Deck 13: Fiscal Policy

Question 1

Use the following news clip to work Problem. Economy Needs Treatment
It's the debt, stupid! Only when the government sets out a credible business plan will confidence and hiring rebound.
Source: The Wall Street Journal , October 7, 2010
Problem
How has the U.S. government debt changed since 2008 What are the sources of the change in U.S. government debt

Answer 1

The government debt to GDP ratio has mounted to 100 percent after the recession of 2008 and is not likely to fall in near future. GDP is a measure of repayment ability of the government - the ability to repay the debt mostly done through taxes. If there is a high debt to GDP ratio, it indicates a rising burden and a falling ratio suggests a falling burden. The dollar value of debt never warns against such events.
One of the major components of debt is the international debt that amounted to $11.7 trillion as of June 2014. Half of this debt was US government's borrowing. US government pays around 50 percent of the total federal revenue in Social Security, Medicaid and Medicare which is going to explode in the near future.

Question 2

Use the following news clip to work the Problem.
Economy Needs Treatment
It's the debt, stupid! Only when the government sets out a credible business plan will confidence and hiring rebound.
What would be a "credible business plan" for the government to adopt

Answer 2

The credible business plan for the government to adopt is to increase its tax revenue (by increasing taxes) and spend it on those items or public assets that yield higher return in comparison to debt interest.

Question 3

The government is considering raising the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions using appropriate graphs. You are being asked about directions of change, not exact magnitudes. What will happen to:
a. The supply of labor and why
b. The demand for labor and why
c. The equilibrium level of employment and why
d. The equilibrium before-tax wage rate and why
e. The equilibrium after-tax wage rate and why
f. Potential GDP

Answer 3

(a) Supply of labor decreased because an income tax weakens the incentive to work and decreases the supply of labor. The reason is that for each dollar of before tax earnings, workers must pay the government an amount determined by the income tax code. Therefore, workers look at the after tax wage rate when they decide how much labor to supply.
(b) In the labor market, the income tax has no effect on the demand for labor. The reason is that, the quantity of labor that firms plan to hire depends only on how productive labor is and what its costs that means its real wage rate.
(c) The level of employment decreases due to a decrease in the supply of labour. The supply of labor decreases, as an income tax weakens the incentive to work. As a result, the wage rate increases.
(d) The equilibrium before tax wage rate rises due to smaller supply of labor.
(e) The equilibrium after tax wage rate falls due to smaller supply of labor as income tax weakens the incentive to work.
(f) An imposition of tax decreases potential GDP because the full employment the quantity of labor decreases. Moreover, a decrease in potential GDP decreases the aggregate supply.

Question 4

What fiscal policy action might increase investment and speed economic growth Explain how the policy action would work.

Question 5

Suppose that instead of taxing nominal capital income, the government taxed real capital income. Use appropriate graphs to explain and illustrate the effect that this change would have on:
a. The tax rate on capital income.
b. The supply of and demand for loanable funds.
c. Investment and the real interest rate.

Question 6

Under current policies, a plausible projection is that U.S. public debt will reach 250 percent of GDP in 30 years and 500 percent in 50 years.
a. What is a fiscal imbalance How might the U.S. government reduce the fiscal imbalance
b. How would your answer to part (a) influence the generational imbalance

Question 7

The economy is in a recession, and the recessionary gap is large.
a. Describe the discretionary and automatic fiscal policy actions that might occur.
b. Describe a discretionary fiscal stimulus package that could be used that would not bring an increase in the budget deficit.
c. Explain the risks of discretionary fiscal policy in this situation.

Question 8

An economy is in a recession with a large recessionary gap and a government budget deficit.
a. Is the government budget deficit a structural deficit or a cyclical deficit Explain.
b. Explain how automatic fiscal policy is changing the output gap.
c. If the government increases its discretionary expenditure, explain how the structural deficit might change.

Question 9

Use the following news clip and fact to work the Problem
Senate Approves Obama Tax Cut Plan
The U.S. Senate has passed legislation extending Bush-era tax cuts for middle-class Americans earning up to $250,000 per year.
Fact: Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes.
a. Explain the intended effect of extending tax cuts for middle-class Americans but not for high-income families. Draw a graph to illustrate the intended effect.
b. Explain why the effect of tax cuts depends on who receives them.

