Fiscal Policy

Fiscal Policy
Claudia Garcia-Szekely
4/14/2014
2002 Claudia Garcia-Szekely
War is the mother of taxes

Saint Gregory Nazianzus
And also the mother of inflation

4/14/2014 2002 Claudia Garcia-Szekely 2
"We're going to be putting money in people's pockets so that they can spend on buying a new computer for their kid's school, so that they can, you know, make sure that they are able to deal with heat and groceries and all the other strains on the family budget, President elect, Obama.
3
Fiscal Policy
Changes in Government Spending and/ or Taxes. Induce a change in Aggregate Spending.
Increase AE
Decrease AE
Expansionary Policy
Increase AE Increase Output and Employment
Increase Government Spending (DG) And or Decrease Taxes (DT)
4/14/2014
G
T
to
National Income generated from production
Circular Flow Diagram

pay
Rest of World
National Income Households - Taxes + Transfers
G G
Firms NX
C
I
Total Produced
Disposable Income is Income available for consumption.

Income generated from production is used to:
Buy goods and services: C. Save: S Pay taxes: Tx
The government pays income transfers to households.

Social Security Welfare Unemployment benefits
Adding Net Taxes

The government collects taxes
Use Tx for Taxes
The government pays Transfers

Use Tr for Transfers
We are only interested in the NET effect on Incomes.

Use T for Net Taxes = Tx - Tr
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Net Taxes T = Tx - Tr
Net amount paid in taxes to the government after subtracting transfers
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FixedTaxes (Lump Sum)

Fixed taxes do not change with income.
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Disposable Income Yd = Y - T
Income left after: Paying taxes Receiving Government Transfers Income available for Consumption and Saving
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C = a + b Yd C = a + b (Y-T) C = a + bY- bT C = (a bT) + bY
The effect of the tax cut

Fixed taxes change the intercept of the consumption function
A tax cut increases or increase in transfers the intercept of the consumption function. Changes in T shift the Consumption Function.
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Government Spending and Taxes affect AE differently

Government Spending (G) Enters directly into AE
AE = C+I+G
Taxes, transfers Enter indirectly (T) into AE via C
AE = +I+G+ C
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The effect of a 70 tax cut

Disposable Income When Taxes Consumers have increase by Decrease by DT = -70 70 more to spend D Yd = 70
When D Yd = 70 When D C = 63 When D AE = 63
4/14/2014
C = a + MPC(Yd) AE = C + I + G AE = C + I + G
C increase by D C = 0.9 (70)

AE increase by D AE = D C = 63 AE line shifts up by 63.
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The effect of A Decrease in Taxes: DT = -70 MPC = 0.9

Taxes change by (DT)=-70 Yd =Y-T change by (DT)=70 Consumption changes by (DT)MPC=70(0.9) AE shifts up by (DT)MPC DY = DC(1/1-MPC) DY = 63(1/1-0.9) DY = 63(10)=630
450
AE= C+I+G
AE= C+I+G
DC =630*0.9=567
DAE = DC=-DT(MPC) =-(-70)(0.9) =63
63 630
4/14/2014
DY = 63(10)
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The effect of A Change in Government Spending

If government Spending increases by DG = 70 AE line Shifts up by DAE= DG = 70 Equilibrium Income increases by: DY = 70(1/1-MPC) 45
AE1 AE0
DC =700*0.9=630 DG =70 DY = 700
DAE = DG = 70
DY = DG(Multiplier)
The Tax Multiplier smaller An extrais $70 in your hands doesnt go as far than the G Multiplier as the same $70 spent
Taxes decrease by 70
by the government! 45 Why? G increases by 70
45
AE1 AE0
AE1 AE0
63
630
DY = 63(10)
4/14/2014
70
700
DY = 70(10)
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Government Spending vs. Tax Cuts

