Fiscal Policy: The Basics

Let’s begin with the obvious: modern governments in economically advanced countries spend a great deal of money and collect a lot in taxes. Figure 15-1 shows government spending and tax revenue as percentages of GDP for a selection of high-income countries in 2007. (We focus on 2007, rather than a more recent year, because it was a largely “normal” year. The numbers for later years were very much affected by the financial crisis of 2008 and its aftermath.) As you can see, the Swedish government sector is relatively large, accounting for more than half of the Swedish economy. The government of the United States plays a smaller role in the economy than those of Canada or most European countries. But that role is still sizable, with the government playing a major role in the U.S. economy. As a result, changes in the federal budget—changes in government spending or in taxation—can have large effects on the American economy.

Government Spending and Tax Revenue for Some High-Income Countries in 2007 We focus on 2007 because it was a “normal” year, not a year of deep economic slump. Government spending and tax revenue are represented as a percentage of GDP. Sweden has a particularly large government sector, representing more than half of its GDP. The U.S. government sector, although sizable, is smaller than those of Canada and most European countries.

Source: OECD.

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.

Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing

What kinds of taxes do Americans pay, and where does the money go? Figure 15-2 shows the composition of U.S. tax revenue in 2007. 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 taxes that generate the greatest revenue 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 48% of total government revenue in 2007; social insurance taxes accounted for 25%; and a variety of other taxes, collected mainly at the state and local levels, accounted for the rest.

Sources of Tax Revenue in the United States, 2007 Personal income taxes, taxes on corporate profits, and social insurance taxes account for most government tax revenue. The rest is a mix of property taxes, sales taxes, and other sources of revenue.

Source: Bureau of Economic Analysis.

Figure 15-3 shows the composition of total U.S. government spending in 2007, which takes two broad forms. One form is purchases of goods and services. This includes everything from ammunition for the military to the salaries of public school teachers (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.

Government Spending in the United States, 2007 The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and the Medicare and Medicaid health care programs. (Numbers do not add to 100% due to rounding.)

Source: Bureau of Economic Analysis.

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:

• Social Security, which provides guaranteed income to older Americans, disabled Americans, and the surviving spouses and dependent children of deceased or retired beneficiaries
• Medicare, which covers much of the cost of health care for Americans over age 65
• Medicaid, which covers much of the cost of health care for Americans with low incomes

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.

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

The Government Budget and Total Spending

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

(15-1) 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, 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 15-1: 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 reduction 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 reduce 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 as we saw in Chapter 14, there are sometimes good reasons to shift the aggregate demand curve. In early 2009, as this chapter’s opening story explained, the Obama administration believed it was crucial that the U.S. government act to increase aggregate demand—that is, to move the aggregate demand curve to the right of where it would otherwise be. The 2009 stimulus package 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.

Expansionary and Contractionary Fiscal Policy

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 15-4 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:

• An increase in government purchases of goods and services
• A cut in taxes
• An increase in government transfers

Expansionary Fiscal Policy Can Close a Recessionary Gap The economy is in short-run macroeconomic equilibrium at E₁, where the aggregate demand curve, AD₁, intersects the SRAS curve. However, it is not in long-run macroeconomic equilibrium. At E₁, there is a recessionary gap of Y_P − Y₁. An expansionary fiscal policy—an increase in government purchases of goods and services, a reduction in taxes, or an increase in government transfers—shifts the aggregate demand curve rightward. It can close the recessionary gap by shifting AD₁ to AD₂, moving the economy to a new short-run macroeconomic equilibrium, E₂, which is also a long-run macroeconomic equilibrium.

The 2009 American Recovery and Reinvestment Act or simply, the Recovery Act, was a combination of all three: a direct increase in federal spending and aid to state governments to help them maintain spending, tax cuts for most families, and increased aid to the unemployed.