Question 10

Use the following news clip and fact to work the Problem
Senate Approves Obama Tax Cut Plan
The U.S. Senate has passed legislation extending Bush-era tax cuts for middle-class Americans earning up to $250,000 per year.
Fact : Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes.
What would have a larger effect on aggregate demand: extending the Bush-era tax cuts to everyone; extending them for middle-class only; or extending them for high-income earners only How would each alternative compare with no tax cuts but an equivalent increase in government expenditure

Question 11

Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services.

Question 12

The Federal Budget
2012 Deficit: Smaller, But Still Big
The Congressional Budget Office said the budget deficit was about $1.1 trillion in fiscal year 2012. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II.
Of the components of government outlays and receipts, which have changed most to contribute to the huge budget deficits in 2011 and 2012

Question 13

Supply-Side Effects of Fiscal Policy
Use the following information to work the Problem.
Suppose that in the United States, investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion.
What is the amount of tax revenue What is the government budget balance

Question 14

Use the following information to work Problem.
Suppose that investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion.
Problem
a. Explain the impact of the government budget balance on investment.
b. What fiscal policy action might increase investment and speed economic growth Explain how the policy action would work.

Question 15

Supply-Side Effects of Fiscal Policy
Suppose that capital income taxes are based (as they are in the United States and most countries) on nominal interest rates. And suppose that the inflation rate increases by 5 percent a year. Use appropriate diagrams to explain and illustrate the effect that this change would have on:
a. The tax rate on capital income.
b. The supply of loanable funds.
c. The demand for loanable funds.
d. Equilibrium investment.
e. The equilibrium real interest rate.

Question 16

Supply-Side Effects of Fiscal Policy
Use the following information to work the Problem.
Policy Changes Scheduled to Take Effect in 2013
A host of significant provisions of the Job Creation Act of 2010 are set to expire on January 1, 2013, including the emergency unemployment benefits and a temporary reduction of 2 percentage points in the Social Security payroll tax.
Explain the supply-side effects of allowing unemployment benefits and the Social Security payroll tax cut to expire.

Question 17

Supply-Side Effects of Fiscal Policy
Use the following information to work the Problem.
Policy Changes Scheduled to Take Effect in 2013
A host of significant provisions of the Job Creation Act of 2010 are set to expire on January 1, 2013, including the emergency unemployment benefits and a temporary reduction of 2 percentage points in the Social Security payroll tax.
a. Explain the potential demand-side effects of extending unemployment benefits and not increasing the Social Security payroll tax.
b. Explain the potential supply-side effects of these fiscal policy actions.
c. Draw a graph to illustrate the combined demand-side and supply-side effect of these fiscal policy actions.

Question 18

Supply-Side Effects of Fiscal Policy
Use the following news clip to work the Problem
Paul Ryan's Roadmap Business Tax
Paul Ryan has proposed replacing the corporate income tax, which is among the highest in the industrialized world, with what he calls a business consumption tax but what is in effect a tax of a firm's value added. He proposes that this tax be set at 8.5 percent, which is half that of the value added taxes in the rest of the industrialized world.
Explain the potential supply-side effects of Paul Ryan's tax plan.

Question 19

Supply-Side Effects of Fiscal Policy
Use the following news clip to work the Problem
Paul Ryan's Roadmap Business Tax
Paul Ryan has proposed replacing the corporate income tax, which is among the highest in the industrialized world, with what he calls a business consumption tax but what is in effect a tax of a firm's value added. He proposes that this tax be set at 8.5 percent, which is half that of the value added taxes in the rest of the industrialized world.
Where on the Laffer curve do you think Paul Ryan believes the U.S. economy lies Explain your answer.

