FIN 30220 Macroeconomic Analysis Fiscal Policy Spending Taxes

FIN 30220: Macroeconomic Analysis Fiscal Policy: Spending & Taxes

The US Government spent $4 Trillion dollars in FY 2016. That’s approximately $12, 000 person! Put another way, government spending is approximately a quarter of all domestic expenditures. GDP = $18 T

While our government is bigger than some, it is much smaller than others Government as a % of GDP USA

Dissecting the Federal Budget In FY 2016, The US Government spent approximately $4 T On Budget: $3, 050 B (76%) + Off Budget: $950 B (24%) Total: $4, 000 B Mandatory: $2, 500 B (58%) Discretionary: $1, 200 B (36%) + Interest: $300 B (6%) Total: $4, 000 B By law, the Social Security System and the US Postal Service must maintain separate budgets and, hence, are “off” the general budget Determined by Congress on an annual basis (ex: Defense) Determined by existing law (ex: Social Security, Medicare) Source: Office of Management and Budget

Timeline for the budget process With the help of the office of management and budget (OMB), the president creates a budget proposal – sent to congress the first week of February Differences between House/Senate proposals are worked out in conference committees – joint resolution presented and voted on January February March April May June July August September October Appropriations bills presented and voted on Fiscal Year Begins With the help of the congressional budget office (CBO), the house and senate budget committees write their own budget proposals

The US Budget is officially titled a “Resolution of Congress” – it is not a Bill. So, what difference does it make? A resolution, once approved by both houses of congress, requires no presidential signature Further, a resolution is not a law and DOES NOT have to be obeyed! However, the budget itself does not allow the government to spend money. It only gives the government the authority to spend money. To actually spend money, the government must pass an appropriation bill. That is a law.

Note that authorized spending need not be appropriated in a given year, but can be carried forward, so actual outlays need not equal budget authority Defense Appropriations Bill (2015) Authorized: $700 B Appropriated: $650 B Defense Appropriations Bill (2016) Authorized: $750 B Appropriated: $800 B $50 B of authorization remaining

The Government Uses “Baseline Budgeting” with a minimum 5 year cycle Current Year 1 Horizon Years Budget Year 2 3 4 Anticipated spending This is what the government is currently spending Adjusted spending under the new law 5

Therefore, a government cut is generally not really a cut! Consider the following example Defense Appropriations Bill Current Year 1 Horizon Years Budget Year 2 3 4 5 2015 $700 B $750 B (+7%) $850 B (+13%) $1, 000 B (+17%) $1, 200 B (+20%) 2016 $750 B $800 B (+6%) $900 B (+12%) $1, 150 B (+16%) $1, 350 B (+17%) In government lingo, this would be called a $50 B( 6%) cut to the defense budget!!

Financing The Government “In this world, nothing is certain, but death and taxes” Income Tax Alternative Minimum Tax 2016 Estate Tax Individual Income Taxes: $1, 610 B Corporate Income Taxes: $433 B + Social Insurance Taxes: $1, 105 B Other Revenues: $282 B Total: $3, 430 B On-Budget: $2, 630 B Off-Budget: $800 B Off –Budget is essentially social security taxes

Who Pays Income Taxes? Quintile Average Income % of Total Taxes Bottom 20% $13, 000 3% <1% 2 nd 20% $30, 000 8% 2% Middle 20% $49, 000 14% 13% 4 th 20% $72, 000 23% 25% Top 20% $147, 000 50% 60% Top 5% $254, 000 21% 40% Top 1% $1, 000 15% 30%

US Income Tax Rates (Single Filers) Taxable Income Tax Rate $0 - $7, 150 10% $7, 151 - $29, 050 15% $29, 051 - $70, 350 25% $70, 351 - $146, 750 28% $146, 751 - $319, 100 33% $319, 101 + 35% Note: These Tax Brackets are annually indexed for inflation Standard Deduction: $5, 000 + Personal Exemption: $3, 200 $8, 200 Taxable Income = Gross Income - $8, 200

