―
The Government and Fiscal Policy
(Part A)
by
Charles Lamson
Nothing in macroeconomics or microeconomics arouses as much controversy as the role of government in the economy.
In microeconomics, the active presence of government in regulating competition, providing roads and education, and redistributing the income is applauded by those who believe a free market simply does not work well if left to its own devices. Opponents of government intervention say it is the government, not the market, that performs badly. They say bureaucracy and inefficiency could be eliminated or reduced if the government played a smaller role in the economy. In macroeconomics, the debate over what the government can and should do has a similar flavor, although the issues are somewhat different. At one end of the spectrum are the Keynesians and their intellectual descendants, who believe that the macroeconomy is likely to fluctuate too much if left on its own and that the government should smooth out fluctuations in the business cycle. These ideas can be traced to Keynes's analysis in The General Theory, which suggests that governments can use their taxing and spending powers to increase aggregate expenditure (and thereby stimulate aggregate output) in recessions or depressions. At the other end are those who claim that government spending is incapable of stabilizing the economy, or worse, is destabilizing and harmful. Perhaps the one thing most people can agree on is that, like it or not, governments are important actors in the economies of virtually all countries. For this alone, it is worth our while to analyze the way government influences the functioning of the macroeconomy.  While the government has a variety of powers---including regulating firms' entry into and exit from an industry, setting the standards for product quality, setting minimum wage levels, and regulating the disclosure of information---in macroeconomics we study a government with general, but limited, powers. Specifically, government can affect the macroeconomy through two policy channels: fiscal policy and monetary policy. Fiscal policy, the focus of the next few posts, refers to the government's spending and taxing behavior---in other words, its budget policy. (The word fiscal comes from the root fisk, which refers to the "treasury" of a government.) Fiscal policy is generally divided into three categories: (1) policies concerning government purchases of goods and services, (2) policies concerning taxes, and (3) policies concerning transfer payments (such as unemployment compensation, Social Security benefits, welfare payments, and veterans' benefits) to households. Monetary policy, in the next several posts, refers to the behavior of the nation's central bank, the Federal Reserve, concerning the nation's money supply. Government in the Economy Given the scope and power of local, state, and federal governments, there are some matters over which they exert great control and some matters beyond their control. We need to distinguish between variables that a government controls directly and variables that are a consequence of government decisions combined with the state of the economy. For example, tax rates are controlled by the government. By law, Congress has the authority to decide who and what should be taxed and at what rate. Tax revenue, on the other hand, is not subject to complete control by the government. Revenue from the personal income tax system depends both on personal tax rates (which Congress sets) and on the income of the household sector (which depends on many factors not under direct government control, such as how much households decide to work). Revenue from the corporate profits tax depends both on corporate profits tax rates and on the size of corporate profits. The government controls corporate tax rates but not the size of corporate profits. Government expenditures also depend both on government decisions and on the state of the economy. For example, in the United States the unemployment insurance program pays benefits to unemployed people. When the economy goes into a recession, the number of unemployed workers increases and so does the level of government unemployed insurance payments.  Because taxes and expenditures often go up or down in response to changes in the economy instead of the result of deliberate decisions by policymakers, we will occasionally use discretionary fiscal policy to refer to changes in taxes or spending that are the results of deliberate changes in government policy.  In the last several posts, we explored the equilibrium level of national output for a simple economy---no taxes, no government spending, and no exports---to provide a general idea of how the macroeconomy operates. To get more realistic, we need to consider an economy in which government is an active participant. We begin by adding the government sector into the simple economy in the last several posts. To keep things simple, we will combine two government activities---the collection of taxes and the payment of transfer payments---into a category we call net taxes (T). Specifically, net taxes are equal to the tax payments made to the government by firms and households minus transfer payments made to households by the government. The other variable we will consider is government purchases of goods and services (G).    By adding T to both sides: Y ≡ C + S + T This identity says aggregate income gets cut into three pieces. Government takes a slice (net taxes, T), and then households divid the rest between consumption (C) and saving (S). Because governments spend money on goods and services, we need to expand our definition of planned aggregate expenditure. Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), planned investment by business firms (I), and government purchases of goods and services (G). AE ≡ C + I + G  The government's budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period: budget deficit ≡ G - T If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling treasury bonds and bills (more on this later). In this case, a part of household saving (S) goes to the government. The dashed lines in Figure 1 mean that some S goes to firms to finance investment projects and some goes to the government to finance its deficit. If G is less than T, which means that the government is spending less than it is collecting in taxes, the government is running a surplus. A surplus is simply a negative deficit. Adding Taxes to the Consumption Function In the last several posts, We examined the consumption behavior of households and noted that aggregate consumption (C) depends on aggregate income (Y): in general, the higher aggregate income is the higher aggregate consumption. For the sake of illustration we used a specific linear consumption function: C = a + bY where a is the amount of consumption that would take place if national income were 0 and b is the marginal propensity to consume.   To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write  or C = a + b(Y - T) Our consumption function now has consumption depending on disposable income instead of before-tax income. Investment What about investment? The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Investment may also vary with economic conditions and interest rates, as we will see later. For our present purposes, we continue to assume that planned investment (I) is autonomous (does not depend on the state of the economy).  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 453-456* end |
No comments:
Post a Comment