Module 9

Fiscal Policy:
Government Spending, Taxes, & Debt

Macmillan Learning, ©2023

 Your economics textbook is
The Federal Budget light reading compared to the
multivolume federal budget.
Every year the president of the United
States releases a proposed budget. In print,
it stands nearly as tall as a toddler!
 Thousands of tables outlining actual
and proposed spending on everything
that is—or might be—funded with
federal dollars.
To budget is to fight over money. And to
fight over money is to fight over priorities.
 If you spend a dollar on one thing,
you’re not spending it on another.

Let’s start by exploring what the money is

spent on, where the money comes from.
2 ChrisMacmillan
Maddaloni/AP Photo
Learning, ©2023
 Federal, state, and local governments have different
Total Government responsibilities, so let’s look at each separately.
Spending
Local [16%]
$1.7 trillion

The figure shows the breakdown of

total government spending in 2020.
 The federal government spends State [19%]
$2 trillion
more than state and local
governments combined. Federal [65%]
$6.9 trillion
 The federal government and its
spending has expanded over
time: 3% of GDP in 1929, 17% of
GDP in 1941, and 25% of GDP in
2022.

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 “The federal government is an insurance company with a military”
Federal government spending
Spending on social insurance
programs plus spending on the
military and veterans’ benefits
account for roughly three-
quarters of federal spending.

Social insurance programs:

government provided insurance
against bad outcomes such as
unemployment, illness, disability,
or outliving your savings.

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 Government spending on social insurance has risen over time, as military
spending has declined.
NOTE: Even though military spending is a lower share of GDP, we still spent roughly 1.6 times as
much on the military in 2021 as we did in 1960 because real GDP has grown more than fivefold.

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 The rest of the pie gets divided into very small slices
Federal government spending Interest on debt takes 5%, leaving
just one-fifth of the budget to pay
for everything else.
Spread across various programs:
 Pell grants, student loans,
school lunch and other food
support programs, highways
and transportation, housing,
science, energy, international
affairs and foreign aid, etc.

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 Much of future federal government spending is already determined!

Mandatory spending: spending on Discretionary spending: spending that

programs that does not get determined Congress appropriates annually.
annually.
 Only accounts for 30% of federal
 Instead, it is set in law  programs like government spending.
Social Security and Medicare.
 About half of that is spent on the
 Anything can become mandatory military.
spending if Congress passes legislation
 The rest is spent on things like
mandating it.
education, housing, science,
 Can only be cut if Congress repeals or energy, environment, and
amends their earlier legislation. international affairs.

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 States and local government
States provide employment and income Local government provides…
support, education and health care.
 Education  primary and secondary
 Education  higher education
 Bus services, water, sewer lines, local parks,
trash collection, police, firefighters, etc.

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 Total government spending is lower in the United States than in other rich countries.

Most developed countries provide greater access to publicly funded health care; low-cost or free
higher education; and paid parental leave. They also offer more support to low-income families.

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 Federal government
revenue (1 of 2)
The federal government primarily collects
revenue from income taxes and payroll taxes.
 Both are deducted from your paycheck!
Individual
income taxes
51%
Payroll taxes
32%

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 Payroll and income taxes

Payroll taxes: taxes on earned income.

 Levied as a fixed percentage of your earned income.
 Funds Medicare (2.9% withheld from your paycheck) and Social Security (6.2% withheld;
cap on Social Security contributions)
 Employer contributes an additional amount to Medicare and Social Security.

Income taxes: taxes collected on all income regardless of its source.

 Includes income you earned from working AND unearned income such as investment income,
pensions, capital gains, and inheritance or gift income.
 CAREFUL: don’t confuse income and wealth, which is your stock of savings and assets.
 Income is all the money you receive in a year.
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 A closer look at income tax

Income taxes are progressive.

 The tax rate you pay increases with your income.
 Depends on how much income you receive throughout the year from all sources, and,
more specifically, on your taxable income.
 Taxable income: the amount of income on that you pay taxes on.
 Taxable income = total income received − deductions

Clearly income taxes have more nuance than payroll taxes.

 Thus, your employer’s withholdings for federal income taxes from your paycheck is their
best guess at how much you might owe.
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 Income Tax: Understanding the income tax rate schedule

Suppose your job paid you $50,000

in 2022.
 Standard deduction: $12,950
Let’s figure out how much you’ll pay
in income tax this year.

