ECO 104 Introduction to Macroeconomics Lecture 6 Chapter

ECO 104: Introduction to Macroeconomics Lecture 6 Chapter 11: Fiscal Policy and the Federal Budget Naveen Abedin 1

Budget � Every government has a budget. The Government of Bangladesh releases a budget every year. � http: //www. mof. gov. bd/en/index. php? option =com_content&view=article&id=268&Itemid =1 � Every federal budget has two parts – Government Expenditures/Government Spending and Tax Revenues Naveen Abedin 2

Tax Revenue � The government imposes taxes and fees that generate revenue Naveen Abedin 3

Income Tax Structures Progressive Income Tax: Tax rate increases as a person’s taxable income increases. For Example, in Year 1, your annual income is Tk. 2 lakh, and the income tax rate charged on your income is 10%. In Year 2, your annual income increases to Tk. 3 lakh, and as a result, your income tax rate also increases to 15%. � Bangladesh maintains a progressive tax rate system: First 1, 65, 000/- Nil Next 2, 75, 000/- 10% Next 3, 25, 000/- 15% Next 3, 75, 000/- 20% Rest Amount 25% � http: //www. asiatradehub. com/bangladesh/tax. asp Naveen Abedin 4

Income Tax Structures (cont. ) � Proportional Income Tax/Flat Tax: The same tax rate is used for all income levels, i. e. the rate of tax is constant. If proportional income tax rate is 10%, then you pay 10% income tax, whether your income is TK. 1 lakh or TK. 10 lakh per year. � Regressive Income Tax: The tax rate decreases as a person’s taxable income level rises. In Year 1, your annual income was TK. 2 lakh, and your tax rate was 10%. In Year 2, your annual income increased to TK. 3 lakh, but your tax rate has decreased to 8%. Naveen Abedin 5

States of Government Budget � The government budget can be in one of these three states: 1) Budget Deficit: Government expenditures are greater than tax revenue 2) Budget Surplus: Tax revenues are greater than government expenditures 3) Balanced Budget: Government expenditures equal tax revenues � When the government is in a budget deficit, it means the government has to borrow funds. Naveen Abedin 6

Types of Deficits � Total Deficit = Structural Deficit + Cyclical Deficit � Structural deficit exists in an economy when the economy is operating at full employment � Cyclical Deficit occurs due to a downturn in economic activity. Initially the government is maintaining a balanced budget, i. e. GE = TR. If the economy falls into a sudden recessionary gap then Real GDP will fall and two effects will happen: 1) Tax revenue will fall (consumption, investment all falls) 2) Government transfer payments will rise (more unemployment benefits) As a result government expenditure will rise and tax revenue will fall, changing the budget from balanced to a deficit. Naveen Abedin 7

Public Debt � When the government is in a budget deficit, it has to borrow from different sources. Public debt/National debt/Federal debt is the amount that the federal government owes to its creditors. � Creditors are other governments, development agencies, etc. from whom the government has taken money as loan. Naveen Abedin 8

Value-Added Tax 1) � a. b. � � � Value-Added Value added is the difference between what a producer sells a final good for and what it pays for an intermediate good. A farmer gets some free wheat seeds from a government agricultural agency. He plants the seeds and harvests wheat. He then sells his wheat for $1 to a baker. Therefore: Sold final good for : $1 Bought intermediate good for : $0 Value Added = Selling price for final good – Buying price for intermediate good Value-Added = $1 - $0 = $1 Farmer gets to keep: $1 Naveen Abedin 9

Value-Added Tax (cont. ) 1. � � � 1. 2. Value-Added (cont. ) The baker bought the wheat from the farmer for $1, and used it to bake bread. He sells his bread for $1. 4. Value added = $1. 4 - $1 = $0. 4 He gets to keep $0. 4 There are two important points to notice about value-added The sum of the values added is equal to the price paid by the consumer for the bread. Value-added at each stage is equal to the profit or residual that the producer gets to keep Naveen Abedin 10

Value-Added Tax (cont. ) 2) Tax � VAT is tax applied to the value added at each stage of production. Suppose VAT is 10%, this means that 10% VAT is applied on the $1 value addition made by the farmer, and 10% VAT is applied on the $0. 4 value addition made by the baker. Total VAT is equal to $0. 1 + $0. 04 = $0. 14. � When VAT is introduced into the picture, the sellers respond accordingly by changing the price of sales. Naveen Abedin 11

Value-Added Tax (cont. ) � Since the farmer has to pay $0. 1 tax to the government on the wheat he sells to the baker, he will shift this tax over to the baker by charging him $1. 10 instead of $1 for the wheat. � The baker now has to pay $1. 1 to the farmer for the wheat, and a VAT of $0. 04 to the government. He will try to shift this increase in cost of production and the VAT to the consumers. The total price he charges consumers for his bread is $1. 4 + $0. 1 + $0. 04 = $1. 54 � Although VAT is charged to producers at each step of sales, producers simply shift this tax to consumers in the form of higher prices. Hence VAT is also known as a sales tax. Naveen Abedin 12

