberate government actions bring about changes in its expenditures and taxes, fiscal policy is said to be:
What two things can be done in this situation to restore the natural level of GDP?
- increased government purchases
- decreased taxes
What two things can be done to eliminate this inflation and bring it back to the natural level of Real GDP
- decreased government purchases
- increased taxes
a decrease in private expenditures (consumption, investment, etc.) as a consequence of increased government spending or the financing of a budget deficit
Crowding out can be ______ or _______
Direct effect of crowding out:
government spends money on publuc libraries, and individuals buy fewer books at bookstores
indirect effect of crowding out
government spends more on social programs and defense without increasing taxes; as a result, the size of the budget deficit increases. consequentl the government must borrow more funds to finance the larger deficit. This increase in borrowing causes the demand for credit (i.e., the demand for loanable funds) to rise, which in turn causes the interest rate to rise. As a result, investment drops. More government spending indirectly leads to less investment spending.
complete crowding out
when $1 of government spending offsets $1 of private spending
incomeplete crowding out
occurs when the decrease in one or more components of private spending only partially ofsets the increase in government spending
Zero, incomeplete, and complete crowding out graph
Given incomplete crowding out, expansionary fiscal policy _______ Real GDP and ________ the unemployment rate but not as much as if there is zero crowding out
5 steps of lags
- 1. the data lag
- 2. the wait-and-see lag
- 3. the legislative lag
- 4. the transmission lag
- 5. the effectiveness lag
the data lag:
policy makers are nto aware of changes in the economy as soon as they happen. For example, if the economy turns down in January, the decline may not be aparent for two to three months.
the wait and see lag
after policy makers are aware of a downturn in economic activity, they rarely enact counteractive measures immediatly. they usually adopt a relatively cautious wait and see attitude to make sure its not just a short run phenomena
the legislative lag
after policy makers decide that some type of fiscal policy measure is required, congress or the president has to propose the measure, build political support for it, and get it passed.
can take many months
the transmission lag
after enacted, a fiscal policy measure takes time to go into effect.
i.e., mandated increased spending for public works projects requires construction and work etc..
the effectiveness lag
after a policy measure is actually implemented, it takes time to affect the economy. If government spending is increased on Monday, the aggregate demand curve does not shift rightward on Tuesday.
when fiscal policy measure affect tax rates, they may affect both :
- aggregate supply
- aggregate demand
marginal tax rate equation
- change in Tax payment
- marginal tax rate = ---------------------------------------------
- change in taxable income
lower marginal tax rates increase the incentive to:
engage in productive activities (work) relative to leisure and tax-avoidance activities.
Laffers objective was to:
explain the possible relationships between tax rates and tax revenues.
Laffers 3 major points about the curve:
1. Zero tax revenues will be collected at two (marginal) tax rates: 0% and 100%. Obviously, no tax revenues will be raised if the tax rate is zero, and if it is 100% no one will work and earn income tax because the entire amount would be taxed
2. an increase in tax rates could cause tax revenues to increase. X to Y
3. A decrese in tax rates could cause tax revenues to increase. Z to Y
Tax revenues equation
Tax revenues = tax base x (average) Tax rate
Why does the tax base expand as tax rate is reduced?
individuals work more, invest more, enter into more trades, and shelter ess income from taxes at lower tax rates.
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