The $787 B stimulus package includes $70 billion in tax cuts, which some economists believe will not create as many new jobs as $70 billion in spending would
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When taxes decrease by 70 MPC=0.9
45
AE1
AE0
70*0.9 70*0.9 * 10 Y0 * Multiplier Y1 70*MPC
P0
630
AD1
AD0
Y0
Y1
The size of the change in equilibrium Y is the size of the shift in AD
When G increases by 70 MPC=0.9
45
AE1
AE0
70 70*10 Y0 Multiplier Y1 70*
P0
700
AD1
AD0
Y0
Y1
The size of the change in equilibrium Y is the size of the shift in AD
The G Multiplier
45
Dc
DG
DY = = DG DY D(1/(1-b)) G + DC
YIncomes 0
Increase
Y1
Output
The G Multiplier
45
700*0.9
70
700
D Y = DG + D C Y 700 = 70 + 630
Output
The G Multiplier
45
Dc
Dc
DY = DY =DGD(1/(1-b)) c + DC
YIncomes 0
Increase
Y1
Output
The T Multiplier
45
630*0.9
63
630
D Y = DC + D C Y 630 = 63 + 567
Output
Change in Consumption
When government spending changes: The resulting change in spending is the sum of the extra government spending + extra consumption induced by the increase in incomes DY = DG + DC
When taxes change all the resulting change in spending is the extra consumption induced by the increase in incomes:
DC = 700 70 =630 DC = DY = 630
DC = DY DG
Changes in Budget Deficit

When government spending changes, the resulting change in the Budget Deficit is:
D Deficit = DG= 70
When taxes change, the resulting change in the Budget Deficit is:
DDeficit = -DT=-(-70)
The Tax Multiplier

D Y = DC x
DC=-DT(MPC)
D Y = -DT(MPC) x D Y = DT
4/14/2014
1 (1- MPC) 1
(1- MPC)
- (MPC)
(1- MPC)
]
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The Tax Multiplier

D Y = DT
- (MPC)
(1- MPC)
] ]
28
D Y = DT
[-
(MPC) (MPS)
4/14/2014
The Tax Multiplier Formula

D Y = DT
- (MPC)
(1- MPC)
]
Taxes and Output move in opposite directions
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A negative Number!
4/14/2014
The Tax Multiplier

Smaller
D Y = DG
[+ [-
1 (MPS)
(MPC) (MPS)
] ]
30
D Y = DT Negative
4/14/2014
The Balanced Budget Multiplier

Captures the effect on equilibrium output from simultaneous identical changes in Taxes and Government Spending
Increase Both G and T by 40

DY = DG 1
What happens if -MPC we the DY =finance DT extra spending with higher 1-MPC taxes?
1-MPC DY = 40
1 1-0.75
DY = 40
-0.75 1-0.75
DY = 40 (4)=160
4/14/2014
DY = 40 (-3)=-120 DY = 160 120= 40

2002 Claudia Garcia-Szekely 32
The Balanced Budget Multiplier is ONE

If DG = DT = 40 DY = 40 (1)
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When government spending changes: The resulting change in spending is the sum of the extra government spending + extra consumption induced by the increase in incomes: When taxes change all the resulting change in spending is the extra consumption induced by the increase in incomes: Balanced Budget change: multiplier effect is completely eliminated. There is NO extra consumption because the increase in incomes and consumption triggered by the increase in G is eliminated by the drop in incomes and consumption resulting from higher taxes:
Changes in Consumption
DC = DY - DG DC = DY
DY= DG ; DC = 0
Changes in Budget Deficit

When government spending changes, the resulting change in the Budget Deficit is: When taxes change, the resulting change in the Budget Deficit is: When both Government Spending and Taxes change by the same amount (a balanced budget change), there is no change in the Budget Deficit :
D Deficit = DG
D Deficit = -DT
D Deficit = 0
Income Tax: changes with income
VARIABLE TAXES
4/14/2014
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Variable Taxes: tY
Fixed Taxes C = a + b(Y-T) C and AE C = a + bY bT C = (a bT) + bY Slope =b Example: C = 1000 + 0.9(Y-700) C = 1000 + 0.9*Y 0.9*700 C = (1000 0.9*700) + 0.9*Y C = (1000 630) + 0.9Y Variable Taxes T= tY C = a + b(Y- tY) C = a + bY-b tY C = a + (b-bt) Y C and AE Slope =b-bt
Example: C = 1000 + 0.9(Y-0.25Y) C = 1000 + 0.9Y 0.9*0.25Y C = 1000+ Y(0.9-0.9*0.25) C = 1000 + (0.9-0.225)Y O.675
slope smaller
37
Variable Taxes: tY
Variable Taxes Fixed Taxes T=T+ tY C = a + b(Y-T) C = a + b(Y- (T+tY)) C and AE C = a + bY-b(T+tY) C and AE C = a + bY bT Slope =b-bt C = (a bT) + bY Slope =b C = a + bY-bT-btY Example: C = (a bT)+ (b-bt)Y C = 1000 + 0.9(Y-700) Example: C = 1000 + 0.9*Y 0.9*700 C = 1000 + 0.9(Y-700 -0.25Y) C = (1000 0.9*700) + C = (1000 630) + (0.90.9*Y 0.9*0.25)Y C = (1000 630) + 0.9Y C = (1000630) + Y(0.9-0.225) C = 1000630 + O.675Y Intercept same, slope 38smaller
Variable taxes make C and AE flatter