Taxable Income Tax Rate $0 - $7, 150 10% $7, 151 - $29, 050 15% $29, 051 - $70, 350 25% $70, 351 - $146, 750 28% $146, 751 - $319, 100 33% $319, 101 + 35% The Tax Brackets indicate marginal tax rates – i. e. the percentage of each additional dollar earned that gets paid in taxes Suppose that you earn $85, 000 per year (single filer) Gross Income: - $85, 000 Standard Deduction: $5, 000 Personal Exemption: $3, 200 Taxable Income $76, 800 Your “Average Rate” = $7, 150 *. 10 = $715 $21, 900 *. 15 = $3, 285 $41, 300 *. 25 = $10, 325 + $6, 450 *. 28 = Tax Bill = $16, 131 X 100 = 19% $85, 000 $1, 806 $16, 131

The Government must make up the difference between taxes collected and spending on current programs by borrowing 2016 Expenditures 2016 Revenues On-Budget: $3, 050 B + Off-Budget: $950 B 2016 Surplus/Deficit On Budget: $2, 630 B + Off Budget: $800 B Total: $4 T On-Budget: - $420 + Off-Budget: - $150 Total: $3, 430 B Total: - $570 B This is the official deficit that’s reported In 2016, the government spent $3, 050 B on programs other than social security In 2016, The Social Security Administration spent $950 B on current benefits $2, 630 B Was paid for with current taxes $420 B was borrowed from the public $800 B Was paid for with current taxes $150 B was borrowed from the public

The US budget was essentially balanced until the early 1970’s Deficit/Surplus (Millions of Current Dollars) $570 B in 2016

Total Debt outstanding represents the cumulative effect of past deficits Total ($20 T) Held By Public ($15 T)

Debt/GDP 1946: 120% 2015: 100% What really matters is debt relative to ability to pay (GDP)

Can we sustain our current policies? Debt is manageable as long as it grows at a slower pace than income (i. e. we can grow out if it!) Current Deficit Total Debt + Interest Rate GPD Growth of Debt $570 B $18 T +. 015 Treasury Rate =. 046 Our economy would need to grow at 4. 6% (nominal) per year to sustain our current projected deficits (i. e. maintain a constant Debt/GDP ratio). Unfortunately, we are only growing at 3. 5%

Can we sustain our current policies? Alternatively, let’s calculate the deficit that is sustainable (Debt/GDP is constant) Deficit Total Debt $18 T GPD Nominal Growth Interest Rate 3. 5% 1. 5% Given the above numbers, we can sustain a $360 B Deficit

Two arguments for Fiscal Policy Efficiency Equity Efficiency refers to the collective well being of an economy. Equity refers to the distribution of well being across individual in an economy. Can we use fiscal policy to increase aggregate income? ) Can we use fiscal policy to redistribute income in a “fair” way?

Let’s suppose that the economy is currently at full employment (the unemployment rate is 5%) and GDP equals $15 T. Government expenditures are currently $3 T. $15 T $12 T $3 T Note: None of the numbers here are calculated

Now, suppose that uncertainty about the future causes consumers and businesses to cut their planned expenditures by 10% $1. 2 T $10. 8 T $3 T $13. 8 T As 8% output gap would be associated with a 8/2. 5 = 3. 2% rise in unemployment Okun’s Law: A 1% rise in unemployment translates to a 2. 5% drop in GDP

The immediate impact would be a drop in the interest rate and production $1. 2 T As 4% output gap would be associated with a 4/2. 5 = 1. 6% rise in unemployment To get back to full employment, we need the interest rate to drop even farther…

The longer term impact would be an additional drop in the interest rate and a decrease in prices (i. e. deflation) Now we are back to full employment…but after a long, painful recession and prolonged deflation

