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Economics 14

Lecture 16: Fiscal Policy

expansionary and contractionary fiscal policy
the tax system
federal government's budget
national debt
national debt in historical perspective
why worry about deficits and the debt?
1990's deficit reduction

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Expansionary and Contractionary Fiscal Policy

Fiscal policy involves the taxing and spending policies of the government.

expansionary fiscal policy (to fight a recession by increasing aggregate demand)

1. increase government spending
2. cut taxes

contractionary fiscal policy (to deal with inflation by reducing aggregate demand)

1. decrease government spending
2. raise taxes

The Tax System

Federal Government

• personal income taxes
• social security taxes
• corporate income taxes
• excise taxes

State and Local Governments

• sales taxes
• income taxes
• propoerty taxes

progressive tax

tax is a higher percentage of income for those with higher incomes than those with lower incomes

proportional tax

tax is the same percentage of income for those with higher incomes as those with lower incomes

regressive tax

tax is a lower percentage of income for those with higher incomes than those with lower incomes

The overall tax system (including income, sales, and property taxes at all levels of government) in the United States is nearly proportional.

Federal Government's Budget

Tax Revenues $1880.1 billion (2004)

• income taxes 8091 b
• social security taxes 733.4 b
• corporate income taxes 189.4 b

Outlays $2292.2 billion

• social security 491.5 b
• national defense 454.1 b
• discretionary no-defense 440.9 b
• net interest on public debt 160.2 b
• Medicare 297.4 b
• Medicaid 176.2 b

Budget deficit = Revenues - Outlays = 1880.1 b - 2292.2 b = $412.1 billion

National Debt

Click here for the up-to-the-second total amount of national debt. Here's the home page of the Bureau of the Public Debt.

When the government overspends, the U.S. Treasury must borrow to finance the difference between expenditures and revenues. It does so by selling Treasury bills, notes, and bonds.

The national debt is the total amount owed by the federal government to owners of government securities.

National Debt in Historical Perspective

In the old days, there was little debt in large part because there was little federal government. Debt-to-GDP ratio up to perhaps 30% of GDP in a war, but little outside of a war. In fact, Andrew Jackson paid off the national debt in 1834 but it reappeared following the Panic of 1837.

Up until World War I there was pattern of running up debt to finance a war, but then run the debt/GDP ratio down close to zero after a war. This hasn't happened following our 20th century wars. In 1913 debt was 3% of GDP; 1930 debtof 20% of GDP; 1975 debt of 25% of GDP. Now, the debt is about 48% of GDP and rising.

With the end of World War I, however, government spending did not go all the way back down to its pre-war share of GDP. Whether it would eventually have done so or not in the absence of a Great Depression is unclear--but with the Great Depression and the movement of the federal government into infrastructure and civilian spending in a big way, government expenditures shot up to nearly ten percent of GDP.

And then came World War II, the Korean War, and the postwar military-industrial buildup associated with the Cold War.

Taxes kept pace--and the underlying growth of the American economy steadily reduced the outstanding national debt as a share of GDP. (The debt to GDP ratio went down from 112% at the end of WWII to about 25% in the mid-1970s.)

Since the end of the 1970s the debt-to-GDP ratio has doubled and there has been an almost steady increase in share of GDP devoted to spending while revenues have been relatively constant as a share of GDP).

Three reasons for persistent budget deficits in the 1980s and 1990s and their recent reemergence:

• the post-1973 slowdown in economic growth- the government's budget automatically heads towards deficit during a recession as tax revenues automatically fall and spending rises
• the Reagan and recent Bush tax cuts - led to a fall in tax revenues as a percent of GDP
• emergence of political immunity against budget deficits - no longer politically disadvantageous to run budget deficits

Why Worry about Deficits and the Debt?

1. Can the government go bankrupt?
   • no
2. passing the debt burden to future generation
   • interest payments mean that future generations will pay more of their tax dollars to the government's creditors and less for highways, education, and defense
3. crowding out
   • government borrowing reduces private spending by raising interest rates

1990's Deficit Reduction

Budget deficits shrunk over the 1990's and a surplus briefly appeared. Deficit reduction in the 1990's was the result of (1) higher income and excise taxes enacted by Presidents G.H.W. Bush and Clinton and (2) reduced military and entitlement spending including Medicare, Medicaid, and food stamps. The reappearance of large budget deficits in 2002 is largely the result of the Bush tax cuts.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31