Session 11 Fiscal Policy Disclaimer The views expressed

Session 11 Fiscal Policy Disclaimer: The views expressed are those of the presenters and do not necessarily reflect those of the Federal Reserve Bank of Dallas or the Federal Reserve System.

TEKS (15) Economics. The student understands the economic impact of fiscal policy decisions at the local, state, and national levels. The student is expected to: (A) identify types of taxes at the local, state, and national levels and the economic importance of each; (B) analyze the categories of revenues and expenditures in the U. S. federal budget; and (C) analyze the impact of fiscal policy decisions on the economy. (6) Economics. The student understands the basic characteristics and benefits of a free enterprise system. The student is expected to: (D) analyze the costs and benefits of U. S. economic policies related to the economic goals of economic growth, stability, full employment, freedom, security, equity (equal opportunity versus equal outcome), and efficiency.

Teaching the Terms

Fiscal Policy • Government spends money to provide goods and services • Government pays for those expenditures through taxation and borrowing

Externalities • Benefits or costs from a transaction extend beyond the buyer or seller • Positive externalities – Education – Technology spillovers or patent protection • Negative externalities – Pollution

Potential Market Failures Excludable? Rival in Consumption? Yes No Yes Private Goods Natural Monopolies No Common Resources Public Goods

Catagorize • • • Cable TV Clothing Congested non-toll roads Congested toll roads Environment Fire protection • • • Fish in the ocean Ice cream National defense Tornado siren Uncongested non-toll roads Uncongested toll roads

Excludable? Yes No Rival in Consumption? Yes No Private Goods Natural Monopolies • Clothing • Fire protection • Congested non-toll • Cable TV roads • Uncongested toll • Ice cream roads Common Resources Public Goods • Fish in the ocean • Tornado siren • Environment • National defense • Congested toll • Uncongested nonroads toll roads

Potential for Market Failure • Public goods are subject to a free-rider problem – Lighthouse, basic research • Common resources can lead to the tragedy of the commons – Clean air and water, congested cities • Role of property rights

Federal Government: Receipts • • Individual income taxes Social insurance taxes Corporate income taxes Other

Federal Government: Spending • • Social Security National defense Income security Medicare Health Net interest Other

Federal Government Revenue Estate and gift taxes Other miscellaneous Customs duties Federal Reserve deposits 1% receipts of earnings 1% 1% 2% Excise taxes 3% Social insurance and retirement receipts 42% Source: Final Monthly Treasury Statement for FY 2009 Individual income taxes 43% Corporation income taxes 7%

Federal Government Funding Other taxes and receipts 5% Corporation income taxes 4% Social insurance and retirement receipts 25% Individual income taxes 26% Source: Final Monthly Treasury Statement for FY 2009 Deficit 40%

Federal Government Expenditures Note: “Other” includes many agencies, such as Transportation, Housing and Urban Development, Education, Homeland Security, Justice, Energy, State, NASA, International Assistance Programs, Interior, Commerce, EPA and Corps of Engineers Veterans Affairs 3% Other 15% Agriculture 3% Labor 4% Health and Human Services 21% Social Security Administration 19% Treasury 8% Interest on the public debt 10% Source: Final Monthly Treasury Statement for FY 2009 Defense. Military 17%

State Government Revenue Borrowing 7% Utility revenue 1% From local governments 1% Insurance trust revenue 19% Sales taxes and gross receipts 18% Licenses 2% From federal government 21% Individual income taxes 13% Charges and Corporate income taxes Property taxes miscellaneous 2% Other taxes 1% 13% 1% http: //www. census. gov/prod/2009 pubs/10 statab/stlocgov. pdf

Texas Revenue Insurance trust includes unemployment, retirement and workers comp funds Insurance Federal trust Governmen revenue t 23% 24% Other general revenue 7% Interest earnings 3% Highways 0% Higher education 5% Other taxes 6% Hospitals 2% Motor vehicle license 1% Sales taxes 28% Local governments 1%

State Government Expenditures Utility expenditure 2% Insurance trust expenditure 11% Education 31% Housing and community Other 13% development 1% Natural resources 1% Corrections 3% Highways 6% Police protection 1% Hospitals 3% Public welfare 24% Health 3% http: //www. census. gov/prod/2009 pubs/10 statab/stlocgov. pdf

Texas Expenditures Other and unallocable. Environment and housing Interest on general debt 3% 1% 1% Governmental administration 2% Public safety 5% Social services and income maintenance 34% Highways 10% Capital outlay 11% Insurance trust expenditure 13% Higher education 17% Libraries Other education Elementary & secondary 0% 2% 0%