What if the government could move the IS curve back to the right by $1. 2 T. The could return the economy to full employment… $1. 2 T We should increase government spending by $1. 2 T, right? We have a drop in demand of $1. 2 T

Suppose that the government pays $100 for a new hammer from the local hardware store Now, suppose that the hardware store owner takes his $100 in new income and spends $95 (95%) at the grocery store Now, suppose that the grocer owner takes his $95 in new income and spends $90. 25 (95%) at the local tavern…. . This will continue to ripple out…

“If I Had a Hammer…” Lets add up all the increases in income due to the initial government purchase of a $100 hammer Hardware Store: $100 Grocer: $95 Tavern: $90. 25 ---- $85. 74 ---- $81. 45 Total: The initial $100 increase in government spending raised total income by $2, 000 (a factor of 20) $2, 000 Marginal Propensity to Consume

If the government bought $60 B worth of hammers, that should do the trick! Before $1. 2 T $10. 8 T $3 T $11. 94 T $3. 06 T After So, with a MPC of 95%

Let’s take the US Economy…. we saw a rise in unemployment from 5% to 10% during the last recession (Dec. 2007 – June 2009). Multiply by 2. 5 (Okun’s law) $1. 75 T 5% cyclical unemployment 12. 5% drop in output $14 T*(. 125) = $1. 75 T The personal savings rate at the time was around 4% (i. e. a consumption rate of 96%) But the government stimulus plan was over $700 B and nothing happened…

However, we need to be careful here…. It could be We need the marginal propensity to consume, using the savings rate, we really have the average propensity to consume Here, we have (at Y = $40, 000) Average propensity to consume

However, we need to be careful here…. Or, it could be We need the marginal propensity to consume, using the savings rate, we really have the average propensity to consume Here, we have (at Y = $40, 000) Average propensity to consume

Now, let’s recalculate a stimulus package for the last recession. Multiply by 2. 5 (Okun’s law) $1. 75 T 5% cyclical unemployment 12. 5% drop in output $14 T*(. 125) = $1. 75 T With a marginal propensity to consume equal to. 46 This is pretty close to the actual size of the stimulus package

However, there is a more fundamental problem. Remember the argument behind the multiplier Lets add up all the increases in income due to the initial government purchase of a $100 hammer Hardware Store: $100 Grocer: $95 Tavern: $90. 25 ---- $85. 74 ---- $81. 45 Total: The initial $100 increase in government spending raised total income by $2, 000 (a factor of 20) $2, 000 Marginal Propensity to Consume What’s the problem here?

“If I Had a Hammer…” The government needs to pay for the hammer. Lets assume that the government taxes the local hardware store and then uses the $100 to buy the hammer. How does this change things? Oops…wrong hammer!! What does the government do with the hammer? Case #1: The government gives the hammer to the grocer across the street (transfer) Case #2: The government throws the hammer into the ocean (wasteful spending) Case #3: Derek Jeter signs the hammer (raising its value to $200) and gives it back to the hardware store (productive spending)

Examples of productive spending can best be found in Public Goods (goods with two distinct characteristics) ØNon-Rivaled: Anyone can use a public good without affecting its use by others (zero marginal cost) ØNon-Excludable: Its either very difficult or very costly to charge for usage of a public good Suppose that there are 10, 000 people living in Springfield. Each resident is willing to pay up to $. 10 to have a drinking fountain in town. The fountain would cost $500 to build. It would be difficult to charge people to use the fountain. Therefore, the private sector probably wouldn’t supply it. Here’s a chance for the government to step in and save the day! Why shouldn’t the government supply private goods?

