Let’s begin with the obvious: modern governments spend a great deal of money and collect a lot in taxes. Figure 20.1 shows government spending and tax revenue as percentages of GDP for a selection of high-income countries in 2012. As you can see, the French government sector is relatively large, accounting for more than half of the French economy. The government of the United States plays a smaller role in the economy than do the governments of Canada or most European countries. But that role is still sizable. As a result, changes in the federal budget—changes in government spending or in taxation—can have large effects on the U.S. economy.

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To analyze these effects, we begin by showing how taxes and government spending affect the economy’s flow of income. Then we can see how changes in spending and tax policy affect aggregate demand.

In the circular-flow diagram discussed in Module 10, we showed the circular flow of income and spending in the economy as a whole. One of the sectors represented in that figure was the government. Funds flow into the government in the form of taxes and government borrowing; funds flow out in the form of government purchases of goods and services and government transfers to households.

What kinds of taxes do Americans pay, and where does the money go? Figure 20.2 shows the composition of U.S. tax revenue in 2013. Taxes, of course, are required payments to the government. In the United States, taxes are collected at the national level by the federal government; at the state level by each state government; and at local levels by counties, cities, and towns. At the federal level, the main taxes are income taxes on both personal income and corporate profits as well as social insurance taxes, which we’ll explain shortly. At the state and local levels, the picture is more complex: these governments rely on a mix of sales taxes, property taxes, income taxes, and fees of various kinds. Overall, taxes on personal income and corporate profits accounted for 43% of total government revenue in 2013; social insurance taxes accounted for 24%; and a variety of other taxes, collected mainly at the state and local levels, accounted for the rest.

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Figure 20.3 shows the composition of total U.S. government spending in 2013, which takes two forms. One form is purchases of goods and services. This includes everything from ammunition for the military to the salaries of public schoolteachers (who are treated in the national accounts as providers of a service—education). The big items here are national defense and education. The large category labeled “Other goods and services” consists mainly of state and local spending on a variety of services, from police and firefighters to highway construction and maintenance.

The other form of government spending is government transfers, which are payments by the government to households for which no good or service is provided in return. In the modern United States, as well as in Canada and Europe, government transfers represent a very large proportion of the budget. Most U.S. government spending on transfer payments is accounted for by three big programs:

The term social insurance is used to describe government programs that are intended to protect families against economic hardship. These include Social Security, Medicare, and Medicaid, as well as smaller programs such as unemployment insurance and food stamps. In the United States, social insurance programs are largely paid for with special, dedicated taxes on wages—the social insurance taxes we mentioned earlier.

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But how do tax policy and government spending affect the economy? The answer is that taxation and government spending have a strong effect on aggregate spending.

Let’s recall the basic equation of national income accounting:

(20-1) GDP = C + I + G + X − IM

The left-hand side of this equation is GDP, the value of all final goods and services produced in the economy. The right-hand side is aggregate spending, the total spending on final goods and services produced in the economy. It is the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and the value of exports (X) minus the value of imports (IM). It includes all the sources of aggregate demand.

The government directly controls one of the variables on the right-hand side of Equation 20-1: government purchases of goods and services (G). But that’s not the only effect fiscal policy has on aggregate spending in the economy. Through changes in taxes and transfers, it also influences consumer spending (C) and, in some cases, investment spending (I).

To see why the budget affects consumer spending, recall that disposable income, the total income households have available to spend, is equal to the total income they receive from wages, dividends, interest, and rent, minus taxes, plus government transfers. So either an increase in taxes or a decrease in government transfers reduces disposable income. And a fall in disposable income, other things equal, leads to a fall in consumer spending. Conversely, either a decrease in taxes or an increase in government transfers increases disposable income. And a rise in disposable income, other things equal, leads to a rise in consumer spending.

The government’s ability to affect investment spending is a more complex story, which we won’t discuss in detail. The important point is that the government taxes profits, and changes in the rules that determine how much a business owes can increase or decrease the incentive to spend on investment goods.

Because the government itself is one source of spending in the economy, and because taxes and transfers can affect spending by consumers and firms, the government can use changes in taxes or government spending to shift the aggregate demand curve, and there can be good reasons for doing so. In early 2008, for example, there was bipartisan agreement that the U.S. government should act to prevent a fall in aggregate demand—that is, to move the aggregate demand curve to the right of where it would otherwise be. The resulting Economic Stimulus Act of 2008 was a classic example of fiscal policy: the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy by shifting the aggregate demand curve.

Why would the government want to shift the aggregate demand curve? Because it wants to close either a recessionary gap, created when aggregate output falls below potential output, or an inflationary gap, created when aggregate output exceeds potential output.

Figure 20.4 shows the case of an economy facing a recessionary gap. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD₁ is the initial aggregate demand curve. At the initial short-run macroeconomic equilibrium, E₁, aggregate output is Y₁, below potential output, Y_P. What the government would like to do is increase aggregate demand, shifting the aggregate demand curve rightward to AD₂. This would increase aggregate output, making it equal to potential output. Fiscal policy that increases aggregate demand, called expansionary fiscal policy, normally takes one of three forms:

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Figure 20.5 shows the opposite case—an economy facing an inflationary gap. At the initial equilibrium, E₁, aggregate output is Y₁, above potential output, Y_P. Policy makers often try to head off inflation by eliminating inflationary gaps. To eliminate the inflationary gap shown in Figure 20.5, fiscal policy must reduce aggregate demand and shift the aggregate demand curve leftward to AD₂. This reduces aggregate output and makes it equal to potential output. Fiscal policy that reduces aggregate demand, called contractionary fiscal policy, is implemented by:

A classic example of contractionary fiscal policy occurred in 1968, when U.S. policy makers grew worried about rising inflation. President Lyndon Johnson imposed a temporary 10% surcharge on income taxes—everyone’s income taxes were increased by 10%. He also tried to scale back government purchases of goods and services, which had risen dramatically because of the cost of the Vietnam War.

Looking at Figures 20.4 and 20.5, it may seem obvious that the government should actively use fiscal policy—always adopting an expansionary fiscal policy when the economy faces a recessionary gap and always adopting a contractionary fiscal policy when the economy faces an inflationary gap. But many economists caution against an extremely active stabilization policy, arguing that a government that tries too hard to stabilize the economy through fiscal policy, or a central bank that does the same with monetary policy, can end up making the economy less stable.

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We’ll leave discussion of the warnings associated with monetary policy to later modules. In the case of fiscal policy, one key reason for caution is that there are important time lags in its use. To understand the nature of these lags, think about what has to happen before the government increases spending to fight a recessionary gap. First, the government has to realize that the recessionary gap exists: economic data take time to collect and analyze, and recessions are often recognized only months after they have begun. Second, the government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation. Finally, it takes time to spend money. For example, a road construction project begins with activities such as surveying that don’t involve spending large sums. It may be quite some time before the big spending begins.

Because of these lags, an attempt to increase spending to fight a recessionary gap may take so long to get going that the economy has already recovered on its own. In fact, the recessionary gap may have turned into an inflationary gap by the time the fiscal policy takes effect. In that case, the fiscal policy will make things worse instead of better.

This doesn’t mean that fiscal policy should never be actively used. In early 2008, for example, there was good reason to believe that the U.S. economy had begun a lengthy slowdown caused by turmoil in the financial markets, so a fiscal stimulus designed to arrive within a few months would almost surely push aggregate demand in the right direction. But the problem of lags makes the actual use of both fiscal and monetary policy harder than you might think from a simple analysis like the one we have just given.