Figure 15-5 shows the opposite case—an economy facing an inflationary gap. Again, 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 equilibrium, E₁, aggregate output is Y₁, above potential output, Y_P. As we’ll explain in later chapters, policy makers often try to head off inflation by eliminating inflationary gaps. To eliminate the inflationary gap shown in Figure 15-5, 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 the opposite of expansionary fiscal policy. It is implemented in three possible ways:

1. A reduction in government purchases of goods and services
2. An increase in taxes
3. A reduction in government transfers

Contractionary Fiscal Policy Can Close an Inflationary Gap The economy is in short-run macroeconomic equilibrium at E₁, where the aggregate demand curve, AD₁, intersects the SRAS curve. But it is not in long-run macroeconomic equilibrium. At E₁, there is an inflationary gap of Y₁ − Y_P. A contractionary fiscal policy—such as reduced government purchases of goods and services, an increase in taxes, or a reduction in government transfers—shifts the aggregate demand curve leftward. It closes the inflationary gap by shifting AD₁ to AD₂, moving the economy to a new short-run macroeconomic equilibrium, E₂, which is also a long-run macroeconomic equilibrium.

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 taxable income—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.

Can Expansionary Fiscal Policy Actually Work?

In practice, the use of fiscal policy—in particular, the use of expansionary fiscal policy in the face of a recessionary gap—is often controversial. We’ll examine the origins of these controversies in detail in Chapter 18. But for now, let’s quickly summarize the major points of the debate over expansionary fiscal policy, so we can understand when the critiques are justified and when they are not.

Broadly speaking, there are three arguments against the use of expansionary fiscal policy.

• Government spending always crowds out private spending
• Government borrowing always crowds out private investment spending
• Government budget deficits lead to reduced private spending

The first of these claims is wrong in principle, but it has nonetheless played a prominent role in public debates. The second is valid under some, but not all, circumstances. The third argument, although it raises some important issues, isn’t a good reason to believe that expansionary fiscal policy doesn’t work.

Claim 1: “Government Spending Always Crowds Out Private Spending” Some claim that expansionary fiscal policy can never raise aggregate spending and therefore can never raise aggregate income, with reasons that go something like this: “Every dollar that the government spends is a dollar taken away from the private sector. So any rise in government spending must be offset by an equal fall in private spending.” In other words, every dollar spent by the government crowds out, or displaces, a dollar of private spending. So what’s wrong with this view? The answer is that the statement is wrong because it assumes that resources in the economy are always fully employed and, as a result, the aggregate income earned in the economy is always a fixed sum—which isn’t true. In particular, when the economy is suffering from a recessionary gap, there are unemployed resources in the economy and output, and therefore income, is below its potential level. Expansionary fiscal policy during these periods puts unemployed resources to work and generates higher spending and higher income. So the argument that expansionary fiscal policy always crowds out private spending is wrong in principle.

Claim 2: “Government Borrowing Always Crowds Out Private Investment Spending” How valid is the argument that government borrowing uses funds that would have otherwise been used for private investment spending—that is, it crowds out private investment spending?

The answer is “it depends.” Specifically, it depends upon whether the economy is depressed or not. If the economy is not depressed, then increased government borrowing, by increasing the demand for loanable funds, can raise interest rates and crowd out private investment spending. However, what if the economy is depressed? In that case, crowding out is much less likely. When the economy is at far less than full employment, a fiscal expansion will lead to higher incomes, which in turn leads to increased savings at any given interest rate. This larger pool of savings allows the government to borrow without driving up interest rates. The Recovery Act of 2009 was a case in point: despite high levels of government borrowing, U.S. interest rates stayed near historic lows.

