In addition to taxation and government spending, their actual rates and structures may also be vital for attaining macroeconomic stability and achieving sustained economic growth. Keynesian theory concludes that persistent and excessive unemployment in a short-run macroequilibrium is not inevitable, and, can be addressed by fiscal policy

Fiscal policy entails the use of government spending and tax policies to stimulate or contract macroeconomic activity.

            Policymakers of the 1960s and 1970s relied heavily on Keynesian analysis to justify stimulative tax cuts and expanded government spending. Predictably, the Keynesian de-emphasis of Aggregate Supply and rejection of classical "laissez-faire" policies did not go unchallenged. The new classical macroeconomics has rejuvenated classical analysis—in contrast to the "activist" role for government counseled by most earlier Keynesians, it supports only a passive governmental role in regulating Aggregate Demand.

 

            One off-shoot of new classical macroeconomics, supply-side economics, was the guiding force behind significant cuts in tax rates in the early 1980s. Supply-siders argued that high tax rates discourage productive effort so much that reducing tax rates would increase Aggregate Supply, National Income, and tax revenues. In the early 1990s, Presidents Bush and Clinton, when trying to reign-in record federal budget deficits, each partially reversed President Reagan's supply-side policies by raising income tax rates—primarily on upper-income Americans.

            Our initial task is to incorporate government spending and taxing into our simple Keynesian model of a closed private economy.[1] Then we will examine how policymakers might adjust taxes and government spending to smooth cyclical swings in Aggregate Demand and, consequently, in output, income, and employment. Finally, we will examine objections from new classical economists to the traditional Keynesian approach, and the differences in policy recommendations that emerge from these competing schools of economic thought.

 

Fiscal Policy: The Demand Side

 

The simple Keynesian model ignored government. A slightly more sophisticated model requires explicit consideration of government taxing and spending.

The federal government operates a balanced budget when its tax revenues equal its outlays of funds, a budget deficit when its outlays exceed revenues, and a budget surplus if tax revenues exceed outlays.

Changes in taxes and government outlays fall into two categories: Discretionary and automatic. We will initially consider how federal policymakers can exercise discretion they change tax laws or the level of government outlays.

Discretionary fiscal policy involves deliberate legislative changes in government outlays or taxes to adjust Aggregate Demand (AD) and stabilize the economy.

            How do Keynesians view the effects of fiscal policy on planned Aggregate Expenditures? We begin by assuming, for simplicity, that (a) government spending (G) is autonomous and shifts neither the planned consumption nor the planned investment schedules, (b) investment (I) is also autonomous—at a constant level independent of income—and (c) taxes (T) are also autonomous. These restrictive assumptions will be relaxed a bit after you gain familiarity with our expanded model.

 

Discretionary Spending and Equilibrium

 

The numerical Keynesian model built in Chapter 10 is expanded in Table 1 to consider government. These data are graphed in Figure 1. Without government, the private sector yields equilibrium spending and income of $7 trillion (point a). But this leaves a GDP gap of $500 billion if full employment income is $7.5 trillion. Keynesian analysis perceives any forces pushing the economy toward full employment as weak, so there is a recessionary gap of $100 billion that will not be remedied quickly through private action.

 

Our multiplier of 5 (the mpc = 0.8) means that $100 billion in extra autonomous spending will close the $500 billion GDP gap. One way to reach potential GDP would be to fill the recessionary gap with $100 billion in government spending (column 8 in Table 1). When Aggregate Expenditure shifts from AE0 to AE1 in Figure 1 because government spending rises from zero to $100 billion, equilibrium moves from point a to full employment at point b.

