Principles of Economics - 3e Chapter 30 Government Budgets and Fiscal Policy

Government Budgets and Fiscal FIGURE Shut Downs and Parks Yellowstone National Park is one of the many national parks forced to close operations during the government shut down in 2013 and . Credit of Close up of sign by David Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Government Spending Taxation Federal and the National Debt Using Fiscal Policy to Fight , Unemployment , and Automatic Stabilizers Practical Problems with Discretionary Fiscal Policy The Question of a Balanced Budget Introduction to Government Budgets and Fiscal Policy BRING IT HOME No Yellowstone Park ?

You had trekked all the way to see Yellowstone National Park in the beautiful month of October 2013 , only to it closed . Closed ! Why ?

For two weeks in October 2013 , the . federal government shut down . Many federal services , like the national parks , closed and federal employees were . Tourists were shocked and so was the rest of the world Congress and the President could not agree on a budget . Inside the Capitol , Republicans and Democrats

724 30 Government Budgets and Fiscal Policy argued about spending priorities and whether to increase the national debt limit . Each year budget , which is over trillion of spending , must be approved by Congress and signed by the President . Two thirds of the budget are entitlements and other mandatory spending which occur without congressional or presidential action once the programs are established . Tied to the budget debate was the issue of increasing the debt high the government national debt can be . The House of Representatives refused to sign on to the bills to fund the government unless they included provisions to stop or change the Affordable Health Care Act ( more colloquially known as ) As the days progressed , the United States came very close to defaulting on its debt . October 2013 was not the first time the government shut down , and it was not the last . Several brief shutdowns occurred in the early , and they occurred periodically in the following years . The longest shutdown took place between December 2018 and January 2019 , when funding a border wall was a core disagreement . Why does the federal budget create such intense debates ?

What would happen if the United States actually defaulted on its debt ?

In this chapter , we will examine the federal budget , taxation , and policy . We will also look at the annual federal budget and the national debt . All levels of , state , and budgets that show how much revenue the government expects to receive in taxes and other income and how the government plans to spend it . Budgets , however , can shift dramatically within a few years , as policy decisions and unexpected events disrupt earlier tax and spending plans . In this chapter , we revisit policy , which we covered in Welcome to Economics ! Fiscal policy is one of two policy tools for tuning the economy ( the other is monetary policy ) While at the Federal Reserve make monetary policy , Congress and the President make policy . The discussion of policy focuses on how federal government taxing and spending affects aggregate demand . All government spending and taxes affect the economy , but policy focuses strictly on federal government policies . We begin with an overview of government spending and taxes . We then discuss policy from a perspective that is , how government uses tax and spending policies to address recession , unemployment , and how periods of recession and growth affect government budgets and the merits of balanced budget proposals . Government Spending LEARNING OBJECTIVES By the end of this section , you will be able to Identify budget and surplus trends over the past decades Explain the differences between the federal budget , and state and local budgets Government spending covers a range of services that the federal , state , and local governments provide . When the federal government spends more money than it receives in taxes in a given year , it runs a budget . Conversely , when the government receives more money in taxes than it spends in a year , it runs a budget surplus . If government spending and taxes are equal , it has a balanced budget . For example , in 2020 , the government experienced its largest budget ever , as the federal government spent trillion more than it collected in taxes . This was about 15 of the size of the in 2020 , making it by far the largest budget relative to since the mammoth borrowing the government used to World War II . To put it into perspective , the previous record were experienced during the Great Recession of , when the reached of . This section presents an overview of government spending in the United States . Total Government Spending Federal spending in nominal dollars ( that is , dollars not adjusted for ) has grown by a multiple of more Access for free at

Government Spending 725 than 38 over the last four decades , from billion in 1960 to trillion in 2020 . Comparing spending over time in nominal dollars is misleading because it does not take into account or growth in population and the real economy . A more useful method of comparison is to examine government spending as a percent over time . The top line in Figure 302 shows the federal spending level since 1960 , expressed as a share of . Despite a widespread sense among many Americans that the federal government has been growing steadily larger , the graph shows that federal spending has hovered in a range from 18 to 22 of most of the time since 1960 . For example , throughout the latter part of the , government expenditures were around 20 of . The other lines in Figure 302 show the major federal spending categories national defense , Social Security , health programs , and interest payments . From the graph , we see that national defense spending as a share of has generally declined since the , although there were some upward bumps in the buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11 , 2001 . In contrast , Social Security and healthcare have grown steadily as a percent . Healthcare expenditures include both payments for senior citizens ( Medicare ) and payments for Americans ( Medicaid ) State governments also partially fund Medicaid . Interest payments are the main category of government spending in Figure . 35 25 spewing 20 Federal ( as percentage ! lU JU , 2320 Year FIGURE Federal Spending , Since 1960 , total federal spending has ranged from about 18 to 22 of . It climbed above that level in 2009 , quickly dropped back down to that level by 2013 , and again climbed above that level in 2020 . The share that the government has spent on national defense has generally declined , while the share it has spent on Social Security and on healthcare expenses ( mainly Medicare and Medicaid ) has increased . Source Economic Report of the President , 2021 , Table , Each year , the government borrows funds from citizens and foreigners to cover its budget . It does this by selling securities ( Treasury bonds , notes , and bills ) essence borrowing from the public and promising to repay with interest in the future . From 1961 to 1997 , the US . government has run budget , and thus borrowed funds , in almost every year . It had budget surpluses from 1998 to 2001 , and then returned to . The interest payments on past federal government borrowing were typically in the and but then climbed above in the and stayed there until the late . The government was able to repay some of its past borrowing by running surpluses from 1998 to 2001 and , with help from low interest rates , the interest payments on past federal government borrowing had fallen back to of by 2020 . We investigate the government borrowing and debt patterns in more detail later in this chapter , but we

726 30 Government Budgets and Fiscal Policy need to clarify the difference between the and the debt . The is not the debt . The difference between the and the debt lies in the time frame . The government ( or surplus ) refers to what happens with the federal government budget each year . The government debt is accumulated over time . It is the sum of all past and surpluses . Ifyou borrow per year for each of the four years of college , you might say that your annual deficit was , but your accumulated debt over the four years is . These four defense , Social Security , healthcare , and interest account for roughly 60 of all federal spending , as Figure 303 shows . Due to the large amount of expenditures by the federal government in 2020 due to the pandemic , the 2019 statistics are presented here . The remaining 40 wedge of the pie chart covers all other categories of federal government spending international affairs science and technology natural resources and the environment transportation housing education income support for people in poverty community and regional development law enforcement and system and the administrative costs of running the government . All other spending ! Net , Healthcare Medicaid Social National defense 15 am FIGURE Slices of Federal Spending , 2019 About 60 of government spending goes to four major areas national defense , Social Security , healthcare , and interest payments on past borrowing . This leaves about 40 of federal spending for all other functions of the government . Source ) State and Local Government Spending Although federal government spending often gets most of the media attention , state and local government spending is also about trillion in 2021 . Figure 304 shows that state and local government spending has increased during the last four decades from around to around 14 today . The single biggest item is education , which accounts for about of the total . The rest covers programs like highways , libraries , hospitals and healthcare , parks , and police and fire protection . Unlike the federal government , all states ( except Vermont ) have balanced budget laws , which means any gaps between revenues and spending must be closed by higher taxes , lower spending , drawing down their previous savings , or some combination of all of these . Access for free at

