Baumol & Blinder MACROECONOMICS (11th ed)

NOTE: Figures are in billions of dollars per year.

FIGURE 3

Fiscal Policy to Eliminate a Recessionary Gap

FIGURE 5

The Goal of Supply-

Side Tax Cuts

D

Price Level

S0

S1

FIGURE 6

A Successful Supply-

Side Tax Reduction

D1

D0

Price Level

S0

What sorts of policies do supply-siders advocate? Here is a sample of their long list of recommended tax cuts:

proposals for radical tax reform have been considered in Washington over the years, but never adopted. However, Congress did reduce the tax rate on dividends to just 15 percent in 2003. And since then, both President Bush and a number of Democrats have proposed additional tax preferences for saving.

Reduce Taxes on Capital Gains When an investor sells an asset for a profit, that profit is called a capital gain. Supply-siders argue that the government can encourage more investment by taxing capital gains at lower rates than ordinary income. This proposal was acted upon in 2003, when the top rate on capital gains was cut to 15 percent.

Reduce the Corporate Income Tax By reducing the tax burden on corporations, proponents argue, the government can provide both greater investment incentives (by raising the profitability of investment) and more investable funds (by letting companies keep more of their earnings).

tax cuts and ignore some undesirable side effects. Here is a brief rundown of some of their main objections.

Small Magnitude of Supply-Side Effects The first objection is that supply-siders are simply too optimistic: No one really knows how to do what Figure 5 shows. Although it is easy, for example, to design tax incentives that make saving more attractive financially, people may not actually respond to these incentives. In fact, most of the statistical evidence suggests that we should not expect much from tax incentives for saving. As the economist Charles Schultze once quipped: “There’s nothing wrong with supply-side economics that division by 10 couldn’t cure.”

FIGURE 7

A More Pessimistic

View of Supply-Side

Tax Cuts

As we have mentioned, Ronald Reagan won landslide victories in 1980 and 1984 by running on a supply-side platform. But in 1992, candidate Bill Clinton attacked supply-side economics as “trickle-down economics,” arguing that it had failed. He emphasized two of the drawbacks of such a fiscal policy: the effects on income inequality and on the budget deficit. The voters apparently agreed with him.

The hallmark of Clintonomics was, first, reducing the budget deficit that Clinton had inherited from the first President George Bush, and second, building up a large surplus. This policy succeeded—for a while. The huge budget deficit turned into a large surplus, the economy boomed, and Clinton, like Reagan before him, was reelected easily.

Then, in the 2000 presidential election, the voters once again switched their allegiance. During that campaign, Democratic candidate Al Gore promised to continue the “fiscal responsibility” of the Clinton years, while Republican candidate George W. Bush echoed Reagan by offering large tax cuts. Bush won in what was virtually a dead heat. Then, in 2004, John Kerry ran against the incumbent George Bush on what amounted to a promise to roll back some of the Bush tax cuts and return to Clintonomics. Bush won again.

In 2008, the very same issue was on the agenda again. The Democrats wanted to repeal most of the Bush tax cuts because, they argued, the government needs the tax revenue. But John McCain wanted to make the tax cuts permanent features of the code.

So which approach do American voters prefer? They appear to be fickle! But one thing is clear: The debate over fiscal policy played a major role in each of the last eight presidential elections.

1.The government’s fiscal policy is its plan for managing aggregate demand through its spending and taxing programs. This policy is made jointly by the president and Congress.

2.Because consumer spending (C) depends on disposable income (DI), and DI is GDP minus taxes, any change in taxes will shift the consumption schedule on a 45° line diagram. Such shifts in the consumption schedule have multiplier effects on GDP.

3.The multiplier for changes in taxes is smaller than the multiplier for changes in government purchases because each $1 of tax cuts leads to less than $1 of increased consumer spending.

4.An income tax reduces the size of the multiplier.

5.Because an income tax reduces the multiplier, it reduces the economy’s sensitivity to shocks. It is therefore considered an automatic stabilizer.

6.Government transfer payments are like negative taxes, rather than like government purchases of goods and services, because they influence total spending only indirectly through their effect on consumption.

7.If the multipliers were known precisely, it would be possible to plan a variety of fiscal policies to eliminate either a recessionary gap or an inflationary gap. Recessionary

gaps can be cured by raising G or cutting T. Inflationary gaps can be cured by cutting G or raising T.

