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FIN 30220:

Macroeconomic
Analysis
Fiscal Policy: Spending & Taxes
The US Government spent $4 Trillion
dollars in FY2016. That’s approximately
$12,000 per person!

Put another way,


government spending
is approximately a
quarter of all domestic
expenditures.

GDP = $18T
While our government is bigger than some, it is much smaller than others

Government as a % of GDP

USA
Dissecting the Federal Budget
In FY2016, The US Government spent
approximately $4T

On Budget: $3,050B (76%) Mandatory: $2,500B (58%)


+ Off Budget: $950B (24%) Discretionary: $1,200B (36%)
Total: $4,000B + Interest: $300B (6%)
Total: $4,000B

By law, the Social Security Determined by Congress on


System and the US Postal an annual basis (ex:
Service must maintain Defense)
separate budgets and, hence,
are “off” the general budget 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)


$50B of
Authorized: $700B
authorization
Appropriated: $650B
remaining

Defense Appropriations Bill (2016)

Authorized: $750B
Appropriated: $800B
The Government Uses “Baseline Budgeting” with a minimum 5 year cycle

Horizon Years
Current Budget
Year Year

1 2 3 4 5

Anticipated
spending

This is what the Adjusted spending


government is currently under the new law
spending
Therefore, a government cut is generally not really a cut! Consider the following
example

Horizon Years
Defense Current Budget
Appropriations Year Year
Bill
1 2 3 4 5

2015 $700B $750B $850B $1,000B $1,200B


(+7%) (+13%) (+17%) (+20%)

2016 $750B $800B $900B $1,150B $1,350B


(+6%) (+12%) (+16%) (+17%)

In government lingo, this would be called a $50B( 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: $1,610B
Corporate Income Taxes: $433B
+ Social Insurance Taxes: $1,105B
Other Revenues: $282B
Total: $3,430B

On-Budget: $2,630B
Off-Budget: $800B Off –Budget is essentially social
security taxes
Who Pays Income Taxes?
Quintile Average % of Total % of Total
Income Income Taxes
Bottom 20% $13,000 3% <1%
2nd 20% $30,000 8% 2%
Middle 20% $49,000 14% 13%
4th 20% $72,000 23% 25%
Top 20% $147,000 50% 60%
Top 5% $254,000 21% 40%
Top 1% $1,000,000 15% 30%
US Income Tax Rates (Single
Filers)
Taxable Income Tax Rate
$0 - $7,150 10%
Note: These Tax
$7,151 - $29,050 15%
Brackets are annually
$29,051 - $70,350 25% indexed for inflation

$70,351 - $146,750 28%


$146,751 - $319,100 33%
$319,101 + 35%

Standard Deduction: $5,000


+ Personal Exemption: $3,200
$8,200 Taxable Income = Gross Income - $8,200
Taxable Income Tax Rate
The Tax Brackets
$0 - $7,150 10% indicate marginal tax
$7,151 - $29,050 15% rates – i.e. the
$29,051 - $70,350 25% percentage of each
additional dollar
$70,351 - $146,750 28%
earned that gets paid
$146,751 - $319,100 33% in taxes
$319,101 + 35%

Suppose that you earn $85,000 per year (single filer)


$7,150 * .10 = $715
Gross Income: $85,000
$21,900 * .15 = $3,285
- Standard Deduction: $5,000
$41,300 * .25 = $10,325
- Personal Exemption: $3,200
+ $6,450 * .28 = $1,806
Taxable Income $76,800
Tax Bill = $16,131

$16,131
Your “Average Rate” = X 100 = 19%
$85,000
The Government must make up the difference between taxes collected
and spending on current programs by borrowing

2016 Expenditures 2016 Revenues 2016 Surplus/Deficit


On-Budget: $3,050B On Budget: $2,630B On-Budget: - $420
+ Off-Budget: $950B + Off Budget: $800B + Off-Budget: - $150
Total: $4T Total: $3,430B Total: - $570B