Taxation 18 16 , 14 Total 12 10 ' Education spending cu 1980 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Year FIGURE State and Local Spending , Spending by state and local government increased from about 10 of in the early to by the . It has remained at roughly that level since . The single biggest spending item is education , including both spending and support for public colleges and universities , which has been about of in recent decades . Source ( Source Bureau of Economic Analysis , presidential candidates often run for pledging to improve the public schools or to get tough on crime . However , in the government system , these tasks are primarily state and local government responsibilities . In year 2020 state and local governments spent about 970 billion per year on education ( including and college and university education ) compared to only 100 billion by the federal government . In other words , about 90 cents of every dollar spent on education happens at the state and local level . A politician who really wants responsibility for reforming education or reducing crime might do better to run for mayor of a large city or for state governor rather than for president of the United States . Taxes are paid by most , but not all , people who work . Even ifyou are part of the 1099 or gig economy , you are considered an independent contractor and must pay taxes on the income you earn in those occupations . Taxes are also paid by consumers whenever they purchase goods and services . Taxes are used for all sorts of roads , to bridges , to schools ( and public higher education ) to police and other public safety functions . Taxes fund vital public services that support our communities . Taxation LEARNING OBJECTIVES By the end of this section , you will be able to Differentiate among a regressive tax , a proportional tax , and a progressive tax Identify major revenue sources for the US . federal budget There are two main categories of taxes those that the federal government collects and those that the state and local governments collect . What percentage the government collects and for what it uses that revenue varies greatly . The following sections will explain the taxation system in the United States . Taxes are paid by most , but not all , people who work . Even ifyou are part of the 1099 or gig economy , you are considered an independent contractor and must pay taxes on the income you earn in those occupations . Taxes are also paid by consumers whenever they purchase goods and services . Taxes are used for all sorts of roads , to bridges , to schools ( and public higher education ) to police and other public safety functions . Taxes fund vital public services that support our communities . 727

728 30 Government Budgets and Fiscal Policy Federal Taxes Just as many Americans erroneously think that federal spending has grown considerably , many also believe that taxes have increased substantially . The top line of Figure 305 shows total federal taxes as a share of since 1960 . Although the line rises and falls , it typically remains within the range of 17 to 20 of , except for , when taxes fell substantially below this level , due to the Great Recession . 25 Total federal tax receipts 20 income tax 10 Payroll taxes taxes Corporate Income taxes Federal Taxes ( as percentage of ) I I 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Year FIGURE Federal Taxes , Federal tax revenues have been about of during most periods in recent . The primary sources of federal taxes are individual income taxes and the payroll taxes that Social Security and Medicare . Corporate income taxes and social insurance taxes provide smaller shares of revenue . Source Economic Report of the President , 2021 . Table , Figure 305 also shows the taxation patterns for the main categories that the federal government taxes individual income taxes , corporate income taxes , and social insurance and retirement receipts . When most people think of federal government taxes , the tax that comes to mind is the individual income tax that is due every year on April 15 ( or the business day after ) The personal income tax is the largest single source of federal government revenue , but it still represents less than half of federal tax revenue . The second largest source of federal revenue is the payroll tax ( captured in social insurance and retirement receipts ) which provides funds for Social Security and Medicare . Payroll taxes have increased steadily over time . Together , the personal income tax and the payroll tax accounted for over 85 of federal tax revenues in 2020 . Although personal income tax revenues account for more total revenue than the payroll tax , nearly of households pay more in payroll taxes than in income taxes . The income tax is a progressive tax , which means that the tax rates increase as a household income increases . Taxes also vary with marital status , family size , and other factors . The marginal tax rates ( the tax due on all yearly income ) for a single taxpayer range from 10 to 35 , depending on income , as the following Clear It Up feature explains . CLEAR IT UP How does the marginal rate work ?

Suppose that a single taxpayer income is per year . Also suppose that income from to is taxed at 10 , income from to is taxed at 15 , and , income from and beyond is taxed at 25 . Since this person earns , their marginal tax rate is 15 . Access for free at

Taxation 729 The key fact here is that the federal income tax is designed so that tax rates increase as income increases , up to a certain level . The payroll taxes that support Social Security and Medicare are designed in a different way . First , the payroll taxes for Social Security are imposed at a rate of up to a certain wage limit , set at in 2020 . Medicare , on the other hand , pays for elderly healthcare , and is at , with no upper ceiling . In both cases , the employer and the employee split the payroll taxes . An employee only sees deducted from their paycheck for Social Security , and from Medicare . However , as economists are quick to point out , the employer half of the taxes are probably passed along to the employees in the form of lower wages , so in reality , the worker pays all of the payroll taxes . lfyou are a member of the gig economy and receive a 1099 tax statement , then you are considered an independent contractor and so you must pay the employee and employer side of the payroll tax . We also call the Medicare payroll tax a proportional tax that is , a percentage of all wages earned . The Social Security payroll tax is proportional up to the wage limit , but above that level it becomes a regressive tax , meaning that people with higher incomes pay a smaller share of their income in tax . The source of federal tax revenue , as Figure shows is the corporate income tax . The common name for corporate income is ?

Over time , corporate income tax receipts have declined as a share of , from about in the to an average of to in the past 40 years . The federal government has a few other , smaller sources of revenue . It imposes an excise is , a tax on a particular gasoline , tobacco , and alcohol . As a share of , the amount the government collects from these taxes has stayed nearly constant over time , from about in the to roughly by 2020 , according to the nonpartisan Congressional Budget . The government also imposes an estate and gift tax on people who pass large amounts of assets to the next after death or during life in the form of gifts . These estate and gift taxes collected about in 2020 . By a quirk of legislation , the government repealed the estate and gift tax in 2010 , but reinstated it in 2011 . Other federal taxes , which are also relatively small in magnitude , include tariffs the government collects on imported goods and charges for inspections of goods entering the country . State and Local Taxes At the state and local level , taxes have been rising as a share over the last few decades to match the gradual rise in spending , as Figure illustrates . The main revenue sources for state and local governments are sales taxes , property taxes , and revenue passed along from the federal government , but many state and local governments also levy personal and corporate income taxes , as well as impose a wide variety of fees and charges . The specific sources of tax revenue vary widely across state and local governments . Some states rely more on property taxes , some on sales taxes , some on income taxes , and some more on revenues from the federal government .