Taxable income = $50,000 − $12,950 = $37,050

 Pay 10% on the first $10,275  0.10 × $10,275 = $1,027.50
 Pay 12% on the remaining $26,775  0.12 × $26,775 = $3,213
 Total income tax for 2022 = $1,027.50 + $3,213 = $4,240.50
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 Concept check: Payroll and income tax

Your current job pays $54,950. You take the standard deduction, so your taxable
income is $42,000. A competitor wants to hire you and is will to pay you $3,000 more.
If you take the new job, you won’t be able to walk to work each day (as you currently
do). Instead, you’ll have to pay $120 each month on bus fare.
 If you took the new job, how much more would you actually make each year after
accounting for taxes and transportation costs?
Solution:
Income taxes for the additional $3,000  0.22 x $3,000 = $660
Payroll taxes  0.062 x $3,000 + 0.029 x $3,000 = $273
New expenses  $120 x 12 months = $1,440
Final answer: $3,000 - $660 – $273 - $1,440 = $627
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 Federal government
revenue (2 of 2)
Nine percent of federal taxes are collected from
corporations…but what does it mean for a
corporation to pay a tax?
 Corporate taxes are paid by people.
Individual
1. Paid by owners of the corporations income taxes
2. Workers also bear some of the burden of 51%
Payroll taxes
corporate taxes. 32%
• As taxes rise, businesses buy less capital, which
makes workers less productive, so employers
aren’t willing to pay them as much.
 CBO estimate: For every dollar of corporate tax,
shareholders lose 75 cents, and workers lose
about 25 cents.

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 State and local government tax revenue (1 of 2)

States and local government collect sale, property, and income taxes.

Sales tax is a tax on purchases.

 Typically, a percentage of
the purchase price.
Excise tax is a tax on a specific
product, such as gas, cigarettes,
or alcohol.
 Typically, levied base on the
quantity you buy, not the
price you pay.

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 State and local government tax revenue (2 of 2)

States and local government collect sale, property, and income taxes.

Property tax is a tax on the value

of property, usually real estate.
 Type of wealth tax based on
the value of property.

Regressive tax is a tax where

those with less income tend to
pay a higher share of their income
on tax.
 Sales, excise, and property
taxes tend to be regressive.

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 Hidden government spending: Tax expenditures

Tax expenditures: special deductions, Tax expenditures have a lower political cost.
exemptions, or credits that lower your tax  Part of the tax code, which is not renewed
obligations, to encourage you to engage in or evaluated each year during the budget
certain kinds of activities. process.
Example: The American Opportunity Tax Credit Tax expenditures encourage spending on
lets you subtract a portion of what you’ve paid in certain goods and services.
tuition from your tax bill—up to $2,500 a year!
 Tax breaks encourage you to purchase
 Alternatively, the government could have health insurance, save for retirement, and
mailed qualifying students or families a buy your own home.
$2,500 check each year.  Example: If you pay $10,000 in interest on
SAME RESULT! Either way you are $2,500 your mortgage, that $10,000 is deducted
better off. from your taxable income.

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 How much is that employment benefit worth?

Suppose you have two job offers: The jobs are NOT equivalent once you’ve
considered your taxable income!
1. Salary $43,000, plus employer-provided
health insurance.  When you buy health insurance through
your employer, you get to subtract your
 You’ll have to contribute $3,000 in
premium payments from your taxable
premium payments.
income.
2. Salary $45,000, but NO health
1. $43,000 becomes $40,000 taxable income.
insurance.
2. $45,000 stays $45,000 taxable income,
 You can buy a similar health
insurance without your employers  Result: you’ll take home more money if
help for $5,000 per year. you accept the lower-wage job that comes
with benefits.
Which job should you accept?
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 Tax expenditures strongly favor the rich
Three reasons why tax
expenditures primarily benefit
the wealthy:
1. The value of tax exclusions
and deductions is higher
when your income tax rate is
higher.
2. Higher-income people tend
to buy more tax-preferred
goods and services.
3. Most tax expenditures don’t
provide much help if your
income tax bill is zero.

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 Reason 1: The value of tax exclusions and deductions is higher when your
income tax rate is higher.
Highest income: 37% marginal income tax rate.
Tax deduction example: Every
dollar you spend on interest for a  Every $100 spent paying mortgage interest
home mortgage reduces your reduces this person’s tax bill by $37.
taxable income by a dollar.
Middle income: 12% marginal income tax rate.
Suppose three people with three
different income levels purchase  Every $100 spent paying mortgage interest
identical homes financed by reduces this person’s tax bill by $12.
identical mortgages.
 How does this tax deduction Lowest income: doesn’t pay federal income
impact each person? taxes.
 No benefit received from this tax deduction.