Question 20

Mandatory Spending Is Hard to Contain
In Fiscal 2012, spending on the big three entitlement programs-Social Security, Medicare, and Medicaid-was $2.1 trillion. The CBO base-line projection sees this expenditure rising by 70 percent to $3.55 trillion by 2022. Over that same period, discretionary expenditure, mainly national defense, is projected to grow by only 17 percent from $1.2 trillion to $1.4 trillion. The deficit is projected to fall from $1 trillion to $200 billion.
Source: Congressional Budget Office, 2012
If politicians continue to avoid debating the projected increases in the three big entitlement programs, how do you think the fiscal imbalance will change If Congress introduced changes that slowed the growth of expenditure on the three entitlement programs, who would benefit and who would pay

Question 21

Fiscal Stimulus
The economy is in a boom and the inflationary gap is large.
a. Describe the discretionary and automatic fiscal policy actions that might occur.
b. Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects.
c. Explain the risks of discretionary fiscal policy in this situation.

Question 22

Fiscal Stimulus
The economy is growing slowly, the inflationary gap is large, and there is a budget deficit.
a. Do we know whether the budget deficit is structural or cyclical Explain your answer.
b. Do we know whether automatic stabilizers are increasing or decreasing aggregate demand Explain your answer.
c. If a discretionary decrease in government expenditure occurs, what happens to the structural budget balance Explain your answer.

Question 23

Fiscal Stimulus
Use the following news clip to work the Problem.
Is Fiscal Stimulus Necessary
China's economy is slowing from its normal 9 percent or higher rate to just below 9 percent. The source of the slowdown is the global economic slowdown that is restricting exports growth and the government's deliberate decision to discourage unproductive investment. The situation now is not like that in 2008 when real GDP growth dropped from 9 percent to 6.8 percent and fiscal stimulus does not appear to be urgently needed.
Explain why fiscal stimulus was needed in 2008 but not in 2012.

Question 24

Fiscal Stimulus
Use the following news clip to work the Problem.
Is Fiscal Stimulus Necessary
China's economy is slowing from its normal 9 percent or higher rate to just below 9 percent. The source of the slowdown is the global economic slowdown that is restricting exports growth and the government's deliberate decision to discourage unproductive investment. The situation now is not like that in 2008 when real GDP growth dropped from 9 percent to 6.8 percent and fiscal stimulus does not appear to be urgently needed.
Would you expect automatic stabilizers to be operating in 2012 and if so, what effects might they have

Question 25

Fiscal Stimulus
Use the following news clip to work the Problem.
Is Fiscal Stimulus Necessary
China's economy is slowing from its normal 9 percent or higher rate to just below 9 percent. The source of the slowdown is the global economic slowdown that is restricting exports growth and the government's deliberate decision to discourage unproductive investment. The situation now is not like that in 2008 when real GDP growth dropped from 9 percent to 6.8 percent and fiscal stimulus does not appear to be urgently needed.
Why might stimulus come too late What are the potential consequences of stimulus coming too late

Question 26

After you have studied Economics in the News on pp. 342-343, answer the following questions.
a. What was the state of the Japanese economy in 2013
b. Explain the effects of Japan's high level of government spending and debt on the level of employment and potential GDP.
c. Explain how inflation and faster growth might lower Japan's government debt ratio and why neither is an attractive option.
d. Explain how monetary policy might be used to offset a fiscal-policy induced decrease in ag­gregate demand and draw a graph to illustrate your answer.

Question 27

Economics in the News
More Fiscal Stimulus Needed
In New York Times articles and in blogs, economists Paul Krugman and Joseph Stiglitz say there is a need for more fiscal stimulus in both the United States and Europe despite the large federal budget deficit and large deficits in some European countries.
a. Do you agree with Krugman and Stiglitz Why
b. What are the dangers of not engaging in further fiscal stimulus
c. What are the dangers of embarking on further fiscal stimulus when the budget is in deficit

Question 28

Economics in the News
Payroll Tax Cut Is Unlikely to Survive Into Next Year
The payroll tax holiday in 2012 reduced workers' tax by $700 for an income of $35,000 a year and by $2,202 for incomes of $110,100 and over. If the tax holiday ends, the Economic Policy Institute recommends replacing the payroll tax cut with infrastructure spending.
a. Explain how a payroll tax affects the before tax and after-tax wage rate and employment and unemployment.
b. Explain the effects of an increase in infrastructure spending on employment and unemployment.
c. Which fiscal policy action would have the bigger effect on employment: continuing the payroll tax cut or new infrastructure spending Explain your answer.