Fiscal Policy 22.1
22 c h a p t e r
FISCAL POLICY
Fiscal policy is the use of government purchases, taxes, and transfer payments to alter RGDP and the price level. Sometimes it is necessary for the government to use fiscal policy to stimulate the economy during a contraction (or recession) or to try to curb an expansion in order to bring inflation under control.
In the early 1980s, large tax cuts helped the U.S. economy out of a recession. In the 1990s, Japan used large government spending programs to help pull itself out of a recessionary slump. In 2001, a large tax cut was implemented to combat an economic slowdown and to promote long-term economic growth in the United States. When should the government use such policies and how well do they work are just a couple of the questions we will answer in this chapter.
FISCAL STIMULUS AFFECTS THE BUDGET
When government spending (for purchases of goods and services and transfer payments) exceeds tax revenues, there is a budget deficit. When tax revenues are greater than government spending, a
budget surplus exists. A balanced budget, where government expenditures equal tax revenues, seldom occurs unless efforts are made to deliberately balance the budget as a matter of public policy.
When the government wishes to stimulate the economy by increasing aggregate demand, it will increase government purchases of goods and services, increase transfer payments, lower taxes, or use some combination of these approaches. Any of those options will increase a budget deficit (or reduce a budget surplus). Thus, expansionary fiscal policy is associated with increased government budget deficits. Likewise, if the government wishes to dampen a boom in the economy by reducing aggregate demand, it will reduce its purchases of goods and services, increase taxes, reduce transfer payments, or use some combination of these approaches.
Thus, contractionary fiscal policy will tend to create or expand a budget surplus, or reduce a budget deficit, if one exists.
466 CHAPTER TWENTY-TWO | Fiscal Policy
Fiscal Policy
s e c t i o n
22.1
_ What is fiscal policy?
_ How does expansionary fiscal policy affect the government’s budget?
_ How does contractionary fiscal policy affect the government’s budget?
1. Fiscal policy is the use of government purchases of goods and services, taxes, and transfer payments to affect aggregate demand and to alter RGDP and the price level.
2. Expansionary fiscal policies will increase the budget deficit (or reduce a budget surplus) through greater government spending, lower taxes, or both.
3. Contractionary fiscal policies will create a budget surplus (or reduce a budget deficit) through reduced government spending, higher taxes, or both.
1. If, as part of its fiscal policy, the federal government increases its purchases of goods and services, is that an expansionary or contractionary tactic?
2. If the federal government decreases its purchases of goods and services, does the budget deficit increase or decrease?
3. If the federal government increases taxes or decreases transfer payments, is that an expansionary or contractionary fiscal policy?
4. If the federal government increases taxes or decreases transfer payments, does the budget deficit increase or decrease?
5. If the federal government increases government purchases and lowers taxes at the same time, does the budget deficit increase or decrease?
s e c t i o n c h e c k
GROWTH IN GOVERNMENT
Government plays a large role in the economy, and its role increased markedly from 1929 to 1975, as seen in Exhibit 1. Although it is true that government spending has changed little since 1970, the composition of government spending has changed considerably. National defense spending has fallen from roughly 9 percent of GDP in 1968 to 3.5 percent in 2001. However, in the aftermath of September 11, and the war in Iraq, we are already starting to see increases in defense spending. Areas of government growth can be partly determined by looking at statistics of the types of government spending.
Exhibit 2 shows categories of government spending as a proportion of total spending.
In Exhibit 3, we see that taxpayers in other parts of the developed world have heavier tax burdens than those in the United States.
Other areas had rapid spending growth as well.
Educational expenditures, for example, tripled in the 1960s alone. By the mid-1970s and for the first time in the nation’s history, roughly half of govern-
Government: Spending and Taxation 467
Government: Spending and Taxation
22.2
_ How does government finance its spending?
_ On what does the public sector spend its money?
_ What are progressive and regressive taxes?
50 45 40 35 30 25 20 15 10 5 0 1929 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Year
Total government expenditures State and local government expenditures
Government Expenditures As a Percentage of GDP
Federal government expenditures
Growth of Government Expenditures as a Percentage of GDP in the United States, 1929–2001
SECTION 22.2
EXHIBIT 1
Government plays a large role in the economy, and that has increased over time.
SOURCE: Economic Report of the President, 2002.
468 CHAPTER TWENTY-TWO | Fiscal Policy
ment spending was for social concerns such as education, health, and public housing. In the 1980s and 1990s, we saw a continued increase in income transfer payments, including Social Security, welfare, and unemployment compensation.