This is the official deficit that’s


reported

In 2016, the government spent $2,630B Was paid for with current taxes
$3,050B on programs other than
social security $420B was borrowed from the public

In 2016, The Social Security $800B Was paid for with current taxes
Administration spent $950B on
current benefits $150B was borrowed from the public
The US budget was essentially balanced until the early 1970’s

Deficit/Surplus (Millions of Current Dollars)

$570B in 2016
Total Debt outstanding represents the cumulative effect of past deficits

Total ($20T)

Held By
Public
($15T)
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

Growth of
Debt
Our economy would need to grow at
4.6% (nominal) per year to sustain our
$570B current projected deficits (i.e. maintain
+ .015 = .046 a constant Debt/GDP ratio).
$18T Unfortunately, we are only growing at
3.5%
Treasury Rate
Can we sustain our current policies?

Alternatively, let’s calculate the deficit that is sustainable


(Debt/GDP is constant)

= -
GPD Nominal
Deficit Total Debt
Growth Interest Rate

$18T 3.5% 1.5%

Given the above numbers, we can sustain a $360B Deficit


Two arguments for Fiscal Policy

Efficiency Equity

Efficiency refers to the Equity refers to the distribution


collective well being of an of well being across individual
economy. in an economy.

Can we use fiscal policy to Can we use fiscal


increase aggregate income?) 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 $15T. Government expenditures
are currently $3T.

FE
r
LM Y = C  I G
$15T $12T $3T
8%

IS
$15T
y

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%

r FE Y = C  I G
LM
$1.2T $10.8T $3T
8%
$13.8T

4%
IS
y
$15T

1. 2
15
= 8% Okun’s Law: A 1% rise in
unemployment translates to a
As 8% output gap would
be associated with a
2.5% drop in GDP
8/2.5 = 3.2% rise in
unemployment
The immediate impact would be a drop in the interest rate and production

r FE
LM
$1.2T

8%
6%
4%
IS
y
$14.4T $15T

As 4% output gap would


.6
= 4% be associated with a
15 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)

FE
r
LM

8%
6%
4%
IS
y
$15T

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 $1.2T.
The could return the economy to full employment…

r FE
We should increase
LM
$1.2T
government spending by
$1.2T, right?
8%

IS
y Y = C  I G
$15T

We have a drop in
demand of $1.2T
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 This will


his $95 in new income and spends $90.25 continue to
(95%) at the local tavern….. 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


The initial $100 increase in
Grocer: $95 government spending raised total
Tavern: $90.25 income by $2,000 (a factor of 20)

-------- $85.74 1 1
-------- $81.45 m= = = 20
1 - MPC 1 - .95

Total: $2,000
Marginal Propensity to Consume
If the government bought $60B worth of hammers, that should do the trick!

Before Y =C  I G
r FE
LM
$1.2T $10.8T $3T

8%

IS After Y = C  I G
y
$13.8T $15T
$11.94T $3.06T

So, with a MPC of 95%

1 1 $1.2T
m= = = 20 20
= $60 B
1 - MPC 1 - .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).

r FE
Multiply by 2.5
LM (Okun’s law)
$1.75T 12.5%
5% cyclical
drop in
unemployment
output

IS
y $14T*(.125) = $1.75T
$12.25T $14T

The personal savings rate at the time


was around 4% (i.e. a consumption
rate of 96%) $1.75T
1 1 = $70 B But the government stimulus
25
m= = = 25 plan was over $700B and

1 - MPC 1 - .96 nothing happened…


However, we need to be careful here…. 1
m=
1 - MPC

It could be We need the marginal


propensity to consume, using
C = .96Y the savings rate, we really have
the average propensity to
consume
C C
Here, we have (at Y = $40,000)
$38, 400 38, 400 Average propensity to
APC = = 96% consume
40, 000