730 30 Government Budgets and Fiscal Policy i , on ' Eco Solo , mu ) 53 my . FIGURE State and Local Tax Revenue as a Share of , State and local tax revenues have increased to match the rise in state and local spending . Source Economic Report of the President , 2020 . Table , Federal Deficits and the National Debt LEARNING OBJECTIVES By the end of this section , you will be able to Explain the US . federal budget in terms of annual debt and accumulated debt Understand how economic growth or decline can a budget surplus or budget Having discussed the revenue ( taxes ) and expense ( spending ) side of the budget , we now turn to the annual budget or surplus , which is the difference between the tax revenue collected and spending over a year , which starts October and ends September 30 of the next year . Figure 307 shows the pattern of annual federal budget and surpluses , back to 1930 , as a share of . When the line is above the horizontal axis , the budget is in surplus . When the line is below the horizontal axis , a budget occurred . Clearly , the biggest as a share of during this time were incurred to World War II . were also large during the , the , the early , the Great Recession ) and 2020 ( the recession ) 10 as Federal Deficit ( as percentage of ) A 2610 4202 ! A Year FIGURE Pattern of Federal Budget Deficits and Surpluses , The federal government has run budget deficits for decades . The budget was briefly in surplus in the late , before heading into deficit again in the first decade of the especially deep in the and 2020 . Source Federal Reserve Bank of Louis ( FRED ) Click to View content ( books pages Access for free at

Federal and the National Debt Federal Surplus or as a Percentage of Gross Domestic Product Ratio Another useful way to view the budget is through the prism of accumulated debt rather than annual . The national debt refers to the total amount that the government has borrowed over time . In contrast , the budget refers to how much the government has borrowed in one particular year . Figure 308 shows the ratio of since 1966 . Until the , the ratio revealed a fairly clear pattern of federal borrowing . The government ran up large and raised the ratio in World War II , but from the to the the government ran either surpluses or relatively small , and so the ratio drifted down . Large in the and early caused the ratio to rise sharply . When budget surpluses arrived from 1998 to 2001 , the ratio declined substantially . The budget starting in 2002 then tugged the ratio a when the recession took hold in . There was another leap in the ratio in 2020 . A 140 120 so ( I 40 20 61 ( 1970 1980 1900 2000 2010 2020 Year FIGURE Federal Debt as a Percentage of , Federal debt is the sum of annual budget and surpluses . Annual do not always mean that the ratio is rising . 19605 and 19705 , the government often ran small , but since the debt was growing more slowly than the economy , the ratio was declining over this time . In the recession , the ratio rose sharply , before leveling off through the later . In 2020 , it rose sharply again . Source ) The next Clear it Up feature discusses how the government handles the national debt . CLEAR IT UP What is the national debt ?

One year federal budget causes the federal government to sell Treasury bonds to make up the difference between spending programs and tax revenues . The dollar value of all the outstanding Treasury bonds on which the federal government owes money is equal to the national debt . Click to view content ( books pages Gross Federal Debt as a Percentage of Gross Domestic Product 731

732 30 Government Budgets and Fiscal Policy The Path from Deficits to Surpluses to Deficits Why did the budget suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to in 2002 ?

Why di the become so large in 2020 ?

Figure suggests some answers . The graph combines the earlier information on total federal spending and taxes in a single graph , but focuses on the federal budget since 1990 . 24 ' 20 ( as percentage of ) in Tax li , I Total Government Spending and Taxes 12 12400 ( 2000 . 2023 Year FIGURE Total Government Spending and Taxes as a Share of , When government spending exceeds taxes , the gap is budget . When taxes exceed spending , the gap is a budget surplus . The recessionary period starting in late 2007 saw higher spending and lower taxes , combining to create a large in 2009 . The same thing happened in a more extreme way in 2020 . Source Economic Report of the President , Tables , Government spending as a share of declined steadily through the . The biggest single reason was that defense spending declined from in 1990 to in 2000 , but interest payments by the federal government also fell by about of . However , federal tax collections increased substantially in the later , jumping from in 1994 to in 2000 . Powerful economic growth in the late fueled the boom in taxes . Personal income taxes rise as income goes up payroll taxes rise as jobs and payrolls go up corporate income taxes rise as go up . At the same time , government spending on transfer payments such as unemployment , foods stamps , and welfare declined with more people working . This sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts , and so budget surpluses came as a surprise . However , in the early , many of these factors started running in reverse . Tax revenues sagged , due largely to the recession that started in March 2001 , which reduced revenues . Congress enacted a series of tax cuts and President George Bush signed them into law , starting in 2001 . In addition , government spending swelled due to increases in defense , healthcare , education , Social Security , and support programs for those who were hurt by the recession and the slow growth that followed . returned . When the severe recession hit in late 2007 , spending climbed and tax collections fell to historically unusual levels , resulting in enormous . budget forecasts , a decade or more into the future , predict enormous . The higher during the Great Recession and the 2020 recession have repercussions , and the demographics will be challenging . The primary reason is the baby boom exceptionally high that began in 1946 , right after World War II , and lasted for about two decades . Starting in 2010 , the Access for free at

Using Fiscal Policy to Fight Recession , Unemployment , and Inflation 733 front edge of the baby boom generation reached age 65 , and in the next two decades , the proportion of Americans over the age of 65 will increase substantially . During the 2020 recession , we saw another wave of early , and we are now in the middle of this major demographic shift . The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs , as the following Clear It Up feature shows thus , the forecast is for increasingly large budget . A decision to collect more revenue to support these programs or to decrease levels would alter this forecast . CLEAR IT UP What is the budget outlook for Social Security and Medicare ?

In 1946 , just one American in 13 was over age 65 . By 2000 , it was one in eight . By 2030 , one American in will be over age 65 . Two enormous federal programs focus on the Security and Medicare . The growing numbers of elderly Americans will increase spending on these programs , as well as on Medicaid . The current payroll tax levied on workers , which supports all of Social Security and the hospitalization insurance part of Medicare , will not be enough to cover the expected costs , so what are the options ?