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 Reason 2: Higher-income people tend to buy more tax-preferred goods and
services.
Of course, high-, middle-, and low-income people don’t tend to buy identical homes.

High-income buys a million-dollar house

 Pays $30,000 per year in mortgage interest.
 Marginal tax rate of 37% implies they reduce their tax
bill by $11,100.

Middle-income buys a $400,000 dollar house

 Pays $15,000 per year in mortgage interest.
 Marginal tax rate of 12% implies they reduce their tax
bill by $1,800.

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 Reason 3: Most tax expenditures don’t provide much help if your federal
income tax bill is zero.
Most tax breaks reduce your taxable income.
 But if your income tax bill is already zero, then you can’t go any lower!

Tax expenditures are often inefficient, poorly targeted, persistent, and rarely evaluated for
effectiveness

A refundable tax credit tries to help by providing benefits even to those who have zero taxable
income.
 Refundable because you can get a tax refund even if you don’t pay any taxes.
 Example: The American Opportunity Tax Credit is a partially refundable tax credit.
 Your family can receive up to $1,000 to help tuition costs!

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 Hidden government spending: Government regulation

So far  government can disguise spending as tax breaks.

Now  government can disguise spending by getting someone else to do it.

Regulation allows the government to require spending, while others pay the bill.
 Example: Require employers to provide parental leave to all workers.
 Instead of Congress budgeting for this program, now employers pay (and, to some extent,
workers pay).
Be careful, because regulation changes incentives.
 Example: requiring companies to pay for parental leave might lead some employers to
avoid hiring workers they suspect might become parents.
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 Key take-aways: The Government Sector

The Government Sector has grown over time as the role of the government
in providing social insurance and education has expanded.
 Social insurance: government-provided insurance against bad outcomes
such as unemployment, illness, disability, or outliving your savings.
Federal spending: social insurance programs, military
State spending: social insurance programs, education
Local spending: education, community services

Hidden government spending: tax expenditures, government regulation.

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 Fiscal Policy: A countercyclical force

Fiscal policy: the government’s use of spending and tax policies to attempt to stabilize the
economy.
 Tries to minimize output fluctuations and keep actual GDP close to potential output.
 Fiscal policy is countercyclical in that it counteracts the effects of the business cycle.

Expansionary fiscal policy: If output in Contractionary fiscal policy: If the

the economy is weak, then the government economy is overheating, then the
increases spending and lowers taxes in government decreases spending and raises
order to boost aggregate demand for taxes in order to weaken aggregate
output and, thus, raise GDP. demand for output and, thus, lower GDP.

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 Government spending can add The multiplier effect makes
to GDP directly and indirectly fiscal policy more potent
Direct: Government purchases Recall: The multiplier effect describes the
possibility that an initial boost in spending
Spending on military equipment, vaccine
will set off ripple effects.
development, and highways directly increases
aggregate expenditure, thus boosting GDP.  Suppose an initial boost increases your
income so you spend more, which
Indirect: Transfer payments
boosts the income of others, causing
Transfer payments (like social security them to spend more, and so on!
checks) don’t directly add to GDP since
 The ripple effects of that initial
nothing is purchased or produced.
boost lead to an even larger rise in
HOWEVER, when households spend the GDP!
money they received, then they boost
Same effects also operate in reverse.
aggregate expenditure!

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 Interpreting the data: Can a one-time government
payment to households boost spending during a recession?

2007–2008 Financial Crisis 2020 COVID Recession

The government mailed out payments of up to Once again, the government mailed out
$600 per person. checks to people.
 Their logic: Higher incomes would lead to  People spent less than half of the
higher consumption and stimulate greater payments they received.
aggregate expenditure and hence output.  The pandemic changed people’s
 Skeptics: This income boost was temporary spending habits.
so people might save rather than spend.  Particularly low marginal
 In total, the government mailed out $100 propensity to consume
billion in rebates.
 Studies show that people spent between $50
and $90 billion of this money.
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 Discretionary government spending
can involve substantial time lags
If the economy starts slipping into a recession, Congress
may consider passing legislation to temporarily increase
spending or cut taxes.
 But there are delays every step of the process.
First delay: It can take months for policymakers to
realize they should act.
Second delay: Formulating and passing legislation can
be difficult due to political disagreement.
Third delay: Finding projects on which to actually spend
the money can take time if there aren’t many ”shovel-
ready projects.”