Claim 3: “Government Budget Deficits Lead to Reduced Private Spending” Other things equal, expansionary fiscal policy leads to a larger budget deficit and greater government debt. And higher debt will eventually require the government to raise taxes to pay it off. So, according to the third argument against expansionary fiscal policy, consumers, anticipating that they must pay higher taxes in the future to pay off today’s government debt, will cut their spending today in order to save money. This argument, first made by the nineteenth-century economist David Ricardo, is known as Ricardian equivalence. It is an argument often taken to imply that expansionary fiscal policy will have no effect on the economy because far-sighted consumers will undo any attempts at expansion by the government. (And will also undo any contractionary fiscal policy, for that matter.)

In reality, however, it’s doubtful that consumers behave with such foresight and budgeting discipline. Most people, when provided with extra cash (generated by the fiscal expansion), will spend at least some of it. So even fiscal policy that takes the form of temporary tax cuts or transfers of cash to consumers probably does have an expansionary effect.

Moreover, it’s possible to show that even with Ricardian equivalence, a temporary rise in government spending that involves direct purchases of goods and services—such as a program of road construction—would still lead to a boost in total spending in the near term. That’s because even if consumers cut back their current spending in anticipation of higher future taxes, their reduced spending will take place over an extended period as consumers save over time to pay the future tax bill. Meanwhile, the additional government spending will be concentrated in the near future, when the economy needs it. So although the effects emphasized by Ricardian equivalence may reduce the impact of fiscal expansion, the claim that it makes fiscal expansion completely ineffective is neither consistent with how consumers actually behave nor a reason to believe that increases in government spending have no effect. So, in the end, it’s not a valid argument against expansionary fiscal policy.

In sum, then, the extent to which we should expect expansionary fiscal policy to work depends upon the circumstances. When the economy has a recessionary gap—as it did when the 2009 Recovery Act was passed—economics tells us that this is just the kind of situation in which expansionary fiscal policy helps the economy. However, when the economy is already at full employment, expansionary fiscal policy is the wrong policy and will lead to crowding out, an overheated economy, and higher inflation.

A Cautionary Note: Lags in Fiscal Policy

Looking back at Figures 15-4 and 15-5, 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 either fiscal policy or monetary policy—can end up making the economy less stable.

We’ll leave discussion of the warnings associated with monetary policy to Chapter 17. In the case of fiscal policy, one key reason for caution is that there are important time lags between when the policy is decided upon and when it is implemented. 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 2009 there was good reason to believe that the slump facing the U.S. economy would be both deep and long and that a fiscal stimulus designed to arrive over the next year or two would almost surely push aggregate demand in the right direction. In fact, as we’ll see later in this chapter, the 2009 stimulus arguably faded out too soon, leaving the economy still deeply depressed. 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.

What was in the Recovery Act?

As we’ve just learned, fiscal stimulus can take three forms: increased government purchases of goods and services, increased transfer payments, and tax cuts. So what form did the Recovery Act take? The answer is that it’s a bit complicated.

Figure 15-6 shows the composition of the budget impact of the Recovery Act, a measure that adds up the dollar value of tax cuts, transfer payments, and government spending. Here, the numbers are broken down into four categories, not three. “Infrastructure and other spending” means spending on roads, bridges, and schools as well as “nontraditional” infrastructure like research and development, all of which fall under government purchases of goods and services. “Tax cuts” are self-explanatory. “Transfer payments to persons” mostly took the form of expanded benefits for the unemployed. But a fourth category, “transfers to state and local governments,” accounted for roughly a third of the funds. Why this fourth category?

The American Recovery and Reinvestment Act of 2009 (Billions of Dollars)

Because America has multiple levels of government. Two of the authors live in Princeton Township, which has its own budget, which is part of Mercer County, which has its own budget, which is part of the state of New Jersey, which has its own budget, which is part of the United States. One effect of the recession was a sharp drop in revenues at the state and local levels, which in turn forced these lower levels of government to cut spending. Federal aid—those transfers to state and local governments—was intended to mitigate these spending cuts.

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Perhaps the most surprising aspect of the Recovery Act was how little direct federal spending on goods and services was involved. The great bulk of the program involved giving money to other people, one way or another, in the hope that they would spend it.