Econ

chapter twelve fiscal policy

CHAPTER OVERVIEW

This chapter looks briefly at the legislative mandates given to government to pursue stabilization of the economy; it then explores the tools of government stabilization policy in terms of the aggregate demand-aggregate (AD-AS) model. Next, some fiscal policy measures that automatically adjust government expenditures and tax revenues when the economy moves through the business cycle phases are examined. Finally, problems, criticism, and complications of government’s fiscal policy are addressed.

WHAT’S NEW

The full-employment budget discussion has been revised and clarified in a section entitled “Evaluating Fiscal Policy.” Current real-world budget surpluses eliminated the need to emphasize the structural deficit. Also the section on budget’s expansionary bias has been deleted. Tables and graphs have been updated and revised for clarity. End-of-chapter questions 7 and 9 and Internet questions are new.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Identify the Employment Act of 1946 and the roles of the CEA and JEC.

2. Distinguish between discretionary and nondiscretionary fiscal policy.

3. Differentiate between expansionary and contractionary fiscal policy.

4. Recognize the conditions for recommending an expansionary or contractionary fiscal policy.

5. Explain expansionary fiscal policy and its effects on the economy and Federal budget.

6. Explain contractionary fiscal policy and its effects on the economy and Federal budget.

7. Describe the two ways to finance a government budget deficit and how each affects the economy.

8. Describe the two ways to handle a government budget surplus and how each affects the economy.

9. Give two examples of how built-in stabilizers help eliminate recession or inflation.

10. Explain the differential impacts of progressive, proportional, and regressive taxes in terms of stabilization policy.

11. Explain the significance of the “full-employment budget” concept.

12. List three timing problems encountered with fiscal policy.

13. State political problems that limit effective fiscal policy.

14. Explain and recognize graphically how crowding out and inflation can reduce the effectiveness of fiscal policy.

15. Give two examples of complications that may arise when fiscal policy interacts with international trade.

16. Give an example of supply-side fiscal policy and three possible positive effects from it.

17. Define and identify terms and concepts at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS

1. Fiscal policy, especially tax policy, is one of the subjects that students usually find very interesting. The chapter provides an excellent opportunity to establish the ties between theory and real-world applications.

2. To give a more human dimension to this chapter, students may identify current members of the Council of Economic Advisers (end-of-chapter question #1). You could assign excerpts from the latest Economic Report of the President, which the Council helps to prepare.

3. Current federal tax or spending issues can illustrate the timing, administrative, and political problems with discretionary fiscal policy. The 2001 tax cut proposal illustrated many of these issues.

4. Current data on the federal budget can be obtained from the Federal Reserve Bulletin, Economic Indicators, the Survey of Current Business, or the Economic Report of the President or websiste given in web-based question #18.

5. Remind students of the multiplier impact that results from changes in government spending and/or taxes. Most students can understand these concepts without reference to the numerical examples. Numbers often confuse those with “math anxiety,” and if you skipped Chapters 9 and 10, they will benefit from a brief overview of the concept.

6. The Last Word for the chapter is on the “leading indicators.” The stock market often reacts immediately to changes in various indicators. One assignment could focus on the impact of latest report.

STUDENT STUMBLING BLOCKS

1. The biggest concern is with the magnitude of information in this chapter. Give students an opportunity to focus on a few concepts at a time rather than assigning the entire chapter at once.

2. Although most students know this, some need to be reminded how Congress and the President establish fiscal policy. This is particularly important when highlighting the different policy-making process for monetary policy.