 

Table 1   Curing a Recessionary Gap with the Keynesian Remedy of Government Spending  (billions of dollars)
Private Sector Only							Addition of Government Sector
(1)   * Employment (millions)	(2)   * National Output	(3)   * Planned Consumption	(4)   * Planned Saving	(5)   * Planned Investment	(6) Aggregate Spending without government (AE0)	(7)     Pressures on  Income and Output	(8)       Government	(9) Aggregate Spending with government (AE1)	(10)     Pressures on Income and Output
100.00	$5,000	$5,100	$-100	$300	$5,400		100.00	$5,500
105.00	5500.00	5500.00	0.00	300.00	5800.00		100.00	5900.00
110.00	6000.00	5900.00	100.00	300.00	6200.00		100.00	6300.00
115.00	6500.00	6,300	200.00	300.00	6600.00		100.00	6700.00
120.00	7000.00	6700.00	300.00	300.00	7000.00	equilibrium	100.00	7100.00
125.00	7500.00	7100.00	400.00	300.00	7400.00		100.00	7500.00	equilibrium
130.00	8000.00	7500.00	500.00	300.00	7800.00		100.00	7900.00
135.00	8500.00	7900.00	600.00	300.00	8100.00		100.00	8100.00

FIGURE 1  Using Fiscal Policy to Achieve Full Employment Equilibrium Income

Equilibrium without government spending is $7.0 trillion (point a), leaving a GDP gap of $500 billion. The economy gravitates to full employment if government spends $100 billion: Aggregate Spending grows from AE0 = C + I  to AE1 = C + I + G. The $100 billion in new government spending is subject to the multiplier just as private autonomous spending is, so the recessionary gap is filled. Thus, the $100 billion times the multiplier (5 ... the mpc = .8) closes the GDP gap and restores full employment at $7.5 trillion.

            Spending multipliers were originally described in terms of investment (DY/DI) but all injections and withdrawals, whether government or private, are subject to the multiplier principle. Government spending is merely a form of injection, so, dollar for dollar, it stimulates Aggregate Expenditure as powerfully as new investment. For example, federal contracts generate new income for contractors and their employees. Some of their new income is saved, but most will be spent. This spending then becomes new income for those from whom they buy, which is then spent or saved. And so on.[2]

 

            The effect of government purchases can be described in a manner parallel to the planned saving = planned investment approach. Saving and taxes are both withdrawals, while investment and government purchases are both injections. Planned injections must equal planned withdrawals at equilibrium.[3]  

            Figure 2 illustrates the planned-injections-equal-planned-withdrawals approach, which parallels the savings-equals-investment model developed when only private spending was considered. Introduction of $100 billion in new government spending boosts total injections (I + G = $300 billion plus $100 billion = $400 billion). Planned saving ($300 billion in planned withdrawals) at the initial equilibrium of $7 trillion is now less than planned investment plus new government spending ($400 billion in total planned injections), so output rises until injections equal withdrawals. Thus, the new equilibrium requires output to rise to $7.5 trillion.

 

FIGURE 2    Injections-Equals-Withdrawals Approach to Equilibrium

Without government, the private economy reaches equilibrium at $7.0 trillion (point a). Introducing $100 billion in new government spending boosts equilibrium income by $500 billion, moving the system to full employment at $7.5 trillion (point b). Injections (I + G) total $400 billion and equal total withdrawals (S + T) at the new equilibrium. Note that in this example, since T = 0, then S = I + G.

Taxes and Equilibrium

 

We now know how raising government spending affects equilibrium. Introducing taxes (T) into our model takes us another step closer to reality. The autonomous tax multiplier can be expressed much like the autonomous expenditures multiplier.

The autonomous tax multiplier is the proportional change in income caused by a given change in autonomous taxes, and is written as DY/ DTa.

Taxes, like saving, are withdrawals that pull down spending and income. Thus, the autonomous tax multiplier is a negative number.

 

            Suppose people began spending almost as fast as they received income. Table 2 reflects this change in behavior by showing planned consumption (column 3) at $500 billion higher and planned saving at $500 billion lower (column 4) for each income level than in Table 1.

 

            Private sector activity alone yields an equilibrium (where column 2 equals column 6) of $9.5 trillion in income, so Aggregate Spending is $2 trillion too high for price-level stability at the $7.5 trillion level of full employment output. This negative GDP gap ($7.5 trillion - $9.5 trillion = -$2 trillion) combines with the autonomous spending multiplier of 5 (mpc = 0.8) to yield an inflationary gap of $400 billion, which means that autonomous spending is $400 billion too high. Alternatively, autonomous saving is $400 billion too low (distance bc in Figure 3). This model lacks government spending, so boosting tax withdrawals is the only way government can reduce Aggregate Expenditures.