Consider the Jones’: The Jones’ live in Buffalo NY. Mr. Jones works 40 hours per week at a local factory. They have an annual household income of $50, 000. Jones’ Family Budget Income: $50, 000 Taxes: $10, 000 $40, 000 Consumption: $30, 000 Savings: $10, 000 Suppose that Trump announces that they will spend $200 B on a bridge that will go halfway to Hawaii (i. e. the bridge has a final value of $0). Each household will be taxed $1, 000 to pay for this project. Remember…this is determined by the Jones’ wealth – not just current income

How should this spending plan influence the Jones’? Jones’ Family Budget Income: $50, 000 Taxes: $11, 000 $39, 000 Consumption: $30, 000 Savings: $9, 000 Savings drops by $1000 Tax Increase of $1, 000 This one time project should have a negligible impact on the Jones’ wealth and, hence a negligible impact on consumption

So, the government raises spending by $1, 000 person, and household consumption is left unchanged (household savings drops by $1, 000) $1, 000 The IS curve moves to the right by $1, 000 – i. e. the government multiplier equals 1

Suppose that the government decides to spend $1, 000 wastefully every year… Households adjust to the permanently lower income by spending less The IS curve moves to the right by $0– i. e. the government multiplier equals 0!

Now, consider another spending plan…Trump decides to nationalize the cable industry. Everyone will receive government provided cable television. They can provide this service for $500 per year. Jones’ Family Budget Income: $50, 000 Taxes: $10, 000 $40, 000 Consumption: $30, 000 Savings: $10, 000 Rent: $15, 000 Food: $10, 000 Transportation: $4, 000 Cable TV: $1, 000 How will this spending plan affect the Jones family?

How should this spending plan influence the Jones’? Jones’ Family Budget Income: $50, 000 Taxes: $10, 500 $39, 500 Consumption: $29, 000 Savings: $10, 000 Extra Income: Tax Increase of $500 Rent: $15, 000 Food: $10, 000 Transportation: $4, 000 Cable TV: $0 $500 If this is a one time increase in income, savings goes up. If it is permanent, consumption goes up by $500

Suppose that this one a one year program only…. Households put the income gain into savings The IS curve moves to the left by $500– i. e. the government multiplier is negative!

If this were a permanent program, households would feel free to spend the $500 savings. The IS curve doesn’t move…again, a government multiplier of zero!! Households put the income gain into consumption

The Simpson's live next door to the Jones’. Homer Simpson works at the local power plant. He earns $20, 000 per year. Jones’ Family Budget Simpson’s Family Budget Income: $50, 000 Income: $20, 000 Taxes: $10, 000 Taxes: $2, 000 $18, 000 $40, 000 Consumption: $30, 000 Consumption: $15, 000 Savings: $10, 000 Savings: $3, 000 Suppose that the government offers a temporary $1, 000 tax credit to lower income households. The program will cost the average upper income household $1, 000

Suppose that the government offers a temporary $1, 000 tax credit to lower income households. The program will cost the average upper income household $1, 000 Jones’ Family Budget Income: $50, 000 Taxes: $11, 000 Simpson’s Family Budget $1, 000 Income: $20, 000 Taxes: $1, 000 $39, 000 $19, 000 Consumption: $30, 000 Consumption: $15, 000 Savings: $9, 000 Savings: $4, 000 The Jones’ lower their savings to finance their higher tax bill The Simpson’s put the tax credit in the bank.

Suppose that the government offers a temporary $1, 000 tax credit to lower income households. The program will cost the average upper income household $1, 000 In principle, this should cancel out in the aggregate!

For transfers to make a difference at the aggregate level, we need different preferences (i. e. different marginal propensities to consume) $500 MPC =. 5 $100 MPC =. 9

So, the government raises spending by $1, 000 person, and household consumption increases by $400 (household savings drops by $400) +$900 $400 -$500 $400 The IS curve moves right!