1
MPC = 96% m= = 25
Y 1 - .96
$40, 000
However, we need to be careful here…. 1
m=
1 - MPC

Or, it could be We need the marginal


propensity to consume, using
C = 20, 000  .46Y the savings rate, we really have
the average propensity to
consume
C
C
Here, we have (at Y = $40,000)
$38, 400
38, 400 Average propensity to
APC = = 96% consume
$20, 000 40, 000

1
Y MPC = 46% m= = 1.85
$40, 000 1 - .46
Now, let’s recalculate a stimulus package for the last recession.

r FE
Multiply by 2.5
LM (Okun’s law)
$1.75T 12.5%
5% cyclical
drop in
unemployment
output

IS
y $14T*(.125) = $1.75T
$12.25T $14T

With a marginal propensity


to consume equal to .46
$1.75T This is pretty close to the
1 1 = $945B actual size of the stimulus
1.85
m= = = 1.85 package
1 - MPC 1 - .46
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


The initial $100 increase in government
Grocer: $95 spending raised total income by $2,000 (a
Tavern: $90.25 factor of 20)

-------- $85.74 1 1
-------- $81.45 m= = = 20
1 - MPC 1 - .95

Total: $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)
Non-Rivaled: Anyone can use a public good without affecting its use by
others (zero marginal cost)
Non-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 Remember…this is
determined by the
Taxes: $10,000 Jones’ wealth – not just
$40,000 current income

Consumption: $30,000
Savings: $10,000

Suppose that Trump announces that they will


spend $200B 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.
How should this spending plan influence the Jones’?

Jones’ Family Budget Tax Increase of $1,000


Income: $50,000
Taxes: $11,000 This one time project should
have a negligible impact on
$39,000
the Jones’ wealth and, hence
Consumption: $30,000 a negligible impact on
consumption
Savings: $9,000
Savings drops by $1000

r S

r*

I  G -T 
S, I
S *, I *
So, the government raises spending by $1,000 per person, and household
consumption is left unchanged (household savings drops by $1,000)

$1,000
r $1,000

Y =C  I G
r

r
S
IS
y
r*

I  G -T  The IS curve moves to the right by


$1,000 – i.e. the government
S, I multiplier equals 1
S *, I *
Suppose that the government decides to spend $1,000 wastefully every
year…
$1,000

Y =C  I G r
$1,000
r
r
S

IS
r*
y
I  G -T 
S, I The IS curve moves to the right by
S *, I * $0– i.e. the government multiplier
Households adjust to the equals 0!
permanently lower income by
spending less
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 Rent: $15,000
Food: $10,000
Consumption: $30,000 Transportation: $4,000
Savings: $10,000 Cable TV: $1,000

How will this spending plan


affect the Jones family?
How should this spending plan influence the Jones’?
Tax Increase of $500
Jones’ Family Budget
Income: $50,000
Taxes: $10,500
$39,500 Rent: $15,000
Food: $10,000
Consumption: $29,000 Transportation: $4,000
Savings: $10,000 Cable TV: $0

Extra Income: $500

r S
If this is a one time
increase in income,
r* savings goes up . If it
is permanent,
I  G -T  consumption goes up
S, I by $500
S *, I *
Suppose that this one a one year program only….

$500

Y =C  I G r $500

$1,000
r
r
$500
S

IS
r*
y
I  G -T 
S, I The IS curve moves to the left by
S *, I * $500– i.e. the government multiplier
Households put the income gain is negative!
into savings
If this were a permanent program, households would feel free to spend
the $500 savings.
$500

Y =C  I G r
$500
r
r
S

IS
r*
y
I  G -T 
S, I The IS curve doesn’t move…again,
S *, I * 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

$40,000 $18,000

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 Simpson’s Family Budget


Income: $50,000 $1,000 Income: $20,000
Taxes: $11,000 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 The Simpson’s put the tax credit in the
finance their higher tax bill 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

r S r S

r* r*
I  G -T  I  G -T 
S *, I *
S, I S, I
S *, I *

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
$100

r S r S

r* r*
I  G -T  I  G -T 
S *, I *
S, I S, I
S *, I *

MPC = .5 MPC = .9
So, the government raises spending by $1,000 per person, and household
consumption increases by $400 (household savings drops by $400)

+$900
r $400

Y = C J  CS  I  G
-$500

r $400
S
IS
y
r*

I  G -T  The IS curve moves right!