projections from the Congressional Budget in 2021 are that Medicare and Social Security spending combined will rise from of in 2021 to about by . If this rise in spending occurs , without any corresponding rise in tax collections , then some mix of changes must occur ( taxes will need to increase dramatically ( other spending will need to be cut dramatically ( the retirement age age receiving Medicare benefits will need to increase , or ( the federal government will need to run extremely large budget deficits . Some proposals suggest cap on wages subject to the payroll tax , so that those with very high incomes would have to pay the tax on the entire amount of their wages . Other proposals suggest moving Social Security and Medicare from systems in which workers pay for retirees toward programs that set up accounts where workers save funds over their lifetimes and then draw out after retirement to pay for healthcare . The United States is not alone in this problem . promised level of retirement and health to a growing proportion of elderly with a falling proportion of workers is an even more severe problem in many European nations and in Japan . How to pay promised levels of to the elderly will be a public policy decision . In the next module we shift to the use of policy to counteract business cycle . In addition , we will explore proposals requiring a balanced is , for government spending and taxes to be equal each year . The Impacts of Government Borrowing will also cover how policy and government borrowing will affect national thus affect economic growth and trade imbalances . Using Fiscal Policy to Fight Recession , Unemployment , and Inflation LEARNING OBJECTIVES By the end of this section , you will be able to Explain how expansionary policy can shift aggregate demand and the economy Explain how policy can shift aggregate demand and the economy Fiscal policy is the use of government spending and tax policy to the path of the economy over time . Graphically , we see that policy , whether through changes in spending or taxes , shifts the aggregate demand outward in the case of expansionary policy and inward in the case of policy . We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger , as businesses invest in new capital , and as technology improves . The result of this is regular shifts to the right of the aggregate supply curves , as Figure i illustrates .

734 30 Government Budgets and Fiscal Policy The original equilibrium occurs at , the intersection of aggregate demand curve ADO and aggregate supply curve , at an output level and a price level of 90 . One year later , aggregate supply has shifted to the right to in the process of economic growth , and aggregate demand has also shifted to the right to , keeping the economy operating at the new level of potential . The new equilibrium ( is an output level of 206 and a price level of 92 . One more year later , aggregate supply has again shifted to the right , now to , and aggregate demand shifts right as well to . Now the equilibrium is , with an output level of 212 and a price level of 94 . In short , the shows an economy that is growing steadily year to year , producing at its potential each year , with only small increases in the price level . 90 Price Level ( base year 100 ) 200 206 212 Real Output ( constant dollars ) FIGURE A Healthy , Growing Economy In this we economy , each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium to to . Each year , the economy produces at potential with only a small inflationary increase in the price level . However , if aggregate demand does not smoothly shift to the right and match increases in aggregate supply , growth with deflation can develop . Aggregate demand and aggregate supply do not always move neatly together . Think about what causes shifts in aggregate demand over time . As aggregate supply increases , incomes tend to go up . This tends to increase consumer and investment spending , shifting the aggregate demand curve to the right , but in any given period it may not shift the same amount as aggregate supply . What happens to government spending and taxes ?

Government spends to pay for the ordinary business of items such as national defense , social security , and healthcare , as Figure shows . Tax revenues , in part , pay for these expenditures . The result may be an increase in aggregate demand more than or less than the increase in aggregate supply . Aggregate demand may fail to increase along with aggregate supply , or aggregate demand may even shift left , for a number of possible reasons households become hesitant about consuming decide against investing as much or perhaps the demand from other countries for exports diminishes . For example , investment by private in physical capital in the economy boomed during the late , rising from of in 1993 to in 2000 , before falling back to by 2002 . Conversely , if shifts in aggregate demand run ahead of increases in aggregate supply , increases in the price level will result . Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand . As these occur , the government may choose to use policy to address the difference . Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in against the business cycle . threatens , the central bank uses an expansionary monetary policy to increase the money supply , increase the quantity of loans , reduce interest rates , and shift aggregate demand to the right . If threatens , the central bank uses monetary policy to reduce the money supply , reduce the quantity of loans , raise interest rates , Access for free at

Using Fiscal Policy to Fight Recession , Unemployment , and Inflation 735 and shift aggregate demand to the left . Fiscal policy is another policy tool for adjusting aggregate demand by using either government spending or taxation policy . Expansionary Fiscal Policy Expansionary policy increases the level of aggregate demand , through either increases in government spending or reductions in tax rates . Expansionary policy can do this by ( increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes ( increasing investment spending by raising through cuts in business taxes and ( increasing government purchases through increased federal government spending on goods and services and raising federal grants to state and local governments to increase their expenditures on goods and services . policy does the reverse it decreases the level of aggregate demand by decreasing consumption , decreasing investment , and decreasing government spending , either through cuts in government spending or increases in taxes . The aggregate supply model is useful whether expansionary or policy is appropriate . Consider the situation in Figure 3011 , which is similar to the economy during the recession . The intersection of aggregate demand ( ADD ) and aggregate supply ( is occurring below the level of potential as the curve indicates . At the equilibrium ( Eg ) a recession occurs and unemployment rises . In this case , expansionary policy using tax cuts or increases in government spending can shift aggregate demand to , closer to the level of output . In addition , the price level would rise back to the level associated with potential . Price Level FIGURE Expansionary Fiscal Policy The original equilibrium ( represents a recession , occurring at a quantity of output ( below potential . However , a shift of aggregate demand from ADO to , enacted through an expansionary policy , can move the economy to a new equilibrium output of at the level of potential which the curve shows . Since the economy was originally producing below potential , any inflationary increase in the price level from to that results should be relatively small . Should the government use tax cuts or spending increases , or a mix of the two , to carry out expansionary policy ?

During the Great Recession , the economy suffered a cumulative loss of . That may not sound like much , but it more than one years average growth rate of . Over that time frame , the unemployment rate doubled from to 10 . The choice between whether to use tax or spending tools often has a political tinge . As a general statement , conservatives and Republicans prefer to see expansionary policy carried out by tax cuts , while liberals and Democrats prefer that the government implement expansionary policy through spending increases . In a bipartisan effort to address the extreme situation , the Obama administration and Congress passed an 830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending . At the same time , however , the federal stimulus was

736 30 Government Budgets and Fiscal Policy partially offset when state and local governments , whose budgets were hard hit by the recession , began cutting their spending . Events were even more severe during the more recent recession . In a single quarter ( Quarter of 2020 ) fell by over , or at an rate of about 34 . were quick to respond with expanded unemployment insurance , aid to state and local governments ( so that they didn have to cut their spending like they did during the Great Recession ) grants and tax breaks for small businesses , and perhaps most , stimulus checks sent to over 100 million households , totaling thousands of dollars each . Since these were mostly spending measures , they were supported more by Democrats than by Republicans , although both groups recognized the severity of the problem and were largely in agreement early on . Especially during the debates over later rounds of the stimulus checks , many discussions were had over the appropriate size and target of the checks . Ultimately , compromises were made and no side got exactly what it wanted . The over which policy tool to use can be frustrating to those who want to categorize economics as liberal or conservative , or who want to use economic models to argue against their political opponents . However , advocates of smaller government , who seek to reduce taxes and government spending can use the AD AS model , as well as advocates of bigger government , who seek to raise taxes and government spending . Economic studies of taxing and spending programs can help inform decisions about whether the government should change taxes or spending , and in what ways . Ultimately , decisions about whether to use tax or spending mechanisms to implement policy is a political decision rather than a purely economic one . Fiscal Policy Fiscal policy can also contribute to pushing aggregate demand beyond potential in a way that leads to . As Figure shows , a very large budget pushes up aggregate demand , so that the intersection of aggregate demand ( ADD ) and aggregate supply ( occurs at equilibrium , which is an output level above potential . Economists sometimes call this an overheating economy where demand is so high that there is upward pressure on wages and prices , causing . In this situation , policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left , to , and causing the new equilibrium to be at potential , where aggregate demand intersects the curve . Price Level Real FIGURE A Fiscal Policy The economy starts at the equilibrium quantity of output , which is above potential . The extremely high level of aggregate demand will generate inflationary increases in the price level . A policy can shift aggregate demand down from ADO to , leading to a new equilibrium Access for free at