LECTURE NOTES

I. Introduction A. One major function of the government is to stabilize the economy (prevent unemployment or inflation). B. Stabilization can be achieved in part by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation. C. This chapter will examine a number of topics. 1. It will look at the legislative mandates given government to pursue stabilization. 2. It explores the tools of government fiscal stabilization policy using AD-AS model. 3. Both discretionary and automatic fiscal adjustments are examined. 4. The problems, criticisms, and complications of fiscal policy are addressed.
II. Legislative mandates—The Employment Act of 1946 A. Congress proclaimed government’s role in promoting maximum employment, production, and purchasing power. B. The Act created the Council of Economic Advisers to advise the President on economic matters. C. It created the Joint Economic Committee of Congress to investigate economic problems of national interest. III. Fiscal Policy and the AD/AS Model A. Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth. “Discretionary” means the changes are at the option of the Federal government. B. Simplifying assumptions: 1. Assume initial government purchases don’t depress or stimulate private spending. 2. Assume fiscal policy affects only demand, not supply, side of the economy. C. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples illustrated in Figure 12-1). 1. Expansionary Policy needed: In Figure 12-1, a decline in investment has decreased AD from AD1 to AD2 so real GDP has fallen and also employment declined. Possible fiscal policy solutions follow: a. An increase in government spending (shifts AD to right by more than change in G due to multiplier), b. A decrease in taxes (raises income, and consumption rises by MPC ∞ change in income; AD shifts to right by a multiple of the change in consumption). c. A combination of increased spending and reduced taxes. d. If the budget was initially balanced, expansionary fiscal policy creates a budget deficit. 2. Contractionary fiscal policy needed: When demand-pull inflation occurs as illustrated by a shift from AD3 to AD4 in the vertical range of aggregate supply in Figure 12-2. Then contractionary policy is the remedy: a. A decrease government spending shifts AD4 back to AD3 once the multiplier process is complete. Here price level returns to its preinflationary level P3 but GDP remains at full-employment level. b. An increase in taxes will reduce income and then consumption at first by MPC ∞ fall in income, and then multiplier process leads AD to shift leftward still further. In Figure 12-2 a tax increase of $6.67 billion decreases consumption by 5 and multiplier causes eventual shift to AD3. c. A combined spending decrease and tax increase could have the same effect with the right combination ($2 billion decline in G and $4 billion rise in T will have this effect). D. Financing deficits or disposing of surpluses: The method used influences fiscal policy effect. 1. Financing deficits can be done in two ways. a. Borrowing: The government competes with private borrowers for funds and could drive up interest rates; the government may “crowd out” private borrowing, and this offsets the government expansion. b. Money creation: When the Federal Reserve loans directly to the government by buying bonds, the expansionary effect is greater since private investors are not buying bonds. (Note: Monetarists argue that this is monetary, not fiscal, policy that is having the expansionary effect in such a situation.) 2. Disposing of surpluses can be handled two ways. a. Debt reduction is good but may cause interest rates to fall and stimulate spending. This could be inflationary. b. Impounding or letting the surplus funds remain idle would have greater anti-inflationary impact. The government holds surplus tax revenues which keeps these funds from being spent. E. Policy options: G or T? 1. Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure. 2. Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.
IV. Built-In Stability A. Built-in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary. Figure 12-3 illustrates how the built-in stability system behaves. 1. Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls. 2. Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP. B. The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built-in stability. In Figure 12-3 line T is steepest with a progressive tax system. 1. A 1993 law increased the highest marginal tax rate on personal income from 31 percent to 39.6 percent and corporate income tax rate to 35% by 1 percentage. This helped prevent demand-pull inflation. 2. Automatic stability reduces instability, but does not correct economic instability.
