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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




Managing Aggregate Demand:
Fiscal Policy
Next, let us turn to the problems of our fiscal policy. Here the myths
are legion and the truth hard to find.
J O H N F. K E N N E DY



I n the model of the economy we constructed in Part 2, the government played a
rather passive role. It did some spending and collected taxes, but that was about it.
We concluded that such an economy has only a weak tendency to move toward an
equilibrium with high employment and low inflation. Furthermore, we hinted that
The government™s fiscal
well-designed government policies might enhance that tendency and improve the
policy is its plan for
economy™s performance. It is now time to expand on that hint”and to learn about spending and taxation. It
some of the difficulties that must be overcome if stabilization policy is to succeed. is designed to steer aggre-
We begin in this chapter with fiscal policy. The next three chapters take up the gate demand in some
government™s other main tool for managing aggregate demand, monetary policy. desired direction.




CONTENTS
ISSUE: AGGREGATE DEMAND, AGGREGATE PLANNING EXPANSIONARY FISCAL POLICY ISSUE: THE PARTISAN DEBATE ONCE MORE
SUPPLY, AND THE CAMPAIGN OF 2008 Toward an Assessment of Supply-Side Economics
PLANNING CONTRACTIONARY
INCOME TAXES AND THE CONSUMPTION FISCAL POLICY | APPENDIX A | Graphical Treatment of Taxes
SCHEDULE and Fiscal Policy
THE CHOICE BETWEEN SPENDING POLICY
Multipliers for Tax Policy
THE MULTIPLIER REVISITED AND TAX POLICY
The Tax Multiplier | APPENDIX B | Algebraic Treatment of Taxes
ISSUE REDUX: DEMOCRATS VERSUS
Income Taxes and the Multiplier and Fiscal Policy
REPUBLICANS
Automatic Stabilizers
SOME HARSH REALITIES
Government Transfer Payments
THE IDEA BEHIND SUPPLY-SIDE TAX CUTS
ISSUE REVISITED: THE 2008 DEBATE OVER
Some Flies in the Ointment
TAXES AND SPENDING




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Part 3
222 Fiscal and Monetary Policy



ISSUE: AGGREGATE DEMAND, AGGREGATE SUPPLY, AND THE CAMPAIGN OF 2008
As this book went to press, the 2008 campaign for the White House was in
full swing although the name of the Democratic candidate (either Barack
Obama or Hillary Clinton) had not yet been determined. One of the main eco-
nomic issues between either Democrat and the Republican John McCain was
what to do about the tax cuts that President Bush and the Republican Con-
gress had enacted during Mr. Bush™s first term”and which are scheduled to
expire in 2010. Both Mr. Obama and Ms. Clinton advocated repeal of many of the tax
cuts, especially those that benefited mainly upper-income people. But Mr. McCain op-
posed this change in fiscal policy, arguing that doing so would damage economic
growth in two ways: by reducing consumer spending (and, thus, aggregate demand),
and by impairing incentives to earn more income (thus reducing aggregate supply).
The two Democrats rejected both claims. With regard to aggregate supply, they
argued that the alleged incentive effects of lower tax rates were minuscule. With regard
to aggregate demand, they made two arguments: First, that wealthy taxpayers do not
spend much of the money they receive from their tax cuts anyway, and second, that
eliminating the tax cuts for the rich would enable the government to spend more on
more important priorities, such as universal health care. On balance, they maintained
(without using the term), aggregate demand would rise, not fall.
The debate over whether to repeal or extend the Bush tax cuts thus revolved around
three concepts that we will study in this chapter:
• The multiplier effects of tax cuts versus higher government spending
• The multiplier effects of different types of tax cuts (e.g., those for the poor versus those
for the rich)
• The incentive effects of tax cuts
By the end of the chapter, you will be in a much better position to form your own opin-
ion on this important public policy issue.
SOURCE: © AP Images / Charlie Neibergall




SOURCE: © AP Images / Rick Bowmer




SOURCE: © AP Images / Doug Mills




INCOME TAXES AND THE CONSUMPTION SCHEDULE
To understand how taxes affect equilibrium gross domestic product (GDP), we begin by
recalling that taxes (T) are subtracted from gross domestic product (Y) to obtain disposable
income (DI):
DI 5 Y 2 T
and that disposable income, not GDP, is the amount actually available to consumers and
is therefore the principal determinant of consumer spending (C). Thus, at any given level of


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Chapter 11 223
Managing Aggregate Demand: Fiscal Policy



GDP, if taxes rise, disposable income falls”and hence so
Tax Cut
does consumption. What we have just described in words is
summarized graphically in Figure 1: C




Real Consumer Spending
Any increase in taxes shifts the consumption schedule Tax
downward, and any tax reduction shifts the consumption Increase
schedule upward.
Of course, if the C schedule moves up or down, so does
the C 1 I 1 G 1 (X 2 IM) schedule. And we know from
Chapter 9 that such a shift will have a multiplier effect on
aggregate demand. So it follows that
An increase or decrease in taxes will have a mutiplier effect
Real GDP
on equilibrium GDP on the demand side. Tax reductions in-
crease equilibrium GDP, and tax increases reduce it.
So far, this analysis just echoes our previous analysis of F I GU R E 1
the multiplier effects of government spending. But there is one important difference. Gov- How Tax Policy Shifts
ernment purchases of goods and services add to total spending directly”through the the Consumption
G component of C 1 I 1 G 1 (X 2 IM). But taxes reduce total spending only indirectly” Schedule
by lowering disposable income and thus reducing the C component of C 1 I 1 G 1 (X 2
IM). As we will now see, that little detail turns out to be quite important.


THE MULTIPLIER REVISITED
To understand why, let us return to the example used in Chapter 9, in which we learned
that the multiplier works through a chain of spending and respending, as one person™s ex-
penditure becomes another™s income. In the example, the spending chain was initiated by
Microhard™s decision to spend an additional $1 million on investment. With a marginal
propensity to consume (MPC) of 0.75, the complete multiplier chain was
$1,000,000 1 $750,000 1 $562,500 1 $421,875 1 . . . .
5 $1,000,000 (1 1 0.75 1 (0.75)2 1 (0.75)3 1 . . .)
5 $1,000,000 3 4 5 $4,000,000.
Thus, each dollar originally spent by Microhard eventually produced $4 in additional
spending.


The Tax Multiplier
Now suppose the initiating event was a $1 million tax cut instead. As we just noted, a tax
cut affects spending only indirectly. By adding $1 million to disposable income, it increases
consumer spending by $750,000 (assuming that the MPC is 0.75). Thereafter, the chain of
spending and respending proceeds exactly as before, to yield:
$750,000 1 $562,500 1 $421,875 1 . . . .
5 $750,000 (1 1 0.75 1 (0.75)2 1 . . .)
5 $750,000 3 4 5 $3,000,000.
Notice that the mutiplier effect of each dollar of tax cut is 3, not 4. The reason is
straightforward. Each new dollar of additional autonomous spending”regardless of
whether it is C or I or G”has a multiplier of 4. But each dollar of tax cut creates only
75 cents of new consumer spending. Applying the basic expenditure multiplier of 4 to the
75 cents of first-round spending leads to a multiplier of 3 for each dollar of tax cut. This
numerical example illustrates a general result:1

You may notice that the tax multiplier of 3 is the spending multiplier of 4 times the marginal propensity to
1

consume, which is 0.75. See Appendix B for an algebraic explanation.


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Licensed to:
Part 3
224 Fiscal and Monetary Policy



The multiplier for changes in taxes is smaller than the multiplier for changes in govern-
ment purchases because not every dollar of tax cut is spent.


Income Taxes and the Multiplier
But this is not the only way in which taxes force us to modify the multiplier analysis of
Chapter 9. If the volume of taxes collected depends on GDP”which, of course, it does in
reality”there is another.
To understand this new wrinkle, return again to our Microhard example, but now as-
sume that the government levies a 20 percent income tax”meaning that individuals pay
20 cents in taxes for each $1 of income they receive. Now when Microhard spends
$1 million on salaries, its workers receive only $800,000 in after-tax (that is, disposable)
income. The rest goes to the government in taxes. If workers spend 75 percent of the
$800,000 (because the MPC is 0.75), spending in the next round will be only $600,000.
Notice that this is only 60 percent of the original expenditure, not 75 percent”as was the
case before.
Thus, the multiplier chain for each original dollar of spending shrinks from
1 1
1 1 0.75 1 (0.75)2 1 (0.75)3 1 . . . 5 54
5
1 2 0.75 0.25
in Chapter 9™s example to
1 1
1 1 0.6 1 (0.6)2 1 (0.6)3 1 . . . 5 5 2.5
5
1 2 0.6 0.4
now. This is clearly a large reduction in the multiplier. Although this is just a numerical
example, the two appendixes to this chapter show that the basic finding is quite general:
The multiplier is reduced by an income tax because an income tax reduces the fraction
of each dollar of GDP that consumers actually receive and spend.
We thus have a third reason why the oversimplified multiplier formula of Chapter 9
exaggerates the size of the multiplier: It ignores income taxes.
REASONS WHY THE OVERSIMPLIFIED FORMULA OVERSTATES THE MULTIPLIER
F I GU R E 2
1. It ignores variable imports, which reduce the size of the multiplier.
The Multiplier in
the Presence of an 2. It ignores price-level changes, which reduce the multiplier.
Income Tax
3. It ignores income taxes, which also reduce
the size of the multiplier.
45
The last of these three reasons is the most im-
portant one in practice.
C + I + G1 + (X “ IM) This conclusion about the multiplier is
E1
shown graphically in Figure 2, which can use-
fully be compared to Figure 10 of Chapter 9
Real Expenditure




C + I + G0 + (X “ IM) (page 186). Here we draw our C 1 I 1 G 1
(X 2 IM) schedules with a slope of 0.6, reflect-
ing an MPC of 0.75 and a tax rate of 20 percent,
rather than the 0.75 slope we used in Chapter 9.
Figure 2 then illustrates the effect of a $400 bil-
$400
lion increase in government purchases of goods
and services, which shifts the total expenditure
E0
schedule from C 1 I 1 G0 1 (X 2 IM) to C 1
I 1 G1 1 (X 2 IM). Equilibrium moves from
point E0 to point E1”a GDP increase from
Y 5 $6,000 billion to Y 5 $7,000 billion.
6,000 7,000 8,000
Thus, if we ignore for the moment any
Real GDP
increases in the price level (which would fur-
ther reduce the multiplier), a $400 billion
NOTE: Figures are in billions of dollars per year.



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