<<

. 69
( 126 .)



>>

232 Fiscal and Monetary Policy




Supply-Side Economics and Presidential Elections
As we have mentioned, Ronald Reagan won landslide victories in So which approach do American voters prefer? They appear to
1980 and 1984 by running on a supply-side platform. But in be fickle! But one thing is clear: The debate over fiscal policy played
1992, candidate Bill Clinton attacked supply-side economics as a major role in each of the last eight presidential elections.
“trickle-down economics,” arguing that it had failed. He empha-
sized two of the drawbacks of such a fiscal policy: the effects on in-
come inequality and on the budget deficit. The voters apparently
agreed with him.




SOURCE: (a) © AP Images (b) © AP Images/Greg Wahl-Stevens; (c) © Wally McNamee/CORBIS;
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 re-
elected easily.
Then, in the 2000 presidential election, the voters once again
switched their allegiance. During that campaign, Democratic can-
didate 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 vir-




(d) © AP Images / J. Scott Applewhite
tually a dead heat. Then, in 2004, John Kerry ran against the in-
cumbent 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.




Toward an Assessment of Supply-Side Economics
On balance, most economists have reached the following conclusions about supply-side
tax initiatives:
1. The likely effectiveness of supply-side tax cuts depends on what kinds of taxes are
cut. Tax reductions aimed at stimulating business investment are likely to pack
more punch than tax reductions aimed at getting people to work longer hours or
to save more.
2. Such tax cuts probably will increase aggregate supply much more slowly than they
increase aggregate demand. Thus, supply-side policies should not be regarded as a
substitute for short-run stabilization policy, but, rather, as a way to promote
(slightly) faster economic growth in the long run.
3. Demand-side effects of supply-side tax cuts are likely to overwhelm supply-side
effects in the short run.
4. Supply-side tax cuts are likely to widen income inequalities.
5. Supply-side tax cuts are almost certain to lead to larger budget deficits.
Some people will look over this list and decide in favor of supply-side tax cuts; others,
perusing the same facts, will reach the opposite conclusion. We cannot say that either
group is wrong because, like almost every economic policy, supply-side economics has its
pros and cons and involves value judgments that color people™s conclusions.




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

Chapter 11 233
Managing Aggregate Demand: Fiscal Policy



Why, then, did so many economists and politicians react so negatively to supply-side
economics as preached and practiced in the early 1980s? The main reason seems to be that
the claims made by the most ardent supply-siders were clearly excessive. Naturally, these
claims proved wrong. But showing that wild claims are wild does not eliminate the kernel
of truth in supply-side economics: Reductions in marginal tax rates do improve economic
incentives. Any specific supply-side tax cut must be judged on its individual merits.




| SUMMARY |
gaps can be cured by raising G or cutting T. Inflationary
1. The government™s fiscal policy is its plan for managing
gaps can be cured by cutting G or raising T.
aggregate demand through its spending and taxing pro-
grams. This policy is made jointly by the president and 8. Active stabilization policy can be carried out either by
Congress. means that tend to expand the size of government (by
raising either G or T when appropriate) or by means that
2. Because consumer spending (C) depends on disposable
income (DI), and DI is GDP minus taxes, any change in reduce the size of government (by reducing either G or
T when appropriate).
taxes will shift the consumption schedule on a 45° line
diagram. Such shifts in the consumption schedule have 9. Expansionary fiscal policy can mitigate recessions, but it
multiplier effects on GDP. also raises the budget deficit.
3. The multiplier for changes in taxes is smaller than the 10. Expansionary fiscal policy also normally exacts a cost in
multiplier for changes in government purchases because terms of higher inflation. This last dilemma has led to a
each $1 of tax cuts leads to less than $1 of increased con- great deal of interest in “supply-side” tax cuts designed
sumer spending. to stimulate aggregate supply.
4. An income tax reduces the size of the multiplier. 11. Supply-side tax cuts aim to push the economy™s aggre-
5. Because an income tax reduces the multiplier, it reduces gate supply curve outward to the right. When success-
the economy™s sensitivity to shocks. It is therefore con- ful, they can expand the economy and reduce inflation
sidered an automatic stabilizer. at the same time”a highly desirable outcome.
6. Government transfer payments are like negative taxes, 12. But critics point out at least five serious problems with
rather than like government purchases of goods and supply-side tax cuts: They also stimulate aggregate de-
services, because they influence total spending only in- mand; the beneficial effects on aggregate supply may be
directly through their effect on consumption. small; the demand-side effects occur before the supply-
side effects; they make the income distribution more un-
7. If the multipliers were known precisely, it would be pos-
equal; and large tax cuts lead to large budget deficits.
sible to plan a variety of fiscal policies to eliminate either
a recessionary gap or an inflationary gap. Recessionary




| KEY TERMS |
Fiscal policy 221 Automatic stabilizer 225 Supply-side tax cuts 229
Effect of income taxes on the
multiplier 224




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 3
234 Fiscal and Monetary Policy



| TEST YOURSELF |
1. Consider an economy in which tax collections are Find the equilibrium graphically. What is the marginal
always $400 and in which the four components of aggre- propensity to consume? What is the tax rate? Use your
gate demand are as follows: diagram to show the effect of a decrease of $60 in gov-
ernment purchases. What is the multiplier? Compare
this answer to your answer to Test Yourself Question 1
DI C I G (X 2 IM)
GDP Taxes
above. What do you conclude?
$1,360 $400 $960 $720 $200 $500 $30
3. Return to the hypothetical economy in Test Yourself
1,480 400 1,080 810 200 500 30
Question 1, and now suppose that both taxes and gov-
1,600 400 1,200 900 200 500 30
ernment purchases are increased by $120. Find the new
1,720 400 1,320 990 200 500 30
equilibrium under the assumption that consumer
1,840 400 1,440 1,080 200 500 30
spending continues to be exactly three-quarters of dis-
posable income (as it is in Test Yourself Question 1).
Find the equilibrium of this economy graphically. What
4. Suppose you are put in charge of