V. Evaluating Fiscal Policy A. A full-employment budget in Year 1 is illustrated in Figure 12-4(a) because budget revenues equal expenditures when full-employment exists at GDP1. B. At GDP2 there is unemployment and assume no discretionary government action, so lines G and T remain as shown. 1. Because of built-in stability, the actual budget deficit will rise with decline of GDP; therefore, actual budget varies with GDP. 2. The government is not engaging in expansionary policy since budget is balanced at F.E. output. 3. The full-employment budget measures what the Federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full employment. 4. Actual budget deficit or surplus may differ greatly from full-employment budget deficit or surplus estimates. C. In Figure 12-4b, the government reduced tax rates from T1 to T2, now there is a F.E. deficit. 1. Structural deficits occur when there is a deficit in the full-employment budget as well as the actual budget. 2. This is expansionary policy because true expansionary policy occurs when the full-employment budget has a deficit. D. If the F.E. deficit of zero was followed by a F.E. budget surplus, fiscal policy is contractionary. E. Recent U.S. fiscal policy is summarized in Table 12-1. 1. Observe that F.E. deficits are less than actual deficits. 2. Column 3 indicates expansionary fiscal policy of early 1990s became contractionary in the later years shown. 3. Actual deficits have disappeared and the U.S. budget has actual surpluses since 1999. (Key Question 7) F. Global Perspectives 12-1 gives a fiscal policy snapshot for selected countries.
VI. Problems, Criticisms and Complications A. Problems of timing 1. Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence. 2. Administrative lag is the difficulty in changing policy once the problem has been recognized. 3. Operational lag is the time elapsed between change in policy and its impact on the economy. B. Political considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy. 1. A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions. a. political business cycle? 2. State and local finance policies may offset federal stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse. In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus. 3. The crowding-out effect may be caused by fiscal policy. a. “Crowding-out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy. (See Figure 12-5) b. Some economists argue that little crowding out will occur during a recession. c. Economists agree that government deficits should not occur at F.E., it is also argued that monetary authorities could counteract the crowding-out by increasing the money supply to accommodate the expansionary fiscal policy. C. With an upward sloping AS curve, some portion of the potential impact of an expansionary fiscal policy on real output may be dissipated in the form of inflation. (See Figure 12-5c)
VI. Fiscal Policy in an Open Economy (See Table 12-2) A. Shocks or changes from abroad will cause changes in net exports which can shift aggregate demand leftward or rightward. B. The net export effect reduces effectiveness of fiscal policy: For example, expansionary fiscal policy may affect interest rates, which can cause the dollar to appreciate and exports to decline (or rise).
VII. Supply-Side Fiscal Policy A. Fiscal policy may affect aggregate supply as well as demand (see Figure 12-6 example). B. Assume that AS is upward sloping for simplicity. C. Tax changes may shift aggregate supply. An increase in business taxes raises costs and shifts supply to left; decrease shifts supply to the right. 1. Also, lower taxes could increase saving and investment. 2. Lower personal taxes may increase effort, productivity and, therefore, shift supply to the right. 3. Lower personal taxes may also increase risk-taking and, therefore, shift supply to the right. D. If lower taxes raise GDP, tax revenues may actually rise. E. Many economists are skeptical of supply-side theories. 1. Effect of lower taxes on a supply is not supported by evidence. 2. Tax impact on supply takes extended time, but demand impact is more immediate.
VIII. LAST WORD: The Leading Indicators A. This index comprises 10 variables that have indicated forthcoming changes in real GDP in the past. B. The variables are the foundation of this index consisting of a weighted average of ten economic measurements. A rise in the index predicts a rise in the GDP; a fall predicts declining GDP. C. Ten components comprise the index: 1. Average workweek: A decrease signals future GDP decline. 2. Initial claims for unemployment insurance: An increase signals future GDP decline. 3. New orders for consumer goods: A decrease signals GDP decline. 4. Vendor performance: Better performance by suppliers in meeting business demand indicates decline in GDP. 5. New orders for capital goods: A decrease signals GDP decline. 6. Building permits for houses: A decrease signals GDP decline. 7. Stock market prices: Declines signal GDP decline. 8. Money supply: A decrease is associated with falling GDP. 9. Interest-rate spread: when short-term rates rise, there is a smaller spread between short-term and long-term rates which are usually higher. This indicates restrictive monetary policy. 10. Index of consumer expectations: Declines in consumer confidence foreshadow declining GDP. D. None of these factors alone is sufficient to predict changes in GDP, but the composite index has correctly predicted business fluctuations many times (although not perfectly). The index is a useful signal, but not totally reliable.