  FIGURE 3  Eliminating Inflationary Pressure with Taxes (Injections = Withdrawals Approach)

 

 

Table 2  Curing an Inflationary Gap with Taxes (billions of dollars)
(1)   Employment (millions)	(2) National Output & Income   Y	(3) Planned Consumption   C	(4) Planned Saving   S	(5) Planned Investment     I	(6) Spending without Taxes	(7) Net Pressure on Output	(8)     Taxes   T	(9)       Yd	(10)       Ct	(11)       St	(12)   Aggregate Spending	(13) Net Pressure on Output
110.00	$6000	$6400	$-400	$300	$6700		$500	$5500	$6000	$-500	$6300
115.00	6500.00	6800.00	-300.00	300.00	7100.00		500.00	6000.00	6400.00	-400.00	6700.00
120.00	7000.00	7200.00	-200.00	300.00	7500		500.00	6500.00	6800.00	-300.00	7100.00
125.00	7500.00	7600.00	-100.00	300.00	7900.00		500.00	7000.00	7200.00	-200.00	7500.00	equilibrium
130.00	8000.00	8000.00	0.00	300.00	8300.00		500.00	7500.00	7600.00	-100.00	7900.00
135.00	8500.00	8400.00	100.00	300.00	8700.00		500.00	8000.00	8000.00	0.00	8300.00
140.00	9000.00	8800.00	200.00	300.00	9100.00		500.00	8500.00	8400.00	100.00	8700.00
145.00	9500.00	9200.00	300.00	300.00	9500.00	equilibrium	500.00	9000.00	8800.00	200.00	9100.00

 

 

            Government spending is ignored in this simple model, and taxes are assumed to affect only spending behavior, not productive effort. Taxes reduce saving by the autonomous tax times the mpc, or 0.2($500 billion), for a total reduction of $100 billion in autonomous saving. However, net withdrawals rise by $400 billion at each income level: DS + DTa =  -$100 billion + $500 billion. Thus, through the multiplier process, equilibrium income falls from $9.5 trillion to $7.5 trillion, so inflationary pressure subsides because of tax withdrawals. The tax multiplier DY/DTa  is -4 in this case (-$2,000 billion/$500 billion = -4).

            Consumer decisions about spending depend on disposable income (Yd) instead of Aggregate Income (Y) because households alone ultimately bear all tax burdens. Consider how new autonomous taxes of $500 billion will affect Aggregate Expenditures. Subtracting these taxes (column 8) from National Income (column 2) yields disposable income (Y - T = Yd), shown in column 9 of Table 2. Note that the relationship between disposable income and consumption is identical to the one between income and consumption from Table 1, when we ignored taxes.

 

            How much of this $500 billion in taxes will come from consumption and how much from saving? With an mpc of 80 percent and an mps of 20 percent, consumption will initially fall 0.8 times the $500 billion in taxes, for a total of $400 billion. This shifts consumption in the Aggregate Expenditure schedule down by $400 billion for every level of gross (pretax) income, while the saving schedule falls $100 billion at all income levels.

 

            The new saving curve St (saving after taxes are imposed) is exactly $100 billion lower (on the vertical axis) than the original saving curve S in Figure 3. (Remember, a drop in saving is shown as a shift of the saving curve to the right because consumers will now save less at each income level.) From the perspective of the injections = withdrawals approach, withdrawals in the form of after-tax saving are shown as St. Taxes of $500 billion are also withdrawals, so the total withdrawal function = St + T. In Figure 3, this is exactly $500 billion above St (distance cd in Figure 3); thus, it is $400 billion above the original S curve for each income level.

 

            On the other side of the ledger, investment of $300 billion is still the only injection in this economy. Equilibrium requires total withdrawals to equal total injections, so St + T = I at point a in Figure 3. Equilibrium National Income (determined now by Aggregate Spending of Ct + I, where Ct reflects after-tax consumption) falls from $9.5 trillion to $7.5 trillion. The autonomous tax multiplier (DY/DTa ) equals -$2,000 billion /$500 billion, so it is -4. Private saving is -$200 billion in this equilibrium; so tax withdrawals of $500 billion precisely offset dissaving ($200 billion) plus the investment injection of $300 billion to ensure full employment without inflation.

