Central banks try to optimize the economy through monetary policy, by controlling the supply of money and interest rates, for instance. Fiscal policy also profoundly affects the economy, and, since much fiscal policy depends on politics, its effects often contradict the goals of monetary policy. Fiscal policy is how the government spends and transfers money, and how it finances those expenditures and transfer payments.
Governments finance themselves by tax revenue and by borrowing. The federal government borrows by selling Treasury bills, notes, and bonds to the general public. Taxes affect disposable income, which affects consumer spending and saving, and investments by firms. So governments often try to stimulate the economy by cutting taxes.
There are 3 categories of fiscal policies:
- government spending policy
- tax policy
- policies regarding transfer payments, such as Social Security benefits, welfare, veterans' benefits, and unemployment
Fiscal policy can also be used to tweak the economy, stimulating it when it is down and cooling it when it becomes overheated. Government can affect the macroeconomy through 2 types of policies: monetary policy and fiscal policy. Monetary policy is generally conducted by the central banks with minimal political influence. Monetary policy is usually implemented by maintaining a target interest rate, effected usually by changing the money supply. On the other hand, fiscal policy is enacted by the legislators and executive branches of the government and is very much influenced by politics. Because the money supply is controlled by the central bank, economic studies and fiscal policies usually assume that the money stock is constant, so that the effects of fiscal policies can be studied with simplified models.
Some factors can be controlled directly by the government; other factors can only be controlled indirectly. For instance, the government can set tax rates and decide which income is taxed and how it is taxed, but it cannot directly control tax revenue. Tax revenue depends on both tax rates and the economy, but the government has little direct control of the economy. Hence, it has little direct control of tax revenue. Although the government can potentially change anything that it does, it is constrained by major political considerations, changes that would require major changes in the law that are not likely to pass. For instance, the government may have the votes to raise taxes on the wealthy to pay down the government debt, but not the votes to cut Medicare and Social Security, since they are popular programs for senior citizens. Discretionary fiscal policy are changes that the government can implement without changing major budget items, such as transfer payments.
Another factor that lessens control of the government over tax revenue is that the tax code is complex, so economic agents, i.e., households and firms, can game the system to lower their tax payment. The main reason why the tax code is so complicated is that politicians carve out special provisions for favored constituencies.
The federal government collects tax revenue from its citizens, but it also makes payments to some of those citizens, such as Social Security payments and welfare payments. Therefore, the amount the government must spend for goods and services, exclusive of any borrowing, is the net tax revenue:
Net Taxes = Tax Revenue – Transfer Payments Made to Households
So, if the United States government collects $4 trillion in taxes and pays $1 trillion in Social Security payments and welfare payments, then it will have a net tax of $3 trillion.
An important factor affecting the economy is disposable income, otherwise known as after-tax income, which is the income remaining after paying taxes.
Disposable Income = Total Income – Net Taxes
Fiscal Policy Multipliers
One monetary policy tool for increasing economic output is by increasing the money supply, but how well that increase in supply stimulates the economy depends on the velocity of money, or how often the new money is spent per unit of time. The higher the velocity, the higher the stimulus. It is the velocity of money that increases the initial stimulus by a certain multiple, the multiplier. So, if the money supply is increased by $100, and that eventually leads to $400 of additional transactions, then the multiplier is 4. Similarly, there are also fiscal policy multipliers, where an initial stimulus leads to more transactions. For instance, if the government spends $200 for goods and services, that expenditure becomes income to the recipient of that money, who will then spend at least some portion of it later. So, if the recipient spends $150 of that income and saves $50, then their marginal propensity to consume (MPC) is 75% and their marginal propensity to save (MPS) is 25%. However, it is the consumption portion that directly stimulates the economy. So, the people who received that $150 get an increase of income of $150, which they will also spend a portion of. So, if the government spends $200, and that ultimately leads to an increase in aggregate demand of $400, then the government spending multiplier is 2 ($400 = $200 ×2).
There are 3 types of fiscal policy multipliers, depending on what causes the multiplier:
- government spending multiplier
- tax multiplier
- balanced-budget multiplier
Government Spending Multiplier
Unlike tax cuts, government spending directly stimulates the economy, which increases the income of the sellers of the products and services that the government buys.