I+G+NX+a
a-bT
I+G+NX+abT
a bT
flatter Steeper When t Increases: C becomes flatter

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When T Increases: C shifts down

4/14/2014
Variable taxes make C and AE flatter

C Steeper: increase in C is larger
DC=100*MPC = 100*0.9 = 90 C Flatter: increase in C is smaller

DC=100*(MPC-MPC*t) = 100*(0.9-0.9*0.25)= 67.5
DY=100
Part of the increase in income goes to pay taxes so consumption does not increase as much.
Variable Taxes(tY) affect the When t rate multipliers increases,

Fixed Taxes
multiplier decreases
D Y = DG
1 (1- b)
Variable Taxes
D Y = DG
1 (1-b+bt)
D Y = DT
-b (1- b)
D Y = DT
-b (1-b+bt)
Both multipliers become smaller
The G multiplier when taxes change with income (Income Taxes)

The effect of an increase in G is smaller with income taxes because as income increases, the government taxes a portion of the increase in income. DY = DG + DC; DC is smaller than before The effect of a tax cut is also smaller with income taxes because as income increases, the government taxes a portion of the increase in income. DY = DC; DC is smaller than before
The oversimplified formula overstates the size of the multiplier
Permanent Tax Cut or Tax Holiday?

A tax cut has more potential impact in the long run than a tax holiday.
A payroll tax credit would provide more of a spending boost since it is a permanent change in the tax code
Households are more likely to spend a tax cut if it is the result of a permanent change rather than a temporary one Households are more likely to save a temporary tax cut.
4/14/2014
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Condition G that must be satisfied for equilibrium:

T Since:
Open Economy with Government
We can rewrite the equilibrium condition as: S C+S+ T= C + I + G +X-M C SavingsS+T must=finance Investment, the I+G+ X-M Total governments deficit and the trade S+T+Mdeficit. =I+G+X Production leakages I = Injections
Firms NX G used to consume, save and pay taxes) Households
Y = C + I + G + X-M Y = C + S + T (Income is
Rest of World
S = I + (G T)+(X-M)
Y > AE
Inventories increase
AE
Leakages = Injections
Y < AE
Inventories fall
Equilibrium
I+G+X=S+T+M
I+G+X
Y
below equilibrium
Equilibrium
above equilibrium
Leakages < Injections
Leakages > Injections
At What Y = is 5,000 3,000 the equilibrium are inventories GDP? rising? Falling? Unchanged? For Forwhat whatvalue valueof ofGDP GDPis: is: Y Y==AE? AE? For what value of GDP is: S = I +(G-T) +(X-M)?
I + (G-T) + (X-M)
Automatic Stabilizers
Features of the economy that reduce its sensitivity to shocks
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Personal Income Taxes
AUTOMATIC STABILIZERS
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1.
Personal Income Taxes

When GDP rises, we earn more income but we also pay more taxes and thus consumption does not rise as much as it would if taxes did not rise with income. When GDP falls, we earn less income but we also pay less taxes and thus consumption does not fall as much as it would if taxes did not fall with income.
Unemployment Compensation, Income supplements for the poor
AUTOMATIC STABILIZERS
4/14/2014
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2. Unemployment Compensation, Income
Supplements for the poor
When GDP falls, more people receive unemployment insurance payments thus dampening the fall in incomes (and consumption) that would occur with a falling GDP. When GDP rises, fewer people receive unemployment insurance payments thus dampening the rise in incomes (and consumption) that comes with a rising GDP.
4/14/2014
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Chart 2-3. The Federal Government Dollar Where It Comes From
2008
Discretionary Spending
Mandatory Spending
Fiscal Policy
MPC = 0.9. Find DG/DT necessary to close the gap. Calculate for each DC, D Deficit.
Fiscal Policy
MPC = 0.9. Find DG/DT necessary to close the gap. Calculate for each DC, D Deficit.
Effect on C, AE, AD, GDP and prices

