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stimulus and pay for these improved public services by increasing taxes when it is
necessary to rein in the economy.
It is important not to confuse the fiscal stabilization issue with the “big-
government” issue. In fact,
Individuals favoring a smaller public sector can advocate an active fiscal policy
just as well as those who favor a larger public sector. Advocates of bigger gov-
“Free gifts to every kid in the ernment should seek to expand demand (when appropriate) through higher
world? Are you a Keynesian or government spending and to contract demand (when appropriate) through tax
something?” increases. But advocates of smaller government should seek to expand demand
by cutting taxes and to reduce demand by cutting expenditures.
Indeed, our two most conservative recent presidents, Ronald Reagan and George W. Bush,
each pursued activist fiscal policies based on tax cuts.

While both parties favored fiscal stimulus, the choice between extending the
Bush tax cuts or replacing them with spending played a central role in the eco-
nomic debate during the 2008 presidential campaign. John McCain staunchly
defended President Bush™s tax cuts, partly on the grounds that “small govern-
ment” is better than “big government.” He even advocated further tax cuts. But
both Barack Obama and Hillary Clinton argued, for example, that providing
health insurance coverage to more Americans was a higher priority than providing tax
cuts for the well-to-do. Democrats also favored other spending on such things as environ-
mental protection and infrastructure.

The mechanics outlined so far in this chapter make the fiscal policy planner™s job look
deceptively simple. The elementary diagrams make it appear that policy makers can drive
GDP to any level they please simply by manipulating spending and tax programs. It
seems they should be able to hit the full-employment bull™s-eye every time. In fact, a

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Chapter 11 229
Managing Aggregate Demand: Fiscal Policy

better analogy is to a poor rifleman shooting through dense fog at an erratically moving
target with an inaccurate gun and slow-moving bullets.
The target is moving because, in the real world, the investment, net exports, and con-
sumption schedules constantly shift about as expectations, technology, events abroad, and
other factors change. For all of these reasons and others, the policies decided on today,
which will take effect at some future date, may no longer be appropriate by the time that
future date rolls around.
The second misleading feature of our diagrams (the “inaccurate gun”) is that we do not
know multipliers as precisely as in our numerical examples. Although our best guess may
be that a $20 billion increase in government purchases will raise GDP by $30 billion (a
multiplier of 1.5), the actual outcome may be as little as $20 billion or as much as $40 bil-
lion. It is therefore impossible to “fine-tune” every little wobble out of the economy™s
growth path. Economic science is simply not that precise.
A third complication is that our target”full-employment GDP”may be only dimly
visible, as if through a fog. For example, with the unemployment rate hovering around
4.5 percent for parts of 2006 and 2007, there was a vigorous debate over whether the U.S.
economy was above or below full employment.
A fourth complication is that the fiscal policy “bullets” travel slowly: Tax and spending
policies affect aggregate demand only after some time elapses. Consumer spending, for ex-
ample, may take months to react to an income-tax cut. Because of these time lags, fiscal pol-
icy decisions must be based on forecasts of the future state of the economy. And forecasts are
not always accurate. The combination of long lags and poor forecasts may occasionally
leave the government fighting the last recession just as the new inflation gets under way.
And, finally, the people aiming the fiscal “rifle” are politicians, not economic technicians.
Sometimes political considerations lead to policies that deviate markedly from what textbook
economics would suggest. And even when they do not, the wheels of Congress grind slowly.
In addition to all of these operational problems, legislators trying to decide whether to
push the unemployment rate lower would like to know the answers to two further ques-
tions. First, since either higher spending or lower taxes will increase the government™s
budget deficit, what are the long-run costs of running large budget deficits? This is a ques-
tion we will take up in depth in Chapter 15. Second, how large is the inflationary cost
likely to be? As we know, an expansionary fiscal policy that reduces a recessionary gap by
increasing aggregate demand will lower unemployment. But, as Figure 4 reminds us, it
also tends to be inflationary. This undesirable side effect may make the government hesi-
tant to use fiscal policy to combat recessions.
Is there a way out of this dilemma? Can we pursue the battle against unemployment
without aggravating inflation? For about 30 years now, a small but influential minority of
economists, journalists, and politicians have argued that we can. They call their approach
“supply-side economics.” The idea helped sweep Ronald Reagan to smashing electoral
victories in 1980 and 1984 and was revived under President George W. Bush. Just what is
supply-side economics?

The central idea of supply-side economics is that certain types of tax cuts increase aggregate
supply. For example, taxes can be cut in ways that raise the rewards for working, saving,
and investing. Then, if people actually respond to these incentives, such tax cuts will increase the
total supplies of labor and capital in the economy, thereby increasing aggregate supply.
Figure 5, on the next page, illustrates the idea on an aggregate supply-and-demand
diagram. If policy measures can shift the economy™s aggregate supply to position S1S1,
then prices will be lower and output higher than if the aggregate supply curve remained
at S0S0. Policy makers will have reduced inflation and raised real output at the same
time”as shown by point B in the figure. The trade-off between inflation and unemploy-
ment will have been defeated, which is the goal of supply-side economics.