S, I
S *, I *
Lets look at a breakdown of Mr. Jones tax liability

Income: $50,000 Mr. Jones taxable income of


$45,000 put him in the 30%
Taxes: $10,000 tax bracket

Tax Code
Income Tax Rate Tax Paid
Taxable Income Tax Rate $10,000 15% $1,500
$0 - $10,000 15% $20,000 20% $4,000
$15,000 30% $4,500
$10,000 - $30,000 20%
Total: $10,000
$30,000 - $50,000 30%
$30,000 + 35% Mr. Jones’ average tax rate is 20%

Standard Deduction = $5,000


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?

Mr. Jones taxable income of


Income: $50,000
$48,000 put him in the 25%
Taxes: $10,000 tax bracket

Tax Code
Income Tax Rate Tax Paid
Taxable Income Tax Rate $10,000 15% $1,500
$0 - $10,000 15% $20,000 20% $4,000
$18,000 25% $4,500
$10,000 - $30,000 20%
Total: $10,000
$30,000 - $50,000 25%
$30,000 + 30%
Mr. Jones’ average tax
rate is still 20%
Standard Deduction = $2,000
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 Income Tax Rate Tax Paid
$10,000 15% $1,500 $10,000 15% $1,500
$20,000 20% $4,000 $20,000 20% $4,000
$15,000 30% $4,500 $18,000 25% $4,500

Total: $10,000 Total: $10,000

w r FE
p s
l
A drop in Mr. Jones’s
*
marginal tax rate
 w increases the incentive to
  work – labor supply
 p increases. This should
ld raise production
l y
A cut in marginal tax rates that leaves average rates unchanged raises the
economy’s capacity as employment rises. But what about expenditures?

r
S

r FE
LM r*

I  G -T 
r*
S, I
S *, I *
A tax cut will increase investment (because higher
employment raises the productivity of capital)
IS r
y*
y

r
Capacity output
increases from
the tax cut IS
y
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?

Mr. Jones taxable income of


Income: $50,000
$45,000 put him in the 30%
Taxes: $8,500 tax bracket

Tax Code
Income Tax Rate Tax Paid
Taxable Income Tax Rate $10,000 10% $1,000
$0 - $10,000 10% $20,000 15% $3,000
$15,000 30% $4,500
$10,000 - $30,000 15%
Total: $8,500
$30,000 - $50,000 30%
$30,000 + 35% Mr. Jones’ average tax
falls to 17%
Standard Deduction = $5,000
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 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 $15,000 30% $4,500

Total: $10,000 Total: $8,500


w
w
p l s
p ls

*
 w
 
 p
ld ld
l l
If households are rational and forward looking, If households are not rational and forward looking,
they should recognize that the tax cut will need to they will feel better off and work less
be repaid and thus will not feel better off…
A tax cut will raise the deficit and increase government borrowing, but what
about household savings?

r
S
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
r*
IS curve are unaffected)

I  G -T 
S, I
S *, I *
r
S

If households are not rational and forward


looking, they will increase expenditures
(and, the IS curve shifts right) r*

I  G -T 
S, I
S *, I *
A cut in average tax rates that leaves marginal rates unchanged actually lowers
the economy’s capacity as employment falls while potentially raising
expenditures

r
S
r FE
LM
r*
r*
I  G -T 
S, I
S *, I *
IS
y*
y 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
If the government invests in purely wasteful spending, the multiplier
effect is the largest, but should that justify spending money on stupid
projects?
Effective 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?
Transfers could give the economy a boost without wasting any
resources. The bigger issue with transfers is economic equity

Taxes
Taxes are an effective stimulus only if you can change marginal
rates while leaving effective rates unchanged.