ANSWERS TO END-OF-CHAPTER QUESTIONS

12-1 What is the central thrust of the Employment Act of 1946? What is the role of the Council of Economic Advisers (CEA) in responding to this law? Class assignment: Determine the names and educational backgrounds of the present members of the CEA. The central thrust of the Employment Act of 1946 is that the government does have a role to play in stabilizing prices (purchasing power), employment, and output. It formally recognized that the government had a role to play in stabilizing economic conditions. The CEA advises the President on economic matters. Its members and staff gather and analyze relevant economic data, make forecasts, formulate policy, and help to “educate” the public and public officials on matters related to the nation’s economic health. Try www.whitehouse.gov for information on CEA.
12-2 (Key Question) Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal. (See Figure 12-1 for illustration). In this problem, the multiplier is 1/.2 or 5 so, the increase in government spending = $5 billion. For tax cut question, initial spending of $5 billion is still required, but only .8 (= MPC) of a tax cut will be spent. So .8 x tax cut = $5 billion or tax cut = $6.25 billion. Part of the tax reduction ($1.25 billion) is saved, not spent. One combination: a $1 billion increase in government spending and a $5 billion tax cut.
12-3 (Key Question) What are government’s fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think a “conservative” economist might favor? A “liberal” economist? Options are to reduce government spending, increase taxes, or some combination of both. See Figure 12-2. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A “conservative” economist might favor cuts in government spending since this would reduce the size of government. A “liberal” economist might favor a tax hike; it would preserve government spending programs.
12-4 (For students who were assigned Chapters 9 and 10) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary gap or an inflationary gap (Figure 10-8). Use the concept of the balanced budget multiplier to explain how equal increases in G and T could eliminate a recessionary gap and how equal decreases in G and T could eliminate an inflationary gap. A recessionary gap could be eliminated by increasing government spending and/or decreasing personal taxes. Both of these policies have the effect of raising aggregate demand and shifting the aggregate expenditures schedule upward toward full-employment GDP. An inflationary gap could be eliminated by pursuing the opposite policies: either decreasing government spending or raising taxes or both. This would reduce aggregate expenditures and would shift actual spending downward toward the full-employment level of real GDP. Because the balanced budget multiplier essentially multiplies any change in government spending by a factor of 1, an increase in government spending and taxes would still have a positive effect on aggregate expenditures, increasing them by the amount of the initial increase in G. If G were large enough, the recessionary gap could be eliminated. Likewise, a balanced decrease in G and T could eliminate an inflationary gap, because the decline in aggregate expenditures would be equal to G. If the decrease in G were large enough to bring aggregate expenditures to the level of full-employment GDP, then the inflationary gap would be eliminated.
12-5 Designate each statement true or false and justify your answer. a. Expansionary fiscal policy during a depression will have a greater positive effect on real GDP if government borrows the money to finance the budget deficit than if it creates new money to finance the deficit. b. Contractionary fiscal policy during severe demand-pull inflation will be more effective if government impounds the budget surplus rather than using the surplus to pay off some of its past debt. (a) The statement is false. The truth is the opposite because when government creates new money during a depression, there is little danger of inflation and all of the new expenditures will be felt through increased aggregate demand as government’s net spending increases. If the government finances its deficit by borrowing, there is danger that this will crowd out some private borrowing and investment spending. The resulting reduction in private spending offsets the expansionary effect of the fiscal deficit. (b) The statement is true. When the government impounds the surplus, these funds are removed from the spending flow. If the government used the surplus to pay of some of its past debt, money is returned to the private sector and at least a portion of it will be pumped into the economy in new expenditures. These expenditures will offset the contractionary effect of the budget surplus.
12-6 Explain how built-in (or automatic) stabilizers work. What are the differences between a proportional, progressive, and regressive tax system as they relate to an economy’s built-in stability? In a phrase, “net tax revenues vary directly with GDP.” When GDP is rising so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation, and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP. A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability. This follows from the previous paragraph. A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, but it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline. 7. (Key Question) Define the “full-employment budget,” explain its significance, and state why it may differ from the “actual budget.” Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 12-3. If the economy is operating at GDP2 instead of GDP3, what is the status of its full-employment budget? Of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure? The full-employment budget (also call standardized) measures what the Federal deficit or surplus would be if the economy reached full-employment level of GDP with existing tax and spending policies. If the full-employment budget is balanced, then the government is not engaging in either expansionary not contractionary policy, even if, for example, a deficit automatically results when GDP declines. The “actual” budget is the deficit or surplus that results when revenues and expenditures occur over a year if the economy is not operating at full-employment. Looking at Figure 12-3, if full-employment GDP level was GDP3, then the full-employment budget is contractionary since a surplus would exist. Even though the “actual” budget has no deficit at GDP2, fiscal policy is contractionary. To move the economy to full-employment, government should cut taxes or increase spending. You would raise G line or lower T line or combination of each until they intersect at GDP3.

