Tax Cuts
Tax cuts have an indirect and positive effect on the consumption variable (C) of GDP (Y=C+I+G+(X-IM)) (Johnson 2006). By reducing taxes individuals and businesses have larger disposable incomes (DI=Y-T) (see Figure 2). This allows individuals to consume more products and services. Business that see these tax cuts are able to have money to hire employees. Tax cuts have an indirect effect on the GDP because increases are dependent upon individuals and businesses spending more and that the marginal propensity to consume (MPC) is less than 1 (Schmitt 2003). This means that tax cuts do not increase disposable income in a ratio of 1:1.
For example a tax cut of $5,000,000, assuming an MPC of 0.8, translates to first round spending of $4,000,000. If we multiply by $4,000,000 1/(1-MPC), (multiplier), AD is increased by $200,000,000. If the government wants to increase AD the tax cut must be large enough to compensate for the portion of the tax cut that is placed in savings from the first round of spending. A reduction in taxes can make the multiplier larger and allows for more rounds of spending to occur (Schmitt 2003).
Taxes cuts have some disadvantages. By reducing taxes the multiplier is increased, but this reduces the stabilizing effect of taxes. This reduction of stabilizing effect may cause the bottoms of recessions to be deeper, and likewise the peaks of booms to be higher. As we will see when we calculate changes in AD from government spending, changes will not be as large as those that come from equal increases in government spending. There are also inflationary pressures that are associated with increased spending caused by tax cuts. Since fiscal policy does not tend to target AS, shifts in AD will cause prices to increase. Depending on which part of the supply curve that we are in, this could be minor (flat portion), or it may be large (steep portion) (Schmitt 2003). By the time that tax cuts are deemed necessary, enacted, and impact the economy the recession may already have self corrected.
Government Spending
Increases in government spending affects the G variable in the GDP calculation. This has a direct impact on GDP. Let us use an example to illustrate this. If we assume a MPC of 0.8 and use an increase in spending equal to the above tax cut, we see an increase in aggregate demand of $250,000,000. The increase in spending can also create decreases in unemployment, by creating government jobs directly or through contractors that perform government work.
Government should be cautious about spending. One of the consequences of deficit spending is a crowding effect. This is due to the finite amount of money available for loan. If the government creates demand for credit, interest rates will increase due to laws of supply and demand (Baumol and Blinder 2006). By making credit more expensive, investment (I) can be reduced in the economy. Reductions in I reduce the GDP. There is a crowding in effect which can counteract the crowding out caused by government borrowing. Deficit spending may increase GDP which helps business see it as more profitable to add to their capacity to meet rising demand (Schmitt 2003). There are also inflationary pressures associated with this deficit spending.
Although this paper is looking at fiscal policy, it is prudent to momentarily discuss monetary policy and how the federal reserve can reduce the risk of inflation caused by deficit spending. The central bank can monetize the deficit by purchasing government bonds. This increases the money supply and helps shift the money supply curve right. By doing this the central bank can stabilize interest rates in the economy (Baumol and Blinder 2006).
National debt may cause future economic growth to be burdened. If the debt is eventually paid down, it will reduce the country’s capital stock and hinder future growth (Baumol and Blinder 2006). Also a persistent crowding out can maintain higher interest rates and raise the cost of debt. Like tax cuts, increases in government spending may occur after the economy has self corrected.
Automatic Fiscal Policies
Policies that kick in automatically when economic downturns occur work as economic stabilizers. One of the most important automatic fiscal policies is unemployment insurance.
Unemployment insurance kicks in with loss of employment. Workers are able to maintain at least part of their income, which helps maintain consumption in the economy. The maintenance of consumption does not eliminate the economic costs of unemployment (Schmitt 2003). It has a stabilizing effect by reducing the depth of economic troughs.
Insurance payments do not account for loss of output, which cannot be replaced (Mann 2007). There is also the risk that people may not be as motivated to return to work after losing their jobs. There is a cost of using fiscal and monetary policies to reduce unemployment; it may cause a permanently higher inflation rate. This is shown by the short-run Phillips curve (Baumol and Blinder 2006). Since the perception of voting individuals is important to politicians, government usually focuses on unemployment.
All of the above fiscal policies have contributed to the relatively stable growth in the GDP and the lower rates of inflation since the end of World War II (Baumol and Blinder 2006). Used in symphony with each other they have guided the U.S. economy to growth and prosperity not seen anywhere else in the world. While each is individually powerful, deliberate use of each in conjunction can be used to deftly navigate economic waters and provide a sustainable level of growth in our economy.
References
Baumol, William J. and Blinder, Alan S. (2006). Economics, Principles and Policy. 10th
ed. Thompson South-Western. pp 461-707.
Johnson, Paul M. (2005). A Glossary of Political Economy Terms. October 15, 2007.
Mann, Jeremiah. SparkNotes. 19 Oct. 2007
Schmitt, Elizabeth D. (2003) Chapter 11: Fiscal Policy, October 15,2007,
Figure 1. Illustration of a recessionary gap. Actual GDP is shown by the intersection of D and S0. The intersection of D and S1 shows the new equilibrium that occurs as prices fall and aggregate supply shifts right, without aggregate demand changes (adapted from Baumol and Blinder 2006).
Figure 2. Illustration of taxes on consumer spending. Tax cuts increase consumer spending (adapted from Baumol and Blinder 2006).