Exhibit 2(a) shows that 38 percent of federal government spending in 2002 went to Social Security and income security programs. Another 21 percent was spent on health care and Medicare (for the elderly). The remaining federal expenditures were national defense,17 percent; interest on the national debt, 10 percent; and miscellaneous items such as foreign aid, education, agriculture, transportation, and housing, 14 percent.
Exhibit 2(b) shows that state and local spending is highly different from federal spending. Education and public welfare account for 50 percent of state and local expenditures. Other areas of state and local spending include highways, utilities, and police and fire protection.
GENERATING GOVERNMENT REVENUE
Governments have to pay their bills like any person or institution that spends money. But how do they obtain revenue? Two major avenues are open: taxation and borrowing.
TYPES OF TAXATION
In most years, a large majority of government activity is financed by taxation. What kinds of taxes are levied on the American population?
At the federal level, most taxes or levies are on income. Exhibit 3 shows that 54 percent of tax revenues come in the form of income taxes on individuals and corporations, called personal income taxes and corporate income taxes, respectively. Most of the remaining revenues come from payroll taxes, which are levied on work-related income—payrolls.
These taxes are used to pay for Social Security and compulsory insurance plans like Medicare. Payroll taxes are split between employees and employers.
The Social Security share of federal taxes has steadily risen as the proportion of the population over age 65 has grown and as Social Security benefits have been increased. Consequently, payroll taxes have risen significantly in recent years. Other taxes on items like gasoline, liquor, and tobacco products provide for a small proportion of government revenues, as do customs duties, estate and gift taxes, and some minor miscellaneous taxes and user charges.
The U.S. federal government relies more heavily on income-based taxes than nearly any other gova.
Federal Expenditures, 2002 b. State and Local Expenditures, 2000
Social Security 23% National Defense 17% Income Security 15% Health 10% Medicare 11% Net Interest on the National Debt 10% Other 14% Education 34% Public Welfare 16% Transportation and Highways 7% Other 43%
Government Expenditures SECTION 22.2
EXHIBIT 2
SOURCE: Economic Report of the President, 2003.
ernment in the world (see Exhibit 4). Most other governments rely more heavily on sales taxes, excise taxes, and customs duties.
A Progressive Tax
One effect of substantial taxes on income is that the “take home” income of Americans is significantly altered by the tax system. Progressive taxes, of which the federal income tax is one example, are designed so that those with higher incomes pay a greater proportion of their income in taxes. A progressive tax is one tool that the government can use to redistribute income. It should be noted, however, that certain types of income are excluded from income for taxation purposes, such as interest on municipal bonds and income in kind—like foods stamps or Medicare.
A Regressive Tax
Payroll taxes, the second most important income source for the federal government, are actually regressive taxes; that is, they take a greater proportion of the income of lower-income groups than of higher-income groups. The reasons for this are simple.
Social Security, for example, is imposed as a fixed proportion (now 7.65 percent on employees and an equal amount on employers) of wage and salary income up to $87,000 in 2003. Also, wealthy persons have relatively more property income that is not subject to payroll taxes. Adding individual income and payroll taxes, the federal tax system is probably only slightly progressive. The same would hold if other taxes were included.
An Excise Tax
Some consider an excise tax—a sales tax on individual products such as alcohol, tobacco, and gasoline —to be the most unfair type of tax because it is generally the most regressive. Excise taxes on specific items impose a far greater burden, as a percentage of income, on the poor and middle class than on the wealthy, because low-income families generally spend a greater proportion of their income on these items than do high-income families.
In addition, excise taxes may lead to economic inefficiencies. By isolating a few products and subjecting them to discriminatory taxation, excise taxes subject economic choices to political manipulation and lead to inefficiency.
Government: Spending and Taxation 469 a. Tax Revenues, Federal Government, 2002 b. Tax Revenues, State and Local Governments, 2000
Personal Income Taxes
46%
Other Taxes
8%
Corporate Income Taxes
Social Security Tax (Payroll Tax)
38%
14%
Property Taxes
16%
Sales Tax
20%
Fed Grants
19%
Other
29%
2%
Tax Revenues SECTION 22.2
EXHIBIT 3
SOURCE: Economic Report of the President and Bureau of Economic Analysis, 2003
FINANCING STATE AND LOCAL GOVERNMENT ACTIVITIES
Historically, the major source of state and local revenue has been property taxes. In recent decades, state and local governments have relied increasingly on sales and income taxes for revenues (see Exhibit 3). Today, sales taxes account for roughly 20 percent of revenues, property taxes account for 16 percent, and personal and corporate income taxes account for 16 percent of revenues. Another 19 percent of state and local revenues come from the federal government in grants. The remaining share of revenues comes from license fees and user charges (e.g., payment for utilities, occupational license fees, tuition fees) and other taxes.
