11 Managing Aggregate Demand Fiscal Policy Next let us turn to the problems of our fiscal policy Here the myths are legion and the truth hard to find JOHN F KENNEDY Contents Contents Income Income Taxes Taxes and and the the Consumption Consumption Schedule Schedule The The Multiplier Multiplier Revisited Revisited Planning Planning Expansionary Expansionary Fiscal Fiscal Policy Policy Planning Planning Contractionary Contractionary Fiscal Fiscal Policy Policy The The Choice Choice Between Between Spending Spending Policy Policy and and Tax Tax Policy Policy Copyright 2006 South Western Thomson Learning All rights reserved Contents Contents continued continued Some Some Harsh Harsh Realities Realities The The Idea Idea Behind Behind Supply Side Supply Side Tax Tax Cuts Cuts Appendix AppendixA A Graphical Graphical Treatment Treatment of of Taxes Taxes and and Fiscal Fiscal Policy Policy Appendix Appendix B B Algebraic Algebraic Treatment Treatment of of Taxes Taxes and and Fiscal Fiscal Policy Policy Copyright 2006 South Western Thomson Learning All rights reserved Income Income Taxes Taxes and and the the Consumption Consumption Schedule Schedule Disposable Disposable Income Income DI DI Y Y TT TT Taxes Taxes Y Y Gross Gross Domestic Domestic Product Product Changes Changes in in taxes taxes affect affect consumption consumption taxes taxes taxes taxes DI DI CC DI DI CC Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 1 1 How How Tax Tax Policy Policy Shifts Shifts Real Consumer Spending the the Consumption Consumption Schedule Schedule Fixed tax cut C Fixed tax increase Real GDP Copyright 2006 South Western Thomson Learning All rights reserved TABLE TABLE 1 1 Effects Effects of of Income Income Tax Tax on on Consumption Consumption Schedule Schedule Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited government government purchases purchases of of goods goods and and services services total total spending spending directly directly through through the the G G component component of of CC II G G X X IM IM taxes taxes total total spending spending indirectly indirectly by by lowering lowering disposable disposable income income and and thus thus reducing reducing the the C C component component of of C C II G G X X IM IM Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited Tax Tax Multiplier Multiplier Multiplier Multiplier for for TT Multiplier Multiplier for for G G G G affects affectsAD ADdirectly directly TTchanges changes only only disposable disposableincome income Resulting Resulting consumption consumption disposable disposable income income Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited Moral Moral Fiscal Fiscal policies policies that that keep keep the the deficit deficit G G T T constant constant do do not not keep keepAD AD constant constant IfIf spending spending increases increases are are financed financed by by tax tax increases increases the the economy economy will will expand expand IfIf tax tax cuts cuts are are financed financed by by spending spending cuts cuts the the economy economy will will contract contract Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited Income Income Taxes Taxes and and the the Multiplier Multiplier When When incomes incomes rise rise aa larger larger amount amount isis taken taken out out in in taxes taxes than than before before leaving leaving aa smaller smaller increase increase in in disposable disposable income income Consumer Consumer make make decisions decisions based based on on their their afteraftertax tax disposable disposable income income income income income income taxes taxes paid paid smaller smallerincrease increase in in consumption consumption with with income income tax tax Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 2 2 The The Multiplier Multiplier in in the the Presence Presence of of an an Income Income Tax Tax 45 C I G1 X IM Real Expenditure E1 C I G0 X IM 400 E0 6 000 7 000 Real GDP 8 000 Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited Reasons Reasons why why the the oversimplified oversimplified multiplier multiplier formula formula overstates overstates the the size size of of the the multiplier multiplier Ignores Ignores variable variable imports imports Ignores Ignores price level price level changes changes Ignores Ignores income income taxes taxes Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited Automatic Automatic stabilizers stabilizers Automatic Automatic stabilizers stabilizers features features of of the the economy economy that that reduce reduce its its sensitivity sensitivity to to shocks shocks Personal Personal income income tax tax Unemployment Unemployment insurance insurance Copyright 2006 South Western Thomson Learning All rights reserved The The Multiplier Multiplier Revisited Revisited Government Government Transfer Transfer Payments Payments Transfers Transfers payments payments to to individuals individuals that that do do not not compensate compensate them them for for any any direct direct contribution contribution to to production production Transfers Transfers are are the the analytical analytical equivalent equivalent of of negative negative taxes taxes Copyright 2006 South Western Thomson Learning All rights reserved Planning Planning Expansionary Expansionary Fiscal Fiscal Policy Policy Three Three types types of of fiscal fiscal policy policy can can be be used used to to stimulate stimulate the the economy economy G G TT Transfer Transfer payments payments Copyright 2006 South Western Thomson Learning All rights reserved FIGURE FIGURE 3 3 Fiscal Fiscal Policy Policy to to Eliminate Eliminate aa Recessionary Recessionary Gap Gap E Potential GDP 45 C I G0 X IM Real Expenditure Real Expenditure Potential GDP 45 F C I G1 X IM C I G0 X IM Recessionary gap 5 000 6 000 7 000 Real GDP a 5 000 6 000 7 000 Real GDP b Copyright 2006 South Western Thomson Learning All rights reserved Planning Planning Contractionary Contractionary Fiscal Fiscal Policy Policy Three Three types types of of fiscal fiscal policy policy can can be be