Lets look at a breakdown of Mr. Jones tax liability Income: $50, 000 Taxes: $10, 000 Tax Code Mr. Jones taxable income of $45, 000 put him in the 30% tax bracket Income Tax Rate Tax Paid $10, 000 15% $1, 500 Taxable Income Tax Rate $0 - $10, 000 15% $20, 000 20% $4, 000 $10, 000 - $30, 000 20% $15, 000 30% $4, 500 $30, 000 - $50, 000 30% Total: $30, 000 + 35% Standard Deduction = $5, 000 $10, 000 Mr. Jones’ average tax rate is 20%

Suppose the government passes a “middle class tax cut”. The top two brackets are reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to $2, 000. How does this impact Mr. Jones? Income: $50, 000 Taxes: $10, 000 Tax Code Mr. Jones taxable income of $48, 000 put him in the 25% tax bracket Income Tax Rate Tax Paid $10, 000 15% $1, 500 Taxable Income Tax Rate $0 - $10, 000 15% $20, 000 20% $4, 000 $10, 000 - $30, 000 20% $18, 000 25% $4, 500 $30, 000 - $50, 000 25% Total: $30, 000 + 30% Standard Deduction = $2, 000 $10, 000 Mr. Jones’ average tax rate is still 20%

Suppose the government passes a “upper class tax cut”. The top two brackets are reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to $2, 000. How does this impact Mr. Jones? Old Tax Code New Tax Code Income Tax Rate Tax Paid $10, 000 15% $1, 500 $20, 000 20% $4, 000 $15, 000 30% $4, 500 $18, 000 25% $4, 500 Total: $10, 000 A drop in Mr. Jones’s marginal tax rate increases the incentive to work – labor supply increases. This should raise production Total: $10, 000

A cut in marginal tax rates that leaves average rates unchanged raises the economy’s capacity as employment rises. But what about expenditures? A tax cut will increase investment (because higher employment raises the productivity of capital) Capacity output increases from the tax cut

Alternatively, suppose the government passes a “lower income class tax cut”. The bottom two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is kept at $5, 000. How does this impact Mr. Jones? Income: $50, 000 Taxes: $8, 500 Tax Code Mr. Jones taxable income of $45, 000 put him in the 30% tax bracket Income Tax Rate Tax Paid $10, 000 10% $1, 000 Taxable Income Tax Rate $0 - $10, 000 10% $20, 000 15% $3, 000 $10, 000 - $30, 000 15% $15, 000 30% $4, 500 $30, 000 - $50, 000 30% Total: $30, 000 + 35% Standard Deduction = $5, 000 $8, 500 Mr. Jones’ average tax falls to 17%

Alternatively, suppose the government passes a “lower income class tax cut”. The bottom two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is kept at $5, 000. How does this impact Mr. Jones? Old Tax Code New Tax Code Income Tax Rate Tax Paid $10, 000 15% $1, 500 $10, 000 10% $1, 000 $20, 000 20% $4, 000 $20, 000 15% $3, 000 $15, 000 30% $4, 500 Total: If households are rational and forward looking, they should recognize that the tax cut will need to be repaid and thus will not feel better off… $10, 000 Total: $8, 500 If households are not rational and forward looking, they will feel better off and work less

A tax cut will raise the deficit and increase government borrowing, but what about household savings? If households are rational and forward looking, they should recognize that the tax cut will need to be repaid and thus increase savings… expenditures (and, the IS curve are unaffected) If households are not rational and forward looking, they will increase expenditures (and, the IS curve shifts right)

A cut in average tax rates that leaves marginal rates unchanged actually lowers the economy’s capacity as employment falls while potentially raising expenditures If households are not rational and forward looking, they will increase expenditures (and, the IS curve shifts right) Capacity output increases from the tax cut

Government Spending ØIf the government invests in purely wasteful spending, the multiplier effect is the largest, but should that justify spending money on stupid projects? ØEffective spending (say, on public goods) could actually lower employment and output (i. e. a negative multiplier), but don’t we want our government spending our money wisely? ØTransfers could give the economy a boost without wasting any resources. The bigger issue with transfers is economic equity Taxes ØTaxes are an effective stimulus only if you can change marginal rates while leaving effective rates unchanged.