Government Budgets

The federal budget is the annual statement of the federal

government’s outlays and tax revenues.
The federal budget has two purposes:
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives

Fiscal policy is the use of the federal budget to achieve

macroeconomic objectives, such as full employment and
sustained economic growth.
Government Budgets
Budget Balance
The federal government’s budget balance equals revenue
minus outlays.
• If revenues (T) exceed outlays (G), the government has a
budget surplus.
• If outlays (G) exceed revenues (T), the government has a
budget deficit.
• If revenues (T) equal outlays (G), the government has a
balanced budget.
Government Budgets
 Government Budgets
Revenues
• Figure 29.2 shows revenues as a percentage of GDP.
 Government Budgets
Outlays
• Figure 29.3 shows outlays as a percentage of GDP.
 Government Budgets
Deficit and Debt

Government debt is the

total amount that the
government borrowing. It is
the sum of past deficits
minus past surpluses.

Figure 29.4 shows the

federal government’s debt
as a percentage of GDP.
The Effects of
Fiscal Policy
• Fiscal policy has important effects on employment,
investment, potential GDP, and the overall economy.
• Changes in income tax for example may encourage or
discourage workers, thus changing full employment and
potential GDP.
• Changes in corporate tax for example may encourage or
discourage investment, thus changing full employment and
potential GDP.
 Private and public savings (S)
• Assuming that Investment comes from savings (own or other
peoples’), then S = I

S = Y-C-G Savings equal Income minus what’s spent

S = (Y - T - C) + (T - G)

Private savings Government (public) savings

• Note that NX has been eliminated from the equation (typically small
as % of GDP) 9
 Types of Fiscal Policy
An expansionary fiscal policy has as an objective the increase in GPD
growth (at risk of increasing inflation) by stimulating the economy through
a higher level of expenditures.

• One approach consists in increasing government expenditures (G) by

financing public works. This will in turn increase workers’ revenue
stimulating consumption (C), profits, thus investment (I) further
contributing to GDP growth (this is called the multiplier effect of
government expenditures, an idea highly pushed by economist John
Maynard Keynes).

GDP = C + I + G + NX
 Types of Fiscal Policy
• Economists against this type of approach argue that an increase in
government spending (G) can only be financed through higher taxation,
which according to the equation below would decrease private savings. It
is then a substitution between private spending and government
spending.

S = (Y - T - C) + (T - G)

• Moreover, if government decides to spend while not increasing taxes, the

increase in expenditures must come from borrowing. It may then be
argued that current government expenditures are made at the expense
of future consumption and future investment, which only pushes the
problem away.
 Types of Fiscal Policy
• The other expansionary approach consists in decreasing taxation for
households and firms, which will in turn increase workers’ revenue
stimulating consumption (C), profits and investment (I) further
contributing to GDP growth.

GDP = C + I + G + NX
S = (Y - T - C) + (T - G)

• Opponents to this view argue that the decrease in taxation will decrease
government revenue and possibly important outlays destined to crucial
programs such as health and education. Besides, they claim that though
private savings may indeed increase, nothing guarantees that that money
will indeed be borrowed and used for consumption and investment.
 Types of Fiscal Policy
A restrictive fiscal policy has as an objective the decrease inflation (at risk
of hindering GDP growth) by cooling down the economy through a lower
level of expenditures.

The approaches work in exactly the opposite direction as those previously

seen, that is:

• Decreasing government expenditures

• Increasing the level of taxation on households and firms
 But how much to tax?
Tax Revenues and the
Laffer Curve
• The relationship
between the tax rate
and the amount of tax
revenue collected is
called the Laffer curve.
• At the tax rate T*,
tax revenue is
maximized.
 The Supply-Side Effects of
Fiscal Policy
• For a tax rate below T*,
a rise in the tax rate increases
tax revenue.
• For a tax rate above T*,
a rise in the tax rate decreases
tax revenue.
• Economists don’t argue about
the curve itself, but about
wher T* is located.
• Recently, Romer & Romer
have argued the that for the
USA, T* is below current
taxation levels.