Increase (decrease) in taxes (fixed or variable) Increase (decrease) in transfers Increase (decrease) in G
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Example:
C = 200 +0.8 (Y-T) I = 300 G = 150 T = 100
Add to get AE
AE = 650 + 0.8 (Y 100) AE =650 0.8(100) + 0.8Y AE = 570 + 0.8Y
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Equilibrium Output
AE = 570 + 0.8Y
Set Y = AE and solve for Y: Y = 570 + 0.8 Y Y 0.8Y = 570 Y(1-0.8) = 570 Y = 570/0.2
Y = 2,850
Equilibrium
C = 200 +0.8 (Y-T) I = 300 G = 150 T = 100
- 80
AE=2,850
570
4/14/2014
Y=2,850
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C = 200 +0.8 (2,850-100) I = 300 G = 150 T = 100

AE=2,850
C = 2,400
Y=2,850 450
I+G=S+T
450
S = Y-C-T S = 2,850 2,400-100
I+G
Y=2,850
S = 350
+
T = 100

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Fiscal Policy

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Fiscal Policy

2002 Claudia Garcia-Szekely

War is the mother of taxes

And also the mother of inflation

Increase Government Spending (DG) And or Decrease Taxes (DT)

2002 Claudia Garcia-Szekely

National Income generated from production

Circular Flow Diagram

National Income Households - Taxes + Transfers

Disposable Income is Income available for consumption.

The government pays income transfers to households.

Adding Net Taxes

The government pays Transfers

We are only interested in the NET effect on Incomes.

2002 Claudia Garcia-Szekely

2002 Claudia Garcia-Szekely

FixedTaxes (Lump Sum)

2002 Claudia Garcia-Szekely

2002 Claudia Garcia-Szekely

C = a + b Yd C = a + b (Y-T) C = a + bY- bT C = (a bT) + bY

The effect of the tax cut

2002 Claudia Garcia-Szekely

Government Spending and Taxes affect AE differently

Taxes, transfers Enter indirectly (T) into AE via C

2002 Claudia Garcia-Szekely

The effect of a 70 tax cut

C increase by D C = 0.9 (70)

The effect of A Decrease in Taxes: DT = -70 MPC = 0.9

DAE = DC=-DT(MPC) =-(-70)(0.9) =63

The effect of A Change in Government Spending

DC =700*0.9=630 DG =70 DY = 700

by the government! 45 Why? G increases by 70

2002 Claudia Garcia-Szekely

Government Spending vs. Tax Cuts

2002 Claudia Garcia-Szekely

When taxes decrease by 70 MPC=0.9

70*0.9 70*0.9 * 10 Y0 * Multiplier Y1 70*MPC

The size of the change in equilibrium Y is the size of the shift in AD

When G increases by 70 MPC=0.9

70 70*10 Y0 Multiplier Y1 70*

The size of the change in equilibrium Y is the size of the shift in AD

DC = 700 70 =630 DC = DY = 630

Changes in Budget Deficit

The Tax Multiplier

2002 Claudia Garcia-Szekely

The Tax Multiplier

2002 Claudia Garcia-Szekely

The Tax Multiplier Formula

2002 Claudia Garcia-Szekely

The Tax Multiplier

2002 Claudia Garcia-Szekely

The Balanced Budget Multiplier

Increase Both G and T by 40

DY = 40 (-3)=-120 DY = 160 120= 40

The Balanced Budget Multiplier is ONE

2002 Claudia Garcia-Szekely

Changes in Budget Deficit

Income Tax: changes with income

2002 Claudia Garcia-Szekely

Variable taxes make C and AE flatter

flatter Steeper When t Increases: C becomes flatter

When T Increases: C shifts down

2002 Claudia Garcia-Szekely

Variable taxes make C and AE flatter

700.9 700.9 * 10 Y0 * Multiplier Y1 70*MPC

70 7010 Y0 Multiplier Y1 70

DC=100MPC = 1000.9 = 90 C Flatter: increase in C is smaller