470 CHAPTER TWENTY-TWO | Fiscal Policy
Sweden Denmark Belgium Finland France Austria Luxembourg Netherlands Italy Canada Switzerland Czech Republic Germany Norway United Kingdom Spain USA Greece Slovak Republic Hungary Australia New Zealand Poland Japan Ireland Portugal Iceland Turkey Korea Mexico 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
Direct Taxes as Percentag e of GDP
Global Tax Comparisons: Direct Taxes as a Percentage of GDP
EXHIBIT 4
SOURCE: Swiss Federal Tax Administration, March 2003.
http://sextonxtra.swlearning.com
To work more with this Chapter’s concepts, log on to Sexton Xtra! now.
Government: Spending and Taxation 471
The offer to double your money in 90 days seemed too good to be true. But once the first people to sign up were paid the promised return on their investment, more and more punters queued up in Boston to put their money into the “Securities Exchange Company.” Charles Ponzi had devised a classic fraud: extravagant payouts to the first investors were easily financed by the growing numbers of those who followed. But not indefinitely.
Once the fraud was uncovered in 1920, Ponzi was sent to jail.
Fifteen years later the American president of the day, Franklin Roosevelt, signed the law establishing Social Security, the name American gives to its public pension system. The first pensioner to benefit was Ida May Fuller, a spinster from Vermont, who had paid the grand sum of $24.75 in contributions. Her first monthly Social Security check in January 1940 was for almost as much. Miss Fuller lived to be 100 and received benefits totaling $22,889.
As it happens, the pension scheme that proved so beneficial to Miss Fuller relies on much the same principle as the Ponzi scam. America’s Social Security scheme is the pay-as-you-go [PAYG] sort in which today’s workers pay for today’s pensioners.
The first few generations of pensioners received much more in benefits than they had paid in contributions. These windfall gains arguably continued until quite recently because the PAYG system was extended to cover more and more workers, and contribution rates kept going up.
Paul Samuelson, a Nobel-prize-winning economist, pinpointed the Ponzi characteristics of pay-as-you-go pensions back in 1967. “The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in . . .
Always there are more youths than old folks in a growing population.
More important, with real incomes growing at some 3% a year, the taxable base upon which benefits rest in any period are much greater than the taxes paid historically by the generation now retired . . . A growing nation is the greatest Ponzi game ever contrived.” After the second world war, politicians in most developed countries joined in the game with gusto. In the 1960s and 1970s, they made state PAYG pensions even more unsound by introducing big hikes in benefits. To this day, PAYG schemes remain the main form of pension provision the world over. They are especially important in the EU, where they account for nearly 90% of total pension income. Even in Britain, where the PAYG scheme is much less generous than in most of continental Europe, it accounts for 60% of total pension income.
Yet all the while the foundations of PAYG schemes were being undermined. As Mr.
Samuelson had pointed out, the underlying return from this kind of pension comes from the growth in the workforce and its real earnings. But in the 1970s, the post-war baby boom gave way to a baby bust that put an end to the indefinite prospect of “more youths than old folks.” Besides, those “old folks” were living longer because of an unprecedented rise in life expectancy at older ages. At the same time the post-war surge in productivity and hence real wages gave way to much more pedestrian growth rates.
What has saved PAYG schemes so far is that demographic developments take a long time to work their way through the system. The schemes are still benefiting from the large number of post-war baby boomers in the working-age population, who will not start to enter retirement for another decade or so.
Today’s problems arise largely from over-generous increases in pension benefits that have already pushed contribution rates to the limit. Americans worry about a Social Security contribution rate of 12.4% of pay, but Germans have to put up with 19.1%, and even that does not make German pensions self-financing: without a subsidy from general taxation, the contribution rate would have to be 25%. In Italy, the contribution rate is an astonishing 33% of eligible pay.
The worst is yet to come. Over the next 30 years, western populations will age at a record rate. The ratio of the over-65s to those aged 20–64 will double. Japan’s working-age population, already declining, will shrink drastically. Something will have to give. Either benefits must halve in relation to average incomes; or contribution rates—already oppressively high in many countries—must double; or the retirement age must go up.
If governments were to leave matters as they are, they would eventually have to borrow to bridge the gap between future pension outlays and tax revenue.
Belatedly, governments are trying to amend this feature of their pension schemes. In America, for example, the normal pensionable age, fixed at 65 in 1935, is due to rise to 67. But this reform, agreed in 1983, only starts to take effect next year and will not be fully phased in until 2027. Meanwhile the life expectancy for a 65-year-old American male has increased by nearly two years in the past 20 years, so the reformers are back where they started.