8.Active stabilization policy can be carried out either by means that tend to expand the size of government (by raising either G or T when appropriate) or by means that reduce the size of government (by reducing either G or T when appropriate).

9.Expansionary fiscal policy can mitigate recessions, but it also raises the budget deficit.

10.Expansionary fiscal policy also normally exacts a cost in terms of higher inflation. This last dilemma has led to a great deal of interest in “supply-side” tax cuts designed to stimulate aggregate supply.

11.Supply-side tax cuts aim to push the economy’s aggregate supply curve outward to the right. When successful, they can expand the economy and reduce inflation at the same time—a highly desirable outcome.

12.But critics point out at least five serious problems with supply-side tax cuts: They also stimulate aggregate demand; the beneficial effects on aggregate supply may be small; the demand-side effects occur before the supplyside effects; they make the income distribution more unequal; and large tax cuts lead to large budget deficits.

1.Consider an economy in which tax collections are always $400 and in which the four components of aggregate demand are as follows:

Find the equilibrium of this economy graphically. What is the marginal propensity to consume? What is the multiplier? What would happen to equilibrium GDP if government purchases were reduced by $60 and the price level remained unchanged?

2.Consider an economy similar to that in the preceding question in which investment is also $200, government purchases are also $500, net exports are also $30, and the price level is also fixed. But taxes now vary with income and, as a result, the consumption schedule looks like the following:

Find the equilibrium graphically. What is the marginal propensity to consume? What is the tax rate? Use your diagram to show the effect of a decrease of $60 in government purchases. What is the multiplier? Compare this answer to your answer to Test Yourself Question 1 above. What do you conclude?

3.Return to the hypothetical economy in Test Yourself Question 1, and now suppose that both taxes and government purchases are increased by $120. Find the new equilibrium under the assumption that consumer spending continues to be exactly three-quarters of disposable income (as it is in Test Yourself Question 1).

4.Suppose you are put in charge of fiscal policy for the economy described in Test Yourself Question 1. There is an inflationary gap, and you want to reduce income by $120. What specific actions can you take to achieve this goal?

5.Now put yourself in charge of the economy in Test Yourself Question 2, and suppose that full employment comes at a GDP of $1,840. How can you push income up to that level?

1.The federal budget for national defense has increased substantially to pay for the Iraq war. How would GDP in the United States have been affected if this higher defense spending led to

a.larger budget deficits?

b.less spending elsewhere in the budget, so that total government purchases remained the same?

2.Explain why G has the same multiplier as I, but taxes have a different multiplier.

3.If the government decides that aggregate demand is excessive and is causing inflation, what options are open to it? What if the government decides that aggregate demand is too weak instead?

4.Which of the proposed supply-side tax cuts appeals to you most? Draw up a list of arguments for and against enacting such a cut right now.

5.(More difficult) Advocates of lower taxes on capital gains argue that this type of tax cut will raise aggregate supply by spurring business investment. Compare the effects on investment, aggregate supply, and tax revenues of three different ways to cut the capital gains tax:

a.Reduce capital gains taxes on all investments, including those that were made before tax rates were cut.

b.Reduce capital gains taxes only on investments made after tax rates are cut.

c.Reduce capital gains taxes only on certain types of investments, such as corporate stocks and bonds.

Which of the three options seems most desirable to you? Why?

Most of the taxes collected by the U.S. government— indeed, by all national governments—rise and fall with GDP. In some cases, the reason is obvious: Personal and corporate income-tax collections, for example, depend on how much income there is to be taxed. Sales tax receipts depend on GDP because consumer spending is higher when GDP is higher. However, other types of tax receipts—such as property taxes— do not vary with GDP. We call the first kind of tax variable taxes and the second kind fixed taxes.

This distinction is important because it governs how the consumption schedule shifts in response to a tax change. If a fixed tax is increased, disposable income falls by the same amount regardless of the level of GDP. Hence, the decline in consumer spending is the same at every income level. In other words, the C schedule shifts downward in a parallel manner, as was depicted in Figure 1 in the chapter (page 223).

But many tax policies actually change disposable income by larger amounts when incomes are higher. That is true, for example, whenever Congress alters the tax rates imposed by the personal income tax, as it did in 2001 and 2003. Because higher tax rates decrease disposable income more when GDP is higher, the C schedule shifts down more sharply at higher income levels than at lower ones, as depicted in Figure 8. The same relationships apply for tax decreases, as the upward shift in the figure shows.