Automatic Stabilizers 737 output , which occurs at potential , where intersects the curve . Again , the model does not dictate how the government should carry out this policy . Some may prefer spending cuts others may prefer tax increases still others may say that it depends on the situation . The model only argues that , in this situation , the government needs to reduce aggregate demand . Automatic Stabilizers LEARNING OBJECTIVES By the end of this section , you will be able to Describe how the federal government can use discretionary policy to stabilize the economy Identify examples of automatic stabilizers Understand how a government can use standardized employment budget to identify automatic stabilizers In 2020 , more than 20 million people could collect unemployment insurance to replace some of their salaries . Federal policies include discretionary policy , when the government passes a new law that explicitly changes tax or spending levels . The 2020 stimulus checks and increases in state and local government aid are an example . Changes in tax and spending levels can also occur automatically , due to automatic stabilizers , such as unemployment insurance and food stamps , which are programs that are already laws that stimulate aggregate demand in a recession and hold down aggregate demand in a potentially boom . Recession and Boom Consider the situation where aggregate demand has risen sharply , causing the equilibrium to occur at a level of output above potential . This situation will increase pressure in the economy . The policy prescription in this setting would be a dose of policy , implemented through some combination of higher taxes and lower spending . To some extent , both changes happen automatically . On the tax side , a rise in aggregate demand means that workers and throughout the economy earn more . Because taxes are based on personal income and corporate , a rise in aggregate demand automatically increases tax payments . On the spending side , stronger aggregate demand typically means lower unemployment and fewer layoffs , and so there is less need for government spending on unemployment , welfare , Medicaid , and other programs in the social safety net . The process works in reverse , too . If aggregate demand were to fall sharply so that a recession occurs , then the prescription would be for expansionary mix of tax cuts and spending increases . The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate , an effect that will reduce the amount of taxes owed automatically . Higher unemployment and a weaker economy should lead to increased government spending on unemployment , welfare , and other similar domestic programs . In 2009 , the stimulus package included an extension in the time allowed to collect unemployment insurance . In addition , the automatic stabilizers react to a weakening of aggregate demand with expansionary policy and react to a strengthening of aggregate demand with policy , just as the analysis suggests . A combination of automatic stabilizers and discretionary policy produced the very large budget in 2020 . The pandemic caused high levels , meaning less economic activity . The high unemployment rate triggered the automatic stabilizers that reduce taxes and increase spending , due to the increased amount of unemployment insurance paid out by the federal and state governments . Most economists , even those who are concerned about a possible pattern of persistently large budget , are much less concerned or even quite supportive of larger budget in the short run of a few years during and immediately after a severe recession . A glance back at economic history provides a second illustration of the power of automatic stabilizers .

738 30 Government Budgets and Fiscal Policy Remember that the length of economic between has become longer in the economy in recent decades ( as we discussed in Unemployment . The three longest economic booms of the twentieth century happened in the , the , and the time period . One reason why the economy has tipped into recession less frequently in recent decades is that the size of government spending and taxes has increased in the second half of the twentieth century . Thus , the automatic stabilizing effects from spending and taxes are now larger than they were in the half of the twentieth century . Around 1900 , for example , federal spending was only about of . In 1929 , just before the Great Depression hit , government spending was still just of . In those earlier times , the smaller size of government made automatic stabilizers far less powerful than in the last few decades , when government spending often hovers at 20 of or more . The Standardized Employment Deficit or Surplus Each year , the nonpartisan Congressional Budget ( calculates the standardized employment is , what the budget or surplus would be if the economy were producing at potential , where people who look for work were in a reasonable period of time and businesses were making normal , with the result that both workers and businesses would be earning more and paying more taxes . In effect , the standardized employment eliminates the impact of the automatic stabilizers . i compares the actual budget of recent decades with the standardized . LINK IT Visit this website to learn more from the Congressional Budget . 2020 Percentage of Standardized ritual I surplus Sum Us Year FIGURE Comparison of Actual Budget Deficits with the Standardized Employment Deficit When the economy is in recession , the standardized employment budget is less than the actual budget because the economy is below potential , and the automatic stabilizers are reducing taxes and increasing spending . When the economy is performing extremely well , the standardized employment deficit ( or surplus ) is higher than the actual budget ( or surplus ) because the economy is producing about potential , so the automatic stabilizers are increasing taxes and need for government spending . Sources Actual and Cyclically Adjusted Budget , Notice that in recession years , like the early , 2001 , or 2009 , the standardized employment is smaller than the actual . These data are only available up until February 2020 , so they do not include the effects of the pandemic . During , the automatic stabilizers tend to increase the budget , so if the economy was instead at full employment , the would be reduced . However , in the late the standardized employment budget surplus was lower than the actual budget surplus . The gap between the standardized budget or surplus and the actual budget or surplus shows the impact of the automatic stabilizers . More generally , the standardized budget allow you to see what the budget Access for free at