The government spending multiplier is the ratio of change of the equilibrium level of economic output to a change in government spending. Using a simple economic model, the government spending multiplier can be shown to be inversely related to the marginal propensity to save (MPS).
Government Spending Multiplier = 1/MPS
So, if the MPS for consumers and firms is .25, and the government increases spending by $50 billion, then the government spending multiplier is 4, leading to an increase in aggregate expenditure of $50 billion × 1/.25 = 50 × 4 = 200 billion dollars.
Tax cuts are often used to stimulate the economy, but the stimulus is delayed, because people do not spend the money right away. This makes tax cuts less effective than government spending.
The tax multiplier is the ratio of the change in equilibrium of output to a change in taxes.
The tax multiplier differs from the government spending multiplier in that consumers only spend a portion of any increase in their disposable income. For instance, if the propensity to consume (MPC) is 75%, then consumers will only spend $0.75 of every dollar of disposable income. On the other hand, when the government decides to spend $1, then the whole dollar is spent, by definition.
When the government spends money, then the change in the economic output equals the initial increase in aggregate expenditure multiplied by 1 divided by MPS. Changes in aggregate expenditure caused by changes in tax rate can be found by substituting the consumption function into real GDP equation (the derivation is shown below).
Tax Multiplier = – MPC/(1 – MPC)
The tax multiplier is negative because a tax cut increases consumption while a tax increase decreases consumption; thus, they are inversely related.
So, if MPC = .75, then the tax multiplier equals -.75/.25 = -3. Thus, a tax cut of $100 will increase output by -100 × -3 = 300, which is $100 less than the government spending multiplier of 4 calculated in the previous example.
Deriving the Multipliers
The government spending multiplier and the tax multiplier can be derived by substituting the consumption function for the consumption component of the economic output equation. The economic output equation (for simplicity, we assume that net exports is 0):
Y = C + I + G
The consumption function:
C = C (Y – T) = C0 + C1 (Y – T)
C0 specifies the level of autonomous consumption, which is consumption that does not depend on disposable income, since autonomous consumption is necessary for survival. C1 = MPC. Y represents real GDP or aggregate demand, while T represents taxes, so Y – T = disposable income.
Substituting the consumption function for the consumption component of the economic output equation yields:
Y = C0 + C1 (Y – T) + I + G
Multiply out the distribution:
Y = C0 + C1 Y – C1 T + I + G
Subtract both sides by C1 Y:
Y – C1 Y = C0 – C1 T + I + G
Factor out Y on the left side of the equation:
Y (1 – C1) = C0 – C1 T + I + G
Divide by 1 – C1on both sides:
Y = 1/(1 – C1) × (C0 – C1 T + I + G)
So, if G increases by $1, and all the other factors remain constant, then Y increases by 1/(1 – C1), where C1 is simply the marginal propensity to consume, MPC.
The tax multiplier can be derived using the same equation. If the tax increases by $1, then holding the other factors constant, Y will decrease by – C1/(1 – C1), which is simply –MPC/MPS.
Although these multipliers can be derived mathematically from simple assumptions, it can also be understood even more simply by considering the fact that when the government spends money, it spends the amount of money that it wants to spend and spends it quickly, by definition. The propensity to consume and to save does not apply to government spending, it only applies to the recipients of that spending: consumers and firms. In this case, the government is the source of the spending. On the other hand, when considering the tax multiplier, it is the consumers and firms that are spending. Therefore, MPC and MPS apply to both, which is why tax cuts are less effective in stimulating the economy than government spending. Another reason why tax cuts are less effective is because the money is spent over time rather than right away.
What if the government increases spending and taxes by the same amount, or decreases both by the same amount? The increase in planned aggregate expenditure due to government spending = 1/MPS. A tax decrease of an equal amount, = - MPC/MPS. Therefore, the balanced-budget multiplier = 1, where the increase in planned aggregate expenditure = the amount of increased government spending. So, if government spending increases by $1 billion and it collects an additional $1 billion in tax revenue, then the government spending will more than offset the reduced consumption because of higher taxes: economic output will increase by $1 billion.
Thus, the balanced-budget multiplier, as the name suggests, creates no deficits or surpluses.