FIGURE 8

How Variable Taxes Shift the Consumption Schedule

Figure 9 illustrates the second reason why the distinction between fixed and variable taxes is important. This diagram shows two different consumption lines. C1 is the consumption schedule used in previous chapters; it reflects the assumption that tax collections are the same regardless of GDP. C2 depicts a more realistic

FIGURE 9

The Consumption Schedule with Fixed versus

Variable Taxes

case in which the government collects taxes equal to 20 percent of GDP. Notice that C2 is flatter than C1. This is no accident. In fact, as pointed out in the chapter:

Variable taxes such as the income tax flatten the consumption schedule in a 45° line diagram.

We can easily understand why. Column (1) of Table 1 shows alternative values of GDP ranging from $4.5 trillion to $7.5 trillion. Column (2) then indicates that taxes are always one-fifth of this amount. Column (3) subtracts column (2) from column (1) to arrive at disposable income (DI). Column (4) then gives the amount of consumer spending corresponding to each level of DI. The schedule relating C to Y, which we need for our 45° line diagram, is therefore found in columns (1) and (4).

TABLE 1

The Effects of an Income Tax on the

Consumption Schedule

NOTE: Figures are in billions of dollars per year.

Notice that each $500 billion increase in GDP in Table 1 leads to a $300 billion rise in consumer spending. Thus, the slope of line C2 in Figure 9 is $300/$500, or 0.60, as we observed in the chapter. But in our

earlier example in Chapter 9, consumption rose by $300 billion each time GDP increased $400 billion— making the slope $300/$400, or 0.75. (See the steeper line C1 in Figure 9.) Table 2 compares the two cases explicitly. In the Chapter 9 example, taxes were fixed at $1,200 billion and each $400 billion rise in Y led to a $300 billion rise in C—as in the left-hand panel of Table 2. But now, with taxes variable (equal to 20 percent of GDP), each $500 billion increment to Y gives rise to a $300 billion increase in C—as in the righthand panel of Table 2.

TABLE 2

The Relationship between Consumption and GDP

TABLE 3

Total Expenditure Schedule with a 20 Percent Income Tax

previous chapters, full employment may occur above or below Y 5 $6,000 billion. If it is below this level, an inflationary gap arises. Prices will probably start to rise, pulling the expenditure schedule down and reducing equilibrium GDP. If it is above this level, a recessionary gap results, and history suggests that prices will fall only slowly. In the interim, the economy will suffer a period of high unemployment.

In short, once we adjust the expenditure schedule for variable taxes, the determination of national income proceeds exactly as before. The effects of government spending and taxation, therefore, are fairly straightforward and can be summarized as follows:

These differences sound terribly mechanical, but the economic reasoning behind them is vital to understanding tax policies. When taxes are fixed, as in line C1, each additional dollar of GDP raises disposable income (DI) by $1. Consumer spending then rises by $1 times the marginal propensity to consume (MPC), which is 0.75 in our example. Hence, each additional dollar of GDP leads to 75 cents more spending. But when taxes vary with income,

each additional dollar of GDP raises DI by less than $1 because the government takes a share in taxes. In our example, taxes are 20 percent of GDP, so each additional $1 of GDP generates just 80 cents more DI. With an MPC of 0.75, then, spending rises by only 60 cents (75 percent of 80 cents) each time GDP rises by $1. Thus, the slope of line C2 in Figure 9 is only 0.60, instead of 0.75.

Table 3 and Figure 10 take the next step by replacing the old consumption schedule with this new one in both the tabular presentation of income determination and the 45o line diagram. We see immediately that the equilibrium level of GDP is at point E. Here gross domestic product is $6,000 billion, consumption is $3,900 billion, investment is $900 billion, net exports are 2$100 billion, and government purchases are $1,300 billion. As we know from

Government purchases of goods and services add to total spending directly through the G component of C 1 I 1 G 1 (X 2 IM). Higher taxes reduce total spending indirectly by lowering disposable income and thus reducing the C component of C 1 I 1 G 1 (X 2 IM). On balance, then, the government’s actions may raise or

45°

C + I + G + (X – IM )

E

Real GDP