Practical Problems with Discretionary Fiscal Policy 739 would look like with the economy held its potential level . Automatic stabilizers occur quickly . Lower wages means that a lower amount of taxes is withheld from paychecks right away . Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for . However , while the automatic stabilizers offset part of the shifts in aggregate demand , they do not offset all or even most of it . Historically , automatic stabilizers on the tax and spending side offset about 10 of any initial movement in the level of output . This offset may not seem enormous , but it is still useful . Automatic stabilizers , like shock absorbers in a car , can be useful if they reduce the impact of the worst bumps , even if they do not eliminate the bumps altogether . Child Tax Credit One new form of government spending meant to support working families is an expanded Child Tax Credit ( Under changes which took effect in 2021 , qualifying families will receive the credit as a monthly payment directly into their bank accounts . The credit is also an expanded amount from per child to per child under the age of ( less for children older than that ) Introduced by President Joe American Rescue Plan , it is hoped that the newly expanded will help reduce child poverty and support families . Because the works like a grant that is automatically extended to households , the is considered a new kind of policy that is related to a universal basic income policy which some have argued for in the past . By sending money out monthly instead of a lump sum as part ofa person tax refund , the intention is to help families better manage monthly bills for things like clothes and food . Practical Problems with Discretionary Fiscal Policy LEARNING OBJECTIVES By the end of this section , you will be able to Understand how policy and monetary policy are interconnected Explain the three lag times that often occur when solving economic problems Identify the legal and political challenges of responding to an economic problem In the early , many leading economists believed that the problem of the business cycle , and the swings between cyclical unemployment and , were a thing of the past . On the cover of its December 31 , 1965 , issue , Time magazine , then the premier news magazine in the United States , ran a picture of John Maynard Keynes , and the story inside theories as the prime on the world The article reported that have used principles not only to avoid the violent business cycles of prewar days but to produce phenomenal economic growth and to achieve remarkably stable This happy consensus , however , did not last . The economy suffered one recession from December 1969 to November 1970 , a deeper recession from November 1973 to March 1975 , and then from January to June 1980 and from July 1981 to November 1982 . At various times , and unemployment both soared . Clearly , the problems of policy had not been completely solved . As economists began to consider what had gone wrong , they a number that make discretionary policy more than it had seemed in the rosy optimism of the . Fiscal Policy and Interest Rates Because policy affects the quantity that the government borrows in capital markets , it not only affects aggregate can also affect interest rates . In Figure , the original equilibrium ( in the capital market occurs at a quantity of 800 billion and an interest rate of . However , an increase in government budget shifts the demand for capital from to . The new equilibrium ( occurs at a quantity of 900 billion and an interest rate of . A consensus estimate based on a number of studies is that an increase in budget ( or a fall in budget surplus ) by will cause an increase of in the interest rate .

740 30 Government Budgets and Fiscal Policy Interest Rate ( Quantity of Financial Capital ( billions of dollars ) FIGURE Fiscal Policy and Interest Rates When a government borrows money in the capital market , it causes a shift in the demand for capital from Do to . As the equilibrium moves from to , the equilibrium interest rate rises from to in this example . In this way , an expansionary policy intended to shift aggregate demand to the right can also lead to a higher interest rate , which has the effect of shifting aggregate demand back to the left . A problem arises here . An expansionary policy , with tax cuts or spending increases , is intended to increase aggregate demand . If an expansionary policy also causes higher interest rates , then and households are discouraged from borrowing and spending ( as occurs with tight monetary policy ) thus reducing aggregate demand . Even if the direct effect of expansionary policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates , policy can end up less powerful than was originally expected . We refer to this as crowding out , where government borrowing and spending results in higher interest rates , which reduces business investment and household consumption . The broader lesson is that the government must coordinate and monetary policy . policy is to work well , then the central bank can also reduce or keep interest rates low . Conversely , monetary policy can also help to ensure that policy does not lead to a recession . Long and Variable Time Lags The government can change monetary policy several times each year , but it takes much longer to enact policy . Imagine that the economy starts to slow down . It often takes some months before the economic statistics signal clearly that a downturn has started , and a few months more to that it is truly a recession and not just a one or blip . Economists often call the time it takes to determine that a recession has occurred the recognition lag . After this lag , become aware of the problem and propose policy bills . The bills go into various congressional committees for hearings , negotiations , votes , and then , eventually for the president signature . Many policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time . Economists often refer to the time it takes to pass a bill as the legislative lag . Finally , once the government passes the bill it takes some time to disperse the funds to the appropriate agencies to implement the programs . Economists call the time it takes to start the projects the implementation lag . Moreover , the exact level of policy that the government should implement is never completely clear . Should it increase the budget by of ?

By of ?

By of ?

In an diagram , it is straightforward to sketch an aggregate demand curve shifting to the potential level of output . In the real world , we only know roughly , not precisely , the actual level output , and exactly how a spending cut or tax increase will affect aggregate demand is always somewhat controversial . Also unknown is the state of the Access for free at

Practical Problems with Discretionary Fiscal Policy 741 economy at any point in time . During the early days of the Obama administration , for example , no one knew the true extent of the economy . During the crisis , the rapid collapse of the banking system and automotive sector made it to assess how quickly the economy was collapsing . Thus , it can take many months or even more than a year to begin an expansionary policy after a recession has even then , uncertainty will remain over exactly how much to expand or contract taxes and spending . When politicians attempt to use policy to recession or , they run the risk of responding to the situation of two or three years ago , in a way that may be exactly wrong for the economy at that time . George Schultz , a professor of economics , former Secretary of the Treasury , and Director of the of Management and Budget , once wrote While the economist is accustomed to the concept of lags , the politician likes instant results . The tension comes because , as I have seen on many occasions , the economist lag is the politician Temporary and Permanent Fiscal Policy A temporary tax cut or spending increase will explicitly last only for a year or two , and then revert to its original level . A permanent tax cut or spending increase is expected to stay in place for the foreseeable future . The effect of temporary and permanent policies on aggregate demand can be very different . Consider how you would react if the government announced a tax cut that would last one year and then be repealed , in comparison with how you would react if the government announced a permanent tax cut . Most people and will react more strongly to a permanent policy change than a temporary one . This fact creates an unavoidable for policy . The appropriate policy may be to have an expansionary policy with large budget during a recession , and then a policy with budget surpluses when the economy is growing well . However , policies are explicitly temporary ones , they will have a less powerful effect than a permanent policy . Structural Economic Change Takes Time When an economy recovers from a recession , it does not usually revert to its exact earlier shape . Instead , the economy internal structure evolves and changes and this process can take time . For example , much of the economic growth of the was in the construction sector ( especially of housing ) and . However , when housing prices started falling in 2007 and the resulting crunch led into recession ( as we discussed in Monetary Policy and Bank Reg , both sectors contracted . The manufacturing sector of the economy has been in recent years as well , under pressure from technological change and foreign competition . Many of the people who lost work from these sectors in the Great Recession will never return to the in the same sectors of the economy . Instead , the economy will need to grow in new and different directions , as the following Clear It Up feature shows . Fiscal policy can increase overall demand , but the process of structural economic expansion of a new set of industries and the movement of workers to those takes time . CLEAR IT UP Why vanish ?