To derive the balanced-budget multiplier, note that an increase of $1 of government spending is accompanied by a $1 increase in taxes. An increase in government spending stimulates aggregate expenditures while an increase in taxes decreases aggregate expenditures, but not by the same amount:
ΔC = ΔT × (MPC)
So the net increase in spending equals:
Increased Spending = ΔG – ΔT × (MPC)
Because ΔG = ΔT, the above equation reduces to:
Increased Spending = ΔG – ΔG × (MPC) = ΔG(1 – MPC) = ΔG – ΔG(MPC)
Because MPS = 1 – MPC:
Increased Spending = ΔG – ΔG(1 – MPC) = ΔG(MPS)
Applying that government spending multiplier of 1/MPS to the above equation yields:
Increased Spending = ΔG(MPS) × 1/MPS = ΔG
The simply says that aggregate expenditures is increased by the amount of government spending.
Government Budget Depends on the Economy
Tax revenues depend on the state of the economy, since tax revenue depends on the tax base, which depends on income, and, therefore, on the economy. The government sets tax rates, but the tax base will depend on economic activity and on national income.
Factors That Diminish Fiscal Multipliers
When considering only fiscal policy, the money stock is neither increased or decreased, because that is the purview of the central bank, which, in the United States, is the Federal Reserve. The demand for money varies inversely with interest rates, so when interest rates drop, the demand for money increases at any given economic output (Y). However, if the government increases spending or decreases taxes, then that will increase aggregate demand, which will increase incomes and economic output. When economic output increases, then interest rates increase relative to the demand for money. Thus, higher interest rates cause consumer spending and capital investments to decline, which offsets at least some portion of the fiscal stimulus.
As already stated, the fiscal multiplier is diminished because people only spend an MPC portion of their additional income, and it is spent over an extended duration.
Another diminishing factor is that tax cuts are usually paid for by issuing more debt, so people may save their tax windfall to pay for future tax increases that surely must come. If this is true, then there is no difference in financing the government with debt or with budget neutral taxes: this is the so-called Ricardian equivalence, 1st postulated by David Ricardo in the 19th century.
(In simplistic economic models, Ricardian equivalence would seem to make sense, but if it were true, then no one would ever borrow money. Why borrow money and pay interest, only to save it to pay back the loan in the future? That people do borrow money demonstrates that people do spend the money, even knowing that they would eventually have to pay it back, with interest. Why would it be different with tax cuts, especially since it may be years before taxes are raised again? Especially for poor people in a poor economy, liquidity constraints would cause people to spend the money quickly.)
As the economy expands, support payments generally decline and tax revenues increase. This helps to dampen the economy so that it does not overheat. When the economy declines into a recession, the support payments, such as unemployment insurance and welfare payments, increases. These revenue and expenditure budget items are known as automatic stabilizers, because they automatically change in such a way as to moderate the economy. When the economy declines, the support payments increase, which allows poor people and the unemployed to spend money that they would not otherwise have, which helps to prevent the economy from falling further. When the economy reaches potential output, then tax revenues increase and support payments decline, thus helping to prevent the economy from overheating.
When the economy reaches potential output, then wages start to increase because the competition for labor. People move into higher tax brackets, which lowers their disposable income, thereby slowing the economy down. This is what is referred to as fiscal drag, because the higher tax rates slow the economic expansion. However, in the United States, tax brackets have been adjusted for inflation since 1982, thus reducing the automatic fiscal drag that existed previously. Much of this fiscal drag was due to inflation. Before 1982, tax brackets were not adjusted for inflation, so people started to pay more of their income in taxes, so their income rose relative to the tax brackets, thus dampening the economy prematurely.
Automatic stabilizers are the reason that most economists argue against having a balanced budget policy. When the economy declines, tax revenue declines. Therefore, the government would either have to cut spending or increase taxes at a time when the economy needs the opposite actions. So, to maintain a balanced budget in a recession, the federal government would have to adapt contractionary fiscal policies, which would only decrease tax revenue even more.
Full Employment Budget
To determine the effectiveness of the fiscal policy, it is often compared to a full employment budget. If the economy is at full employment, and, therefore, at its potential output, then whatever deficit remains is because tax revenue is not sufficient to support expenditures. This is called the structural deficit, because it is a deficit that remains even at full employment, because tax rates are insufficient to pay for expenditures. A portion of the deficit also depends on the economic cycle. This portion of the deficit is referred to as the cyclical deficit, because it increases when the economy declines.