29 David R. Frazier Photolibrary, Inc./Alamy Stock Photo Macmillan Learning, ©2023

 The three T s of fiscal policy

Fiscal policy works best when it’s timely, targeted, and temporary:
 Timely: Policymakers must act quickly!
 Targeted: Fiscal policy should focus on the specific regions, industries, and groups of
workers who need the most help.
 Temporary: Extra spending is no longer required when the economy has recovered.

30 ChrisMacmillan
Maddaloni/AP Photo
Learning, ©2023
 Key Definition (1 of 2) Diving into the Definition

Expansionary fiscal policy requires the

Crowding out: the decline in private government to spend, not save.
spending—particularly investment—that  This decreases the supply of loanable funds!
follows from a rise in government spending.

Why can government spending lead to a

decline in private investment?
 Expansionary fiscal policy leads to higher
real interest rates, which reduces private
spending.

Let’s explore this relationship in more detail.

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 Key Definition (2 of 2) Diving into the Definition

Automatic stabilizers: fiscal policy (i.e., The progressive tax system helps counter both
booms and busts.
spending and tax programs) that adjusts
as the economy expands and contracts  Bust: drop into a lower tax bracket which
allows consumer to keep (and spend) more!
without policymakers taking any
deliberate action.  Boom: rise into a higher tax bracket which
means consumers keep (and spend) less than
 Automatic: no action required by they otherwise would.
policymakers. Spending on government support programs
 Stabilizing: these adjustments are automatically adjusts during business cycles:
countercyclical:  Bust: More people qualify for government
benefits.
• Boosts output during recessions  Boom: People earn more money, so fewer
people qualify for government support
• Reduces output during expansions programs.
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 Automatic stabilizers are timely, targeted, and temporary

Automatic stabilizers are timely:

 Automatically triggered whenever people’s incomes decline.

Automatic stabilizers are targeted:

 Taxes decline only for those whose income has fallen.
 Only eligible people receive support from government programs.

Automatic stabilizers are temporary:

 They automatically reverse course as the economy reverses course.

Even economists who are wary of discretionary fiscal policy are often in favor
of creating more automatic stabilizers.

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 Fiscal policy and monetary policy interactions

When will one tool be more effective than the other?

Monetary policy is more nimble:
 The Fed’s decision to lower interest rates can be implemented by the end of an afternoon!
 HOWEVER, changes in interest rates can take a year or more to stimulate or dampen spending.
Fiscal policy can be more targeted:
 Example: An oil price shock can cause a boom in the oilfields of Texas, and a recession in
Michigan as auto sales plummet.
 Fiscal policy can target just the auto sector!
Fiscal policy is particularly important at the zero lower bound:
 If the Fed can’t cut short-term nominal rates any further, fiscal policy is the only tool remaining!

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 Key take-aways: Fiscal Policy

Fiscal policy: the government’s use of spending and tax policies to attempt to
stabilize the economy.
 Very important tool at the zero lower bound!
 Works best when it’s timely, targeted, and temporary.

Discretionary fiscal policy: policy Automatic stabilizers: spending

that temporarily changes spending and tax programs that adjust as the
or taxes to boost or slow the economy expands and contracts,
economy. without policymakers taking any
deliberate action.

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 Budget deficit or budget surplus (1 of 2)

Government  The total accumulated amount of money that it owes.

debt  Measures the accumulated stock of borrowing at a point in time.

The flow of new borrowing over a course of a year can either be classified as a budget
deficit or budget surplus.

Budget deficit The difference between spending and revenue in a year in which
spending exceeds revenue. A budget deficit for a given year adds to the total debt.

Budget surplus The difference between spending and revenue in a year in which
revenue exceeds spending. A budget surplus for a given year can be used to repay debt.
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 Budget deficit or budget surplus (2 of 2)

Four facts about government

spending and revenue:

1. The federal government typically

runs budget deficits.

2. Persistent large budget deficits

are a relatively recent
phenomenon.

3. Wars and pandemics require a

sudden surge of spending that
results in budget deficits.

4. Business cycles create budget

deficit cycles.

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 When should the government run deficits?

Typical perspective about budget deficits:

 Budget deficits reflect a mismatch between how much the government spends and
how much revenue it takes in.
Alternative perspective about budget deficits:
 Budget deficits reflect a mismatch between when the government spends and
when it takes in the revenue to pay for this spending.
 This perspective suggests deficits often make sense!