People can lose jobs for a variety of reasons because of a recession , but also because of changes in the economy , such as new technology . Productivity improvements in auto manufacturing , for example , can reduce the number of workers needed , and eliminate these jobs in the long run . The internet has created jobs but also caused job loss , from travel agents to book store clerks . Many of may never come back . policy to reduce unemployment can create jobs , but it can not replace jobs that will never return . The Limitations of Fiscal Policy Fiscal policy can help an economy that is producing below its potential to expand aggregate demand so

742 30 Government Budgets and Fiscal Policy that it produces closer to potential , thus lowering unemployment . However , policy can not help an economy produce at an output level above potential without causing At this point , unemployment becomes so low that workers become scarce and wages rise rapidly . LINK IT UP Visit this website to read about how policies are affecting the recovery . Political and Discretionary Fiscal Policy A problem for discretionary policy arises out of the of explaining to politicians how policy that runs against the tide of the business cycle should work . Some politicians have a belief that when the economy and tax revenues slow down , it is time to hunker down , pinch pennies , and trim expenses . policy , however , says that when the economy has slowed , it is time for the government to stimulate the economy , raising spending , and cutting taxes . This offsets the drop in the economy in the other sectors . Conversely , when economic times are good and tax revenues are rolling in , politicians often feel that it is time for tax cuts and new spending . However , policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending . Politicians tend to prefer expansionary policy over policy . There is rarely a shortage of proposals for tax cuts and spending increases , especially during . However , politicians are less willing to hear the message that in good economic times , they should propose tax increases and spending limits . In the economic upswing of the late and early , for example , the grew rapidly . Estimates from respected government economic forecasters like the nonpartisan Congressional Budget Office and the of Management and Budget stated that the was above potential , and that unemployment rates were low . However , no mainstream politician took the lead in saying that the booming economic times might be an appropriate time for spending cuts or tax increases . Discretionary Fiscal Policy Summing Up Expansionary policy can help to end and policy can help to reduce . Given the uncertainties over interest rate effects , time lags , temporary and permanent policies , and unpredictable political behavior , many economists and knowledgeable had concluded by the that discretionary policy was a blunt instrument , more like a club than a scalpel . It might still make sense to use it in extreme economic situations , like an especially deep or long recession . For less extreme situations , it was often preferable to let policy work through the automatic stabilizers and focus on monetary policy to steer efforts . The Question of a Balanced Budget LEARNING OBJECTIVES By the end of this section , you will be able to Understand the arguments for and against requiring the federal budget to be balanced Consider the and effects of a federal budget For many decades , going back to the , various legislators have put forward proposals to require that the government balance its budget every year . In 1995 , a proposed constitutional amendment that would require a balanced budget passed the House of Representatives by a wide margin , and failed in the Senate by only a single vote . For the balanced budget to have become an amendment to the Constitution would have required a vote by Congress and passage by of the state legislatures . Most economists view the proposals for a perpetually balanced budget with bemusement . After all , in the short term , economists would expect the budget and surpluses to up and down with the economy and the automatic stabilizers . Economic should automatically lead to larger budget or Access for free at

The Question of a Balanced Budget 743 smaller budget surpluses , while economic booms lead to smaller or larger surpluses . A requirement that the budget be balanced each and every year would prevent these automatic stabilizers from working and would worsen the severity of economic fluctuations . Some supporters of the balanced budget amendment like to argue that , since households must balance their own budgets , the government should too . However , this analogy between household and government behavior is severely . Most households do not balance their budgets every year . Some years households borrow to buy houses or cars or to pay for medical expenses or college tuition . Other years they repay loans and save funds in retirement accounts . After retirement , they withdraw and spend those savings . Also , the government is not a household for many reasons , one of which is that the government has responsibilities . The argument of policy is that the government needs to lean against the wind , spending when times are hard and saving when times are good , for the sake of the overall economy . There is also no particular reason to expect a government budget to be balanced in the medium term of a few years . For example , a government may decide that by running large budget , it can make crucial term investments in human capital and physical infrastructure that will build the country productivity . These decisions may work out well or poorly , but they are not always irrational . Such policies of ongoing government budget may persist for decades . As the experience from the end of World War 11 up to about 1980 shows , it is perfectly possible to run budget almost every year for decades , but as long as the percentage increases in debt are smaller than the percentage growth of , the ratio will decline at the same time . Nothing in this argument is a claim that budget are always a wise policy . In the short run , a government that runs a very large budget can shift aggregate demand to the right and trigger severe . Additionally , governments may borrow for foolish or impractical reasons . The Impacts of Government Borrowing will discuss how large budget , by reducing national saving , can in certain cases reduce economic growth and even contribute to international crises . A requirement that the budget be balanced in each calendar year , however , is a misguided overreaction to the fear that in some cases , budget can become too large . BRING IT HOME No Yellowstone Park ?

The 2013 federal budget shutdown illustrated the many sides to policy and the federal budget . In 2013 , Republicans and Democrats could not agree on which spending policies to fund and how large the government debt should be . Due to the severity of the recession , the stimulus , and previous policies , the federal budget and debt was historically high . One way to try to cut federal spending and borrowing was to refuse to raise the legal federal debt limit , or tie on conditions to appropriation bills to stop the Affordable Health Care Act . This disagreement led to a federal government shutdown and got close to the deadline where the federal government would default on its Treasury bonds . Finally , however , a compromise emerged and the government avoided default . This shows clearly how closely policies are tied to politics .

744 30 Key Terms Key Terms automatic stabilizers tax and spending rules that have the effect of slowing down the rate of decrease in aggregate demand when the economy slows down and restraining aggregate demand when the economy speeds up , without any additional change in legislation balanced budget when government spending and taxes are equal budget when the federal government spends more money than it receives in taxes in a given year budget surplus when the government receives more money in taxes than it spends in a year policy policy that decreases the level of aggregate demand , either through cuts in government spending or increases in taxes corporate income tax a tax imposed on corporate crowding out federal spending and borrowing causes interest rates to rise and business investment to fall discretionary policy the government passes a new law that explicitly changes overall tax or spending levels with the intent of the level of overall economic activity estate and gift tax a tax on people who pass assets to the next after death or during life in the form of gifts excise tax a tax on a gasoline , tobacco , and alcohol expansionary policy policy that increases the level of aggregate demand , either through increases in government spending or cuts in taxes implementation lag the time it takes for the funds relating to policy to be dispersed to the appropriate agencies to implement the programs individual income tax based on the income , of all forms , received by individuals legislative lag the time it takes to get a policy bill passed marginal tax rates or the tax that must be paid on all yearly income national debt the total accumulated amount the government has borrowed , over time , and not yet paid back payroll tax a tax based on the pay received from employers the taxes provide funds for Social Security and Medicare progressive tax that collects a greater share of income from those with high incomes than from those with lower incomes proportional tax a tax that is a percentage of income earned , regardless of level of income recognition lag the time it takes to determine that a recession has occurred regressive tax in which people with higher incomes pay a smaller share of their income in tax standardized employment budget the budget or surplus in any given year adjusted for what it would have been if the economy were producing at potential Key Concepts and Summary Government Spending Fiscal policy is the set of policies that relate to federal government spending , taxation , and borrowing . In recent decades , the level of federal government spending and taxes , expressed as a share of , has not changed much , typically between about 18 to 22 of . However , the level of state spending and taxes , as a share , has risen from about to about 20 over the last four decades . The four main areas of federal spending are national defense , Social Security , healthcare , and interest payments , which together account for about 70 of all federal spending . When a government spends more than it collects in taxes , it is said to have a budget . When a government collects more in taxes than it spends , it is said to have a budget surplus . If government spending and taxes are equal , it is said to have a balanced budget . The sum of all past and surpluses make up the government debt . Taxation The two main federal taxes are individual income taxes and payroll taxes that provide funds for Social Security and Medicare these taxes together account for more than 80 of federal revenues . Other federal taxes include Access for free at