Fiscal Policy � This is the use of Government Expenditures and Tax Revenue to achieve economic stability, reduce unemployment and promote economic growth. � Expansionary Fiscal Policy: Government expenditures are up and/or taxes are down � Contractionary Fiscal Policy: Government expenditures are down and/or taxes are up � Discretionary Fiscal Policy: When the government deliberately/intentionally brings about changes in expenditure and taxes, fiscal policy is discretionary. � Automatic Fiscal Policy: When changes in expenditures or taxes occur automatically in response to economic situations. Naveen Abedin 13

Demand-Side Fiscal Policy � Fiscal policy that affects aggregate demand through changes in Government Purchases (G) and Taxes (T) is known as Demand-Side Fiscal Policy � AD = C + I + G + NX � If G increases, AD increases (rightward shift) � If taxes(T) increases, that affects both C and I negatively, causing AD to decrease (leftward shift). Naveen Abedin 14

Keynesian Economics and Fiscal Policy � Keynesian economists believe that the economy is not selfregulating. So if it in a recessionary gap, then it will need the help of the government to return to long-run equilibrium. Naveen Abedin 15

Crowding-out Effects � Crowding out is a decrease in private expenditures (consumption, investment) as a consequence of increased government spending or financing needs of a budget deficit. Crowding out can occur in two ways: � Direct crowding out effect � Indirect crowding out effect Naveen Abedin 16

Crowding-out Effects (cont. ) Types of Crowding Out Effects � If government spends $2 million more on public libraries but that does not reduce the consumption of books from bookstores by even $1, then there is no crowding out effect. ∆G > 0; ∆C =0 � If the government spends $2 million more on public libraries and as a result people spent $2 million less on books bought in bookstores then there is complete crowding out effect, meaning the degree of crowding out is dollar for dollar. ∆G > 0; ∆C < 0, where ∆G = |∆C| � If the government spends $2 million on public libraries but that causes consumers to spend $1. 2 million less on books from bookstores then we have incomplete crowding out effect. ∆G > 0; ∆C < 0, where ∆G > |∆C| Naveen Abedin 17

Crowding-out Effects (cont. ) � In the event of complete or incomplete crowding out effect, expansionary fiscal policy will have less impact on aggregate demand Real GDP than Keynesian theory predicts. Naveen Abedin 18

Lag Effects � Data Lag: It takes some time to realize that the economy is unstable due to time it takes to collect relevant data. � The Wait-and See Lag: Economists usually wait for some time to see if the economy does recover itself � The Legislative Lag: Take majority vote in parliament � Transmission Lag: It takes time to implement the policy, i. e. communicate and apply the changes � The Effectiveness Lag: Takes time for the actual policy effect to sink in into the economy - just because government expenditure increased this week does not mean AD will shift right next week Naveen Abedin 19

Lag Effects (cont. ) Naveen Abedin 20

Supply-side Fiscal Policy � Marginal tax rate is the change in a person’s tax payment divided by the change in the person’s taxable income. � As marginal tax rate of individuals decreases, people are more encouraged to engage in productive activities rather than succumb to leisure and tax-avoidance activities. For example, if Person A’s income increases by $1, and she has to pay a tax of $0. 28 on her additional $1 income, then her marginal tax rate is 28%. Naveen Abedin 21

Supply-side Fiscal Policy � As the marginal tax rate decreases the incentive to engage in productive activities increases. The effect of this on the economy will be a rightward shift of the SRAS curve, which will allow the economy to reach stability. � If the marginal tax rate is permanently low, this might even allow the LRAS curve to shift rightward. Naveen Abedin 22

Laffer Curve � The reason why SRAS shifts right if marginal tax rate decreases can be explained by the Laffer curve. � Laffer curve is a very famous curve in macroeconomics that shows the relationship between tax rate and tax revenue. There are three construction points to the Laffer curve: 1) There will be no tax revenue at marginal tax rates 0% and 100%. 2) An increase in tax rate could cause the tax revenue to increase. 3) A decrease in tax rates could cause tax revenues to increase. Naveen Abedin 23

Laffer Curve (cont. ) � Tax Revenues = Tax base × (average) Tax Rate � Tax base is the total amount of taxable income in the economy. � For example, if tax rate is 20% and tax base is $100 billion, then Tax Revenues will equal to TR = $100 billion × 0. 2 = $20 billion � Case 1: Suppose tax rate decreased from 20% to 15% - a 25% reduction in tax rate. This causes tax base to expand from $100 billion to $120 billion. Tax revenue drops to $18 billion. � Case 2: Tax rate drop by 25% from 20% to 15%. This causes the tax base to expand from $100 billion to $150 billion, which is a 50% increase in tax base. This causes tax revenue to increase to $22. 5 billion. Naveen Abedin 24

Laffer Curve (cont. ) � If the economy is on the downward sloping portion, a reduction in tax rate causes tax revenue to increase. If the economy is on the upward sloping portion of the curve, a reduction in tax rate causes tax revenues to decrease. Naveen Abedin 25