SOURCE: “Snares and Delusions,” The Economist, February 14, 2002.
http://www.economist.com.
SOCIAL SECURITY: A PONZI SCHEME?
In The NEWS (continued on next page)
Prosperous Ponzi
© Bettmann/CORBIS
CHANGES IN RGDP
The RGDP will change anytime the amount of any one of the four forms of purchases—consumption, investment, government purchases, and net exports —changes. If, for any reason, people generally decide to purchase more in any of these categories out of given income, aggregate demand will shift rightward. If they decide to purchase less, there will be a reduction in aggregate demand.
472 CHAPTER TWENTY-TWO | Fiscal Policy
CONSIDER THIS: Rumor has it that most young people believe that there is a greater chance that they will see an unidentified flying object (UFO) in their lifetime than a Social Security payment.
We are often told that Social Security is a retirement program.
However, it is really a tax plan that transfers money from workers to the elderly. Social Security is a pay-as-yougo system—payments to current retirees are derived from payroll taxes imposed on current workers.
The Social Security Trust Fund is slowly going broke, and if it not fixed, it is predicted to go belly up by 2037 (and some say serious problems could occur as soon as 2016). At that point, retirees would only get 75 percent of their promised benefits. The problem is that many baby boomers will begin to retire in the next several years and there will simply not be enough workers to pay for these new retirees. In addition, demographers’ forecasts of declining birth rates and longer life expectancies only make matters worse.
The reason why the government is interested in investing part of Social Security in the stock market is that historically the returns are much greater in the stock market. The real rate of return (indexed for inflation) is roughly 7 percent in the stock market compared with only 2 percent for government bonds. However, one of the drawbacks of government investment in the stock market is that there is the potential for political abuse. With such a large amount of funds, there may be the temptation for the government to favor some firms and punish others. An alternative would be to put some of the payroll tax in an individual retirement plan and let individuals manage their own funds—perhaps choosing from a list of mutual funds.
A third option might be to let individuals choose to continue with the current Social Security system or contribute a minimum of, say, 10 percent or 20 percent of their wages to a private investment fund. This has been tried in a number of Central and South American countries. In Chile, almost 90 percent of workers choose to leave the government Social Security program to invest privately.
Critics of the private plan argue that it is risky, individuals might make poor investment decisions, and the government might ultimately have to pay for their mistakes. However, if the government were to approve only low- to moderate-risk mutual funds, with their diverse portfolios, this should offset most of the risk associated with this criticism.
The Multiplier Effect
22.3
_ What is the multiplier effect?
_ How does the marginal propensity to consume affect the multiplier effect?
_ How does investment interact with the multiplier effect?
1. Over a third of federal spending goes towards pensions and income security programs.
2. A progressive tax takes a greater proportion of the income of higher-income groups than of lower-income groups.
3. A regressive tax takes a greater proportion of the income of lower-income groups than of higherincome groups.
1. What options are available for a government to finance its spending?
Any one of the components of purchases of goods and services (C, I, G, or X 2 M) can initiate changes in aggregate demand and thus a new shortrun equilibrium. Changes in total output are often brought about by alterations in investment plans, because investment purchases are a relatively volatile category of expenditures. However, if policymakers are unhappy with the present short-run equilibrium GDP, perhaps because they consider unemployment too high, they can deliberately manipulate the level of government purchases to obtain a new short-run equilibrium value. Similarly, by changing taxes or transfer payments, they can alter the amount of disposable income of households and thus bring about changes in consumption purchases.
THE MULTIPLIER EFFECT
Usually, when an initial increase in purchases of goods or services occurs, the ultimate increase in total purchases will tend to be greater than the initial increase, called the multiplier effect. But how does this effect work? Suppose the government increases its defense budget by $10 billion to buy aircraft carriers.
When the government purchases the aircraft carriers, not only does it add to the total demand for goods and services directly, it also provides $10 billion in added income to the companies that actually construct the aircraft carriers. Those companies will then hire more workers and buy more capital equipment and other inputs to produce the new output. The owners of these inputs therefore receive more income because of the increase in government purchases. What will they do with this additional income? Although behavior will vary somewhat among individuals, collectively, they will probably spend a substantial part of the additional income on additional consumption purchases, pay some additional taxes incurred because of the income, and save a bit of it as well. The marginal propensity to consume (MPC) is the fraction of additional disposable income that a household consumes rather than saves.
THE MULTIPLIER EFFECT AT WORK
Suppose that out of every dollar in ad...
Januszek66