Example: Why make the government to pay for infrastructure upfront when the
benefits of things like highways, research, and airports are multigenerational?
 The government can simply borrow and pay for those investments over time.
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 Short-run political incentives

Budget deficits may reflect short-run political incentives:

 Spending programs are popular with voters…
 But raising taxes to pay for those programs is NOT!
 Result: unbalanced incentives
 Might help explain why the federal government typically runs budget deficits.

Common proposal to fix unbalanced incentives: require the government to balance its
budget.
 But is this a good solution? Let’s explore!

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 Requiring a balanced budget would make business cycles WORSE

Requiring the federal government to balance its budget each year would prevent the
use of fiscal policy to counteract business cycles.
Let’s think through a recession:
 Economic downturns lead to lower tax revenues, and so a balanced budget rule
would…
1. Require government support programs to be scaled back at exactly the time when more
people need them.
2. Force higher taxes, or lower spending, or BOTH!
 This contractional fiscal policy would reduce aggregate expenditures, causing output
to decline even more!

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 skipperchong/iStock/Getty Images

Making things worse

Many state legislatures are required by law to balance the
budget each year.
During the 2007–2009 recession, state governments that
faced a balanced budget requirement saw their revenues
decline.
 Responded by raising tax rates and cutting spending.
 Exacerbated the downturn!
 Half a million municipal workers, including
teachers, police, firefighters, and other emergency
responders were cut from city payrolls, further
increasing unemployment and depressing
aggregate expenditure.
Lesson learned: During the 2020 recession, the federal
government provided funding to states to help offset
declines in their tax revenues.
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 Government debt

Government  The total accumulated amount of money that it owes.

debt  Measures the accumulated stock of borrowing at a point in time.

It reflects the long history of both past borrowing to fund budget deficits, and past repayments
from occasional surpluses.
How does the government borrow?
 Sells government bonds to savers both in the United States and abroad.
 Government bonds are like an IOU—promising to repay the amount borrowed, plus
interest.
Gross government debt: $31 trillion in 2022 $6.5 trillion of this is money that
one part of the federal government
Net government debt: $25 trillion in 2022 owes to another part.
 Also called “debt held by the public”
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 Evaluate a country’s debt relative to a country’s GDP

Debt-to-GDP ratio helps us think about a

country’s debt relative to its capacity to repay it.
Ex. The 2021 U.S. debt-to-GDP ratio was 97%.
 Net government debt is equivalent to what
we currently produce in 97% of a year.

U.S. government debt is comparable to that of

other advanced countries.

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 Government debt is currently high, relative to our history

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 Government debt is expected to grow rapidly over coming decades

Much of the federal budget (and much

of its rise) reflects promises the
government has made about future
payments.
 Social Security and Medicare are
projected to grow rapidly.

Unfunded liability: a commitment to

incur expenses in the future without a
plan to pay for them.
 Primary driver of rising deficits and
debt.

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 Reasons not to worry about government debt

1. Most of our government debt is money owed by Americans to Americans.

2. Future generations can help repay the debt.
3. It wouldn’t take a big adjustment to repay the debt.
4. The government never really needs to repay the debt.
5. The government has options that you don’t.
 Raise taxes
 Print money (but beware of inflation, or worse, hyperinflation)

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 Reasons to worry about government debt

1. Slower economic growth

 The government borrows funds that might otherwise be used to finance investments in
productive capital.
2. Future fiscal choices are constrained
3. The risk of a crisis of confidence
 A perceived risk of not getting paid would lead lenders to charge the government a higher interest
rate, making it difficult/impossible to make loan repayments.
4. A debt crisis becomes more likely
 Higher government debt can lead to a debt crisis in which the government simply can’t repay its
loans.

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 Peathegee Inc/Tetra images/Getty Images

Can you count on Social Security?

The premise behind Social Security:
 Contribute to the program through payroll
taxes during your working years, and later
you’ll get a reasonable retirement income.
The concern: the current form of Social
Security appears poised for financial
difficulties.
 Existing cash runs out around 2033.
But Social Security won’t suddenly stop
paying benefits when the stockpile runs out!
 Worst-case scenario: Retirees will still get
roughly 70% of what’s been promised.
 There are reasons to believe things will They’re worried Social Security
work out. won’t be there for them.
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 Key take-aways: Government Deficits and Debt

Budget deficit: when spending exceeds revenue over a year.

Budget surplus: when revenue exceeds spending over a year.
Gross government debt: the total accumulated amount of money the
government owes.
Net government debt: the debt that the government owes to individuals,
businesses, and other governments both here and abroad.

There are both reason to worry and not to worry about government debt.

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