Self-Check Questions

the corporate income tax, excise taxes on alcohol, gasoline and tobacco, and the estate and gift tax. A progressive tax is one, like the federal income tax, where those with higher incomes pay a higher share of taxes out of their income than those with lower incomes. A proportional tax is one, like the payroll tax for Medicare, where everyone pays the same share of taxes regardless of income level. A regressive tax is one, like the payroll tax (above a certain threshold) that supports Social Security, where those with high income pay a lower share of income in taxes than those with lower incomes.

17.3 Federal Deficits and the National Debt

For most of the twentieth century, the U.S. government took on debt during wartime and then paid down that debt slowly in peacetime. However, it took on quite substantial debts in peacetime in the 1980s and early 1990s, before a brief period of budget surpluses from 1998 to 2001, followed by a return to annual budget deficits since 2002, with very large deficits in the recession of 2008 and 2009. A budget deficit or budget surplus is measured annually. Total government debt or national debt is the sum of budget deficits and budget surpluses over time.

17.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.

17.5 Automatic Stabilizers

Fiscal policy is conducted both through discretionary fiscal policy, which occurs when the government enacts taxation or spending changes in response to economic events, or through automatic stabilizers, which are taxing and spending mechanisms that, by their design, shift in response to economic events without any further legislation. The standardized employment budget is the calculation of what the budget deficit or budget surplus would have been in a given year if the economy had been producing at its potential GDP in that year. Many economists and politicians criticize the use of fiscal policy for a variety of reasons, including concerns over time lags, the impact on interest rates, and the inherently political nature of fiscal policy. We cover the critique of fiscal policy in the next module.

17.6 Practical Problems with Discretionary Fiscal Policy

Because fiscal policy affects the quantity of money that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending, reducing aggregate demand in a situation called crowding out. Given the uncertainties over interest rate effects, time lags (implementation lag, legislative lag, and recognition lag), temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers have concluded that discretionary fiscal policy is a blunt instrument and better used only in extreme situations.

17.7 The Question of a Balanced Budget

Balanced budget amendments are a popular political idea, but the economic merits behind such proposals are questionable. Most economists accept that fiscal policy needs to be flexible enough to accommodate unforeseen expenditures, such as wars or recessions. While persistent, large budget deficits can indeed be a problem, a balanced budget amendment prevents even small, temporary deficits that might, in some cases, be necessary.

Self-Check Questions

1 . When governments run budget deficits, how do they make up the differences between tax revenue and spending? 2 . When governments run budget surpluses, what is done with the extra funds? 3 . Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer. 4 . Suppose that gifts were taxed at a rate of 10% for amounts up to $100,000 and 20% for anything over that amount. Would this tax be regressive or progressive? 5 . If an individual owns a corporation for which he is the only employee, which different types of federal tax will he have to pay? 6 . What taxes would an individual pay if he were self-employed and the business is not incorporated? 7 . The social security tax is 6.2% on employees’ income earned below $113,000. Is this tax progressive, regressive or proportional? 8 . Debt has a certain self-reinforcing quality to it. There is one category of government spending that automatically increases along with the federal debt. What is it? 9 . True or False: a. Federal spending has grown substantially in recent decades. b. By world standards, the U.S. government controls a relatively large share of the U.S. economy. c. A majority of the federal government’s revenue is collected through personal income taxes. d. Education spending is slightly larger at the federal level than at the state and local level. e. State and local government spending has not risen much in recent decades. f. Defense spending is higher now than ever. g. The share of the economy going to federal taxes has increased substantially over time. h. Foreign aid is a large portion, although less than half, of federal spending. i. Federal deficits have been very large for the last two decades. j. The accumulated federal debt as a share of GDP is near an all-time high. 10 . What is the main reason for employing contractionary fiscal policy in a time of strong economic growth? 11 . What is the main reason for employing expansionary fiscal policy during a recession? 12 . In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget? 13 . What is the main advantage of automatic stabilizers over discretionary fiscal policy? 14 . Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP. 15 . What would happen if expansionary fiscal policy was implemented in a recession but, due to lag, did not actually take effect until after the economy was back to potential GDP? 16 . What would happen if contractionary fiscal policy were implemented during an economic boom but, due to lag, it did not take effect until the economy slipped into recession? 17 . Do you think the typical time lag for fiscal policy is likely to be longer or shorter than the time lag for monetary policy? Explain your answer? 18 . How would a balanced budget amendment affect a decision by Congress to grant a tax cut during a recession? 19 . How would a balanced budget amendment change the effect of automatic stabilizer programs?

Review Questions

20 . Give some examples of changes in federal spending and taxes by the government that would be fiscal policy and some that would not. 21 . Have the spending and taxes of the U.S. federal government generally had an upward or a downward trend in the last few decades? 22 . What are the main categories of U.S. federal government spending? 23 . What is the difference between a budget deficit, a balanced budget, and a budget surplus? 24 . Have spending and taxes by state and local governments in the United States had a generally upward or downward trend in the last few decades? 25 . What are the main categories of U.S. federal government taxes? 26 . What is the difference between a progressive tax, a proportional tax, and a regressive tax? 27 . What has been the general pattern of U.S. budget deficits in recent decades? 28 . What is the difference between a budget deficit and the national debt? 29 . What is the difference between expansionary fiscal policy and contractionary fiscal policy? 30 . Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy? 31 . What is the difference between discretionary fiscal policy and automatic stabilizers? 32 . Why do automatic stabilizers function “automatically?” 33 . What is the standardized employment budget? 34 . What are some practical weaknesses of discretionary fiscal policy? 35 . What are some of the arguments for and against a requirement that the federal government budget be balanced every year?

Critical Thinking Questions

36 . Why is government spending typically measured as a percentage of GDP rather than in nominal dollars? 37 . Why are expenditures such as crime prevention and education typically done at the state and local level rather than at the federal level? 38 . Why is spending by the U.S. government on scientific research at NASA fiscal policy while spending by the University of Illinois is not fiscal policy? Why is a cut in the payroll tax fiscal policy whereas a cut in a state income tax is not fiscal policy? 39 . Excise taxes on tobacco and alcohol and state sales taxes are often criticized for being regressive. Although everyone pays the same rate regardless of income, why might this be so? 40 . What is the benefit of having state and local taxes on income instead of collecting all such taxes at the federal level? 41 . In a booming economy, is the federal government more likely to run surpluses or deficits? What are the various factors at play? 42 . Economist Arthur Laffer famously pointed out that, in some cases, income tax revenue can actually go up when tax rates go down. Why might this be the case?