 

The Tax Multiplier

 

            In our example, the autonomous spending multiplier (DY/DA, where A = the sum of all forms of autonomous spending) is 5, because the marginal propensity to consume is 0.8. But the autonomous tax multiplier (DY/DTa ) was just calculated as -4 in this case. Notice the relationship: One minus the autonomous spending multiplier equals the tax multiplier

1 - (1/mps)= DY/DTa

1 - 5       =      -4.

The autonomous tax multiplier is the negative value of one less than the spending multiplier.[4] An example of why this is so is shown in Table 3.

Table 3 

Table 3  Round-by-Round Effects of $100 Billion Increases in Spending, Taxing, and the Balanced Budget  (billions of dollars)
Effect	(1) $100 billion In extra government spending	(2) $100 billion in extra autonomous taxes	(3) $100 billion in extra taxes and purchases
Round 1: Initial effect of change on income	$100	0	100
Round 2: induced spending	80	- 80	0
Round 3: induced spending	64	- 64	0
Round 4 through all subsequent rounds	256	- 256	0
Total Change	500	- 400	100
Multiplier   (mpc = 0.8)	5.00	-4.00	1.00
Note: Each $1 increase in government purchases creates $1 in new income in Round 1, but each $1 in new taxes does not influence first-round income. In Round 2, each $1 in new government purchases has caused the person whose income was increased to spend $0.80, but this is offset by the reduced spending of $0.80 caused by each $1 in new taxes. Moreover, the effects of the new spending and taxing offset each other in all subsequent rounds. Thus, only Round 1 spending has any net effect on income, and the balanced-budget multiplier equals one.

 

            Table 3 traces the effects on spending of $100 billion increases in government purchases and taxes, both individually and together, through a few rounds of transactions, assuming that the mpc = 0.8. In column 1, 80 percent of each extra dollar of income is spent and becomes someone else's income. Thus, a new injection of $100 billion in government spending (Round 1) means that $80 billion in consumer spending is induced in the second round. The people whose incomes rise by this $80 billion then spend $64 billion, which becomes other people's extra income. And so on. The autonomous spending multiplier is 5, indicated at the bottom of column 1.

 

            The effect of new autonomous taxes of $100 billion on spending is shown in column 2. Note that in Round 1, this tax does not affect gross (pretax) incomes—the $100 billion tax hike may be viewed by taxpayers as a cut in disposable income, but National Income is not affected initially. Only after the drop in disposable income lowers consumer spending would output be reduced if all else (including government spending) were constant. Thus, government purchases affect Aggregate Spending in Round 1; new taxes do not. Subsequent rounds cancel, so the autonomous tax multiplier is negative, and equals one minus the spending multiplier.

 

The Balanced-Budget Multiplier

            See Balanced Budge Multiplier

 

Table 3 has a startling conclusion. If both government spending (column 1) and autonomous taxes (column 2) rise $100 billion, equilibrium income, on balance, grows exactly $100 billion (end of column 3). Thus, a basic Keynesian balanced-budget multiplier is exactly one.[5]

The balanced budget multiplier indicates that identical increases in autonomous spending and in autonomous taxes will yield an identical increase in equilibrium income, so it always equals 1.

            The conclusion is that equal increases (decreases) in government spending and taxes will raise (or lower) equilibrium National Income by an identical amount. Table 3 should help you discern the fiscal mechanisms at work when either spending or taxing is changed.

 

            Let us summarize the discretionary fiscal policies Keynesians traditionally prescribe to cure specific economic ills. Inflationary pressures can be relieved through tax hikes, cuts in government outlays, or a mix of both. Tax increases or cut in government spending drive federal budgets toward surplus or reduce deficits. If excessive unemployment is the major problem, then tax cuts or increased government outlays temporarily move the budget into a deficit (or reduce a surplus) and expand output, employment, and income.

 

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