30 Key Concepts and Summary 745 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 . Federal Deficits and the National Debt For most of the twentieth century , the 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 19805 and early , before a brief period of budget surpluses from 1998 to 2001 , followed by a return to annual budget since 2002 , with very large in the recession of 2008 and 2009 . A budget or budget surplus is measured annually . Total government debt or national debt is the sum and budget surpluses over time . Using Fiscal Policy to Fight Recession , Unemployment , and Inflation Expansionary policy increases the level of aggregate demand , either through increases in government spending or through reductions in taxes . Expansionary policy is most appropriate when an economy is in recession and producing below its potential . policy decreases the level of aggregate demand , either through cuts in government spending or increases in taxes . policy is most appropriate when an economy is producing above its potential . Automatic Stabilizers Fiscal policy is conducted both through discretionary 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 or budget surplus would have been in a given year if the economy had been producing at its potential in that year . Many economists and politicians criticize the use of policy for a variety of reasons , including concerns over time lags , the impact on interest rates , and the inherently political nature of policy . We cover the critique policy in the next module . Practical Problems with Discretionary Fiscal Policy Because policy affects the quantity of money that the government borrows in capital markets , it not only affects aggregate can also affect interest rates . If an expansionary policy also causes higher interest rates , then 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 have concluded that discretionary policy is a blunt instrument and better used only in extreme situations . 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 policy needs to be enough to accommodate unforeseen expenditures , such as wars or . While persistent , large budget can indeed be a problem , a balanced budget amendment prevents even small , temporary that might , in some cases , be necessary .

746 30 Questions Questions . 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . When governments run budget , how do they make up the differences between tax revenue and spending ?

When governments run budget surpluses , what is done with the extra funds ?

Is it possible for a nation to run budget and still have its ratio fall ?

Explain your answer . Is it possible for a nation to run budget surpluses and still have its ratio rise ?

Explain your answer . Suppose that gifts were taxed at a rate of 10 for amounts up to and 20 for anything over that amount . Would this tax be regressive or progressive ?

If an individual owns a corporation for which he is the only employee , which different types of federal tax will he have to pay ?

What taxes would an individual pay if he were and the business is not incorporated ?

The social security tax is on employees income earned below . Is this tax progressive , regressive or proportional ?

Debt has a certain quality to it . There is one category of government spending that automatically increases along with the federal debt . What is it ?

True or False Federal spending has grown substantially in recent decades . By world standards , the government controls a relatively large share of the economy . A majority of the federal governments revenue is collected through personal income taxes . Education spending is slightly larger at the federal level than at the state and local level . State and local government spending has not risen much in recent decades . Defense spending is higher now than ever . The share of the economy going to federal taxes has increased substantially over time . Foreign aid is a large portion , although less than half , of federal spending . Federal have been very large for the last two decades . The accumulated federal debt as a share is near an high . What is the main reason for employing policy in a time of strong economic growth ?

What is the main reason for employing expansionary policy during a recession ?

In a recession , does the actual budget surplus or fall above or below the standardized employment budget ?

What is the main advantage of automatic stabilizers over discretionary policy ?

Explain how automatic stabilizers work , both on the taxation side and on the spending side , in a situation where the economy is producing less than potential and then in a situation where the economy is producing more than potential . What would happen if expansionary policy was implemented in a recession but , due to lag , did not actually take effect until after the economy was back to potential ?

What would happen if policy were implemented during an economic boom but , due to lag , it did not take effect until the economy slipped into recession ?

Do you think the typical time lag for policy is likely to be longer or shorter than the time lag for monetary policy ?

Explain your answer ?

Access for free at 30 Review Questions 747 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 policy and some that would not . 21 . Have the spending and taxes of the federal government generally had an upward or a downward trend in the last few decades ?

22 . Wiat are the main categories of federal government spending ?

23 . Wiat is the difference between a budget , 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 ?

are the main categories of federal government taxes ?

is the difference between a progressive tax , a proportional tax , and a regressive tax ?

28 . 27 . Wiat has been the general pattern of budget in recent decades ?

Wiat is the difference between a budget and the national debt ?

is the difference between expansionary policy and policy ?

30 . Under what general circumstances might a government use expansionary policy ?

might it use policy ?

31 . Wiat is the difference between discretionary policy and automatic stabilizers ?

32 . do automatic stabilizers function automatically ?

33 . Wiat is the standardized employment budget ?

34 . Wiat are some practical weaknesses policy ?

35 . Wiat are some of the arguments for and against a requirement that the federal government budget be balanced every year ?

Critical Thinking Questions 36 . is government spending typically measured as a percentage of rather than in nominal dollars ?

37 . are expenditures such as crime prevention and education typically done at the state and local level rather than at the federal level ?

38 . is spending by the government on research at NASA policy while spending by the University of Illinois is not policy ?

Why is a cut in the payroll tax policy whereas a cut in a state income tax is not 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 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 ?

What are the various factors at play ?

748 30 Problems 42 . 43 . 44 . 45 . 46 . 47 . 48 . 49 . 50 . Economist Arthur 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 ?

Is it possible for a nation to run budget and still have its ratio fall ?

Explain your answer . Is it possible for a nation to run budget surpluses and still have its ratio rise ?

Explain your answer . How will cuts in state budget spending affect federal expansionary policy ?

Is expansionary policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government ?

Explain your answer . Is Medicaid ( federal government aid to families and individuals ) an automatic stabilizer ?

What is a potential problem with a temporary tax decrease designed to increase aggregate demand if people know that it is temporary ?

If the government gives a 300 tax cut to everyone in the country , explain the mechanism by which this will cause interest rates to rise . Do you agree or disagree with this statement It is in the best interest of our economy for Congress and the President to run a balanced budget each year . Explain your answer . During the Great Recession of , what actions would have been required of Congress and the President had a balanced budget amendment to the Constitution been ?

What impact would that have had on the unemployment rate ?

Problems 51 . 52 . 53 . A government starts offwith a total debt of billion . In year one , the government runs a of 400 million . In year two , the government runs a of billion . In year three , the government runs a surplus of 200 million . What is the total debt of the government at the end of year three ?

Ifa government runs a budget of 10 billion dollars each year for ten years , then a surplus of billion for years , and then a balanced budget for another ten years , what is the government debt ?

Specify whether expansionary or policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer a . A recession . A stock market collapse that hurts consumer and business . Extremely rapid growth of exports . Rising . A rise in the natural rate of unemployment . A rise in oil prices . Access for free at