Local Governments Revenue Insurance trust revenue 7% Utility revenue 14% Special assessment 1% Interest earnings 4% Sewerage 4% Property taxes 44% Education charges 3% Hospital charges Other taxes Sales taxes and 5% 4% Corporate income taxes Individual income taxes gross receipts 1% 10% 3% http: //www. census. gov/prod/2009 pubs/10 statab/stlocgov. pdf

Local Government Expenditures Insurance trust expenditure Utility expenditures 2% 11% Other 9% Interest 4% Administration 5% Education 39% Housing and community development 3% Sewerage 3% Parks and Recreation. Corrections 2% 2% Public welfare 3% Health Police protection Hospitals 3% Highways 5% 5% 4% http: //www. census. gov/prod/2009 pubs/10 statab/stlocgov. pdf

Structure of Taxes Regressive • % of income paid in taxes ↓ as income ↑ Progressive • % of income paid in taxes ↑ as income ↑ Proportional • % of income paid in taxes is fixed as income changes

Structure of Taxes Regressive • Sales tax, Social Security taxes Progressive • U. S. federal income tax, estate taxes Proportional • Flat tax, Medicare tax

Budget Lingo Balanced budget • Revenues = Expenditures Budget deficit • Revenues < Expenditures Budget surplus • Revenues > Expenditures Government debt • Sum of all deficits – Sum of all surpluses

Deficits and Debt • Government must borrow money when it runs a budget deficit • Government borrows from – Individuals – Corporations – Financial institutions – Foreign entities or foreign governments

Fiscal Policy and Economic Goals • National economic goals include – Growth – Stability – Full employment – Freedom – Security – Equity – Efficiency • Using government spending and taxation programs to achieve goals

What is the Goal? Taxes Deductions Spending • Capital gains • Tariffs • Mortgage interest • Student loan interest • Charitable donations • Social Security • NASA • Food stamps • Defense Spending

Business Cycle Long Run Growth Trend Real GDP Expansion Recession Time

Price Level Aggregate Supply PL 1 Aggregate Demand YF Full Employment Level of Output Real GDP

Expansionary Fiscal Policy • Response to a recession (economy is operating below full employment) • Seeks to stimulate production (and consumption) – Directly (expenditures ↑) – Indirectly (taxes ↓ to encourage household spending or investment spending)

Fiscal Responses to 2008 Recession Emergency Economic Stabilization Act of 2008 American Recovery and Reinvestment Act of 2009 Established the Troubled Assets Relief Program (TARP) Renewable energy and weatherize buildings New infrastructure (roads, bridges, and mass transit) Fund Pell Grants Making Work Pay tax credit and Child Tax Credit

Contractionary fiscal policy • Response to inflation (economy is operating above full employment and prices are rising) • Seeks to reduce production (and consumption) – Directly (expenditures ↓) – Indirectly (taxes ↑ to discourage household or investment spending) • Politically difficult

Measuring Fiscal Policy’s Effects • Effects are not limited to the initial dollar value of the change in policy • The eventual effects may be larger or smaller, depending on: – Multiplier effect – Crowding-out effect

Multiplier Effect • Spending and tax policies create a chain reaction in the economy as people spend new income • Many factors complicate the multiplier – Taxes – International trade – Differing consumption patterns among various segments of the population

Crowding Out • Investment or consumption spending that is lost because government borrowing drives up interest rates • Government is entering the same market for funds as investors

Two Types of Fiscal Policy • Discretionary fiscal policy – Policymakers change tax policies or spending programs in response to fluctuations in the business cycle (at their discretion) • Automatic stabilizers – Implemented without any deliberate action from policymakers – Found in the tax system and spending programs

Automatic Stabilizers – Tax System • Taxes are linked to economic activity – Progressive income tax rates (individual and corporate) – Payroll taxes – Sales and excise taxes • Recessions → automatic “tax cut” • Expansion → automatic “tax increase”

Automatic Stabilizers – Spending • Government spending responds to the business cycle – Unemployment insurance benefits – Welfare benefits – School lunch programs – Other income-support programs • Recessions → more spending • Expansion → less spending

Challenges Related to Fiscal Policy • Political factors • Time lags – Time required to create and pass legislation – Time required to implement legislation • Supply side impacts • Forecasting difficulties • Monetary policies may reinforce or offset fiscal policies

Questions?