12-8 As shown in Table 12-1, between 1990 and 1991 the actual budget as a percent of GDP grew more rapidly than the full-employment budget deficit. What could explain this fact? The explanation must be that the economy entered a recessionary phase during those years (it did, in fact), and for that reason the deficit was greater than it would have been in a full-employment economic situation. During a recession, tax revenues are lower than they would be at full employment and government expenditures for entitlement programs rise more than they would at full employment. Therefore, the actual deficit is greater than the full-employment budget deficit.
12-10 (Key Question) Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the notion of a political business cycle. What is the crowding-out effect and why is it relevant to fiscal policy? In what respect is the net export effect similar to the crowding-out effect? It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation. A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability. The crowding-out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending, financed by borrowing. The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the impact of the expansionary fiscal policy may be reduced. The next export effect also arises from the higher interest rates accompanying expansionary fiscal policy. The higher interest rates make U.S. bonds more attractive to foreign buyers. The inflow of foreign currency to buy dollars to purchase the bonds drives up the international value of the dollar, making imports less expensive for the United States, and U.S. exports more expensive for people abroad. Net exports in the United States decline, and like the crowding-out effect, diminish the expansionary fiscal policy.
12-11 In view of your answers to question 10, explain the following statement: “While fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to ‘fine-tune’ the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely.” As suggested, the answer to question 9 explains this quote. While fiscal policy is useful in combating the extremes of severe recession with its built-in “safety nets” and stabilization tools, and while the built-in stabilizers can also dampen spending during inflationary periods, it is undoubtedly not possible to keep the economy at its full-employment, noninflationary level of real GDP indefinitely. There is the problem of timing. Each period is different, and the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation. Fiscal policy operates in a political environment in which the unpopularity of higher taxes and specific cuts in spending may dictate that the most appropriate economic policies are ignored for political reasons. Finally, there are offsetting decisions which may be made at any time in the private and/or international sectors. For example, efforts to revive the economy with more government spending could result in reduced private investment or lower net export levels. Even if it were possible to do any fine tuning to get the economy to its ideal level in the first place, it would be virtually impossible to design a continuing fiscal policy that would keep it there for all of the reasons mentioned above.
12-12 Suppose that government engages in deficit spending to push the economy away from recession and that this spending is directed toward new “public capital” such as roads, bridges, dams, harbors, office parks, and industrial sites. How might this spending increase the expected rate of return on some types of potential private investment projects? What are the implications for the crowding-out effect? Government spending which is directed toward the improvement of the infrastructure (roads, bridges, dams, and harbors) provides additional “public capital” which increases the “production possibilities” of the nation. Private business firms benefit from these improvements through more convenient and reliable transportation systems and other amenities that lower production costs and make their business locations more desirable. Business firms that benefit from these public projects are, in effect, being subsidized by the government spending. These firms are likely to find that the publicly funded improvements increase the expected rate of return on their own investment projects. Some economists argue that little crowding out will occur if the deficit spending is carried out during a recession. In addition, if the increased government spending improves business profit expectations, as suggested above, private investment need not fall, even though interest rates rise.
12-13 Use Figure 12-4(a) to explain why a deliberate increase in the full-employment budget (resulting from the tax cut) will reduce the size of the actual deficit if the fiscal policy succeeds in pushing the economy to its full-employment output of GDP3. In requesting a tax cut in the early 1960s, President Kennedy said, “It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise tax revenues in the long run is to cut tax rates now.” Relate this quotation to your previous answer. To the extent the deficit increase is successful in expanding the economy, equilibrium GDP will be to the right of its original position in Figure 12-4. The higher GDP means greater income and employment, which should raise total tax revenues despite lower rates and automatically reduce government spending on many social programs as fewer recipients qualify for support. The expansionary policy could have a beneficial effect on both the economy and the actual budget deficit. Especially in the relatively noninflationary early 1960s, President Kennedy was right. The cut in tax rates, finally achieved under President Johnson, did indeed increase real GDP. The cut in taxes boosted production, so that out of the increased real GDP, tax revenues became greater than they had been before the tax cut—as Figure 12-4 would have predicted.
12-14 Discuss: “Mainstream economists tend to focus on the aggregate demand effects of tax-rate reductions; supply-side economists emphasize the aggregate supply effects.” Identify three routes through which a tax cut might increase aggregate supply. If tax cuts are so good for the economy, why don’t we cut taxes to zero? Mainstream economists come from the Keynesian tradition, which focused on the demand side of the economy. Keynes emphasized deficient aggregate demand as the major cause of recessions and depressions, and the recessionary gap concept implies that shifting demand is the solution to the unemployment problem. Supply-side economists take their name from their focus on the supply side of the economy. They argue that the tax structure has a major effect on the supply side of the economy through its impact on work incentives and productivity as well as its impact on saving and investment. They argue that a lighter tax burden has an encouraging effect in all of these areas. Taking these factors one by one, tax cuts may provide more incentive to work harder and longer, as workers and employers keep more of their after-tax earnings; encourage investment, especially if the tax cuts are aimed at promoting saving and business investment via such avenues as tax-free interest on certain types of saving, investment tax credits, and/or lower capital gains income taxes; the latter tax cuts might also encourage risk-taking and more innovation and new business. Of course, zero taxes are absurd because there is a certain level of government that all agree is necessary, and we must pay for it. Lower taxes might provide additional revenue under circumstances where the existing structure has imposed an excessive burden, but there is a point below which lower tax rates will mean lower revenue. One might think of the incentive factor of lower taxes as producing diminishing returns.
12-15 Advanced analysis: (For students assigned Chapters 9 and 10) Assume that, without taxes, the consumption schedule for an economy is as shown below:

| | |
|GDP, |Consumption, |
|billions |billions |
| | |
| | |
|$100 | |$120 | |
|200 | |200 | |
|300 | |280 | |
|400 | |360 | |
|500 | |440 | |
|600 | |520 | |
|700 | |600 | |
| | |

a. Graph this consumption schedule and determine the size of the MPC. b. Assume a lump-sum (regressive) tax is imposed such that the government collects $10 billion in taxes at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with that of the pretax consumption schedule. c. Now suppose a proportional tax system with a 10 percent tax rate is imposed instead of the regressive system. Calculate the new consumption schedule, graph it, and note the MPC and the multiplier. d. Impose a progressive tax system such that the tax rate is zero percent when GDP is $100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of the tax system on the MPC and multiplier. e. Explain why proportional and progressive tax systems contribute to greater economic stability, while a regressive system does not. Demonstrate using a graph similar to Figure 12-3. (a) [pic] (b)
| | | | | |
| | | | |Tax rate, |
|GDP, |Tax, |DI, |Consumption |percent |
|billions |billions |billions |after tax |billions |
| | | | | |
| | | | | |
|$100 | |$10 | |$ 90 | |$112 | | 10% | |
|200 | |10 | |190 | |192 | |5.0 | |
|300 | |10 | |290 | |272 | |3.33 | |
|400 | |10 | |390 | |352 | |2.5 | |
|500 | |10 | |490 | |432 | |2.0 | |
|600 | |10 | |590 | |512 | |1.67 | |
|700 | |10 | |690 | |592 | |1.43 | |
| | | | | |

[pic][pic] (c)
| | | | |
| | | |Consumption |
|GDP, |Tax, |DIs |after tax, |
|billions |billions |billions |billions |
| | | | |
| | | | |
|$100 | | |10% |$90 | |$112 | |
|200 | | |10 |180 | |184 | |
|300 | | |10 |270 | |256 | |
|400 | | |10 |360 | |328 | |
|500 | | |10 |450 | |400 | |
|600 | | |10 |540 | |472 | |
|700 | | |10 |630 | |544 | |
| | | | |

[pic] [pic] (d)
| | | | | | |
| | | | |Tax rate, | |
|GDP |Tax, |DI, |Consumption |percent | |
|billions |billions |billions |after tax |billions |MPC |
| | | | | | |
| | | | | | |
|$100 | |$ 0 | |$100 | |$120 | | | 0% | undefined |
|200 | |10 | |190 | |192 | | |5 |0.72 |
|300 | |30 | |270 | |256 | | |10 |0.64 |
|400 | |60 | |340 | |312 | | |15 |0.56 |
|500 | |100 | |400 | |360 | | |20 |0.48 |
|600 | |150 | |450 | |400 | | |25 |0.40 |
|700 | |210 | |490 | |432 | | |30 |0.32 |
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(e) The MPC decreases as shown in the right-hand column above. Proportional and (especially) progressive tax systems reduce the size of the MPC and, therefore, the size of the multiplier. A lump-sum tax does not alter the MPC or the multiplier.
NOTE: For instructors who assign the graphs, the following would be true. For each graph (a) through (d), plot the consumption schedule against the GDP. Graph (a) will have a slope of .8 and will cross the 45 degree line at C = GDP = 200. Graph (b) is parallel to (a) but $10 billion below it and will cross the 45 degree line at C = GDP = 150, indicating the multiplier of 5 ($10 billion loss in income leads to $50 billion drop in equilibrium GDP). Graph (c) will not be as steep as (a) or (b) with a slope of .72 and equilibrium between GDP = 200 and GDP = 300 on the diagram. Graph (d) has a decreasing slope so it will not be a straight line. Equilibrium is just beyond GDP = 200. The multiplier is illustrated by noting the change in equilibrium GDP if any curve were to be shifted by a given amount. The multiplier is the ratio of change in equilibrium GDP to the vertical shift.
12-16 (Last Word) What is the index of leading economic indicators and how does it relate to discretionary fiscal policy? The index of leading indicators is a monthly composite index of a group of variables that in the past has provided advance notice of changes in GDP. Changes in the index provide a clue to the future direction of the economy and may shorten the length of the “recognition lag” associated with the implementation of discretionary fiscal policy.