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Part 3
230 Fiscal and Monetary Policy

What sorts of policies do supply-siders advocate? Here is a sample of their long list of
F I GU R E 5
recommended tax cuts:
The Goal of Supply-
Side Tax Cuts
Lower Personal Income-Tax Rates Sharp cuts in personal
taxes were the cornerstone of the economic strategy of George W.
Bush, just as they had been for Ronald Reagan 20 years earlier.
D Since 2001, tax rates on individuals have been reduced in stages,
and in several ways. The four upper tax bracket rates, which
were 39.6 percent, 36 percent, 31 percent, and 28 percent when
President Bush assumed office, have been reduced to 35 percent,
Price Level

A 33 percent, 28 percent, and 25 percent, respectively. In addition,
B some very low income taxpayers have seen their tax rate fall
from 15 percent to 10 percent. Lower tax rates, supply-siders ar-
gue, augment the supplies of both labor and capital.

Reduce Taxes on Income from Savings One extreme form
of this proposal would simply exempt from taxation all income
from interest and dividends. Because income must be either con-
Real GDP sumed or saved, doing this would, in effect, change our present
personal income tax into a tax on consumer spending. Several such
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 addi-
tional 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).

Let us suppose, for the moment, that a successful supply-side tax cut is enacted. Be-
cause both aggregate demand and aggregate supply increase simultaneously, the economy
may be able to avoid the inflationary consequences of an expansionary fiscal policy
shown in Figure 4 (page 228).
F I GU R E 6 Figure 6 illustrates this conclusion. The two aggregate demand curves and the initial ag-
gregate supply curve S0S0 carry over directly from Figure 4. But now we have introduced
A Successful Supply-
Side Tax Reduction an additional supply curve, S1S1, to reflect the successful sup-
ply-side tax cut depicted in Figure 5. The equilibrium point for
the economy moves from E to C, whereas with a conventional
D1 S0 demand-side tax cut it would have moved from E to A. As com-
pared with point A, which reflects only the demand-side effects
D0 of a tax cut, output is higher and prices are lower at point C.
A good deal, you say. And indeed it is. The supply-side ar-
Price Level

gument is extremely attractive in principle. The question is:
Does it work in practice? Can we actually do what is depicted
in Figure 6? Let us consider some of the difficulties.

Some Flies in the Ointment
S0 S1 D0 Critics of supply-side economics rarely question its goals or the
basic idea that lower taxes improve incentives. They argue,
Real GDP
instead, that supply-siders exaggerate the beneficial effects of

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Chapter 11 231
Managing Aggregate Demand: Fiscal Policy

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,
F I GU R E 7
people may not actually respond to these incentives. In fact, most of the statistical evi-
A More Pessimistic
dence suggests that we should not expect much from tax incentives for saving. As the
View of Supply-Side
economist Charles Schultze once quipped: “There™s nothing wrong with supply-side Tax Cuts
economics that division by 10 couldn™t cure.”
Demand-Side Effects The second objection is that supply- D1
siders ignore the effects of tax cuts on aggregate demand. If you S0
cut personal taxes, for example, individuals may possibly work S1
more. But they will certainly spend more.
The joint implications of these two objections appear in Figure 7.

Price Level
This figure depicts a small outward shift of the aggregate supply E
curve (which reflects the first objection) and a large outward shift of
the aggregate demand curve (which reflects the second objection).
The result is that the economy™s equilibrium moves from point E (the
intersection of S0S0 and D0D0) to point C (the intersection of S1S1 and
D1D1). Prices rise as output expands. The outcome differs only a little S1
from the straight “demand-side” fiscal stimulus depicted in Figure 4.
Problems with Timing Investment incentives are the most Real GDP
promising type of supply-side tax cuts. But the benefits from greater
investment do not arrive by overnight mail. In particular, the expenditures on investment
goods almost certainly come before any expansion of capacity. Thus, supply-side tax cuts have
their primary short-run effects on aggregate demand. Effects on aggregate supply come later.
Effects on Income Distribution The preceding objections all pertain to the likely ef-
fects of supply-side policies on aggregate supply and demand. But a different problem
bears mentioning: Most supply-side initiatives increase income inequality. Indeed, some
tilt toward the rich is an almost inescapable corollary of supply-side logic. The basic aim
of supply-side economics is to increase the incentives for working and investing”that is,
to increase the gap between the rewards of those who succeed in the economic game (by
working hard, investing well, or just plain being lucky) and those who fail. It can hardly
be surprising, therefore, that supply-side policies tend to increase economic inequality.
Losses of Tax Revenue You can hardly help noticing that most of the policies sug-
gested by supply-siders involve cutting one tax or another. Thus supply-side tax cuts are
bound to raise the government budget deficit. This problem proved to be the Achilles™
heel of supply-side economics in the United States in the 1980s. The Reagan tax cuts left in
their wake a legacy of budget deficits that took 15 years to overcome. Opponents argue
that President George W. Bush™s tax cuts put us in a similar position: The tax cuts used up
the budget surplus and turned it into a large deficit.

Several of the items on the preceding list played prominent roles in the 2008 presi-
dential campaign. Democrats argued that the Bush tax cuts had very small supply-
side incentive effects, were unfair because they went mainly to the well-to-do, and
were the primary cause of the large budgets deficits that emerged in 2002. Republi-
cans countered that the tax cuts substantially improved the economy™s growth, that
it was fair to give the largest tax cuts to those who pay the highest taxes, and that
the Bush tax cuts were not the major cause of the budget deficit”which they blamed on the
2001 recession and the spending required after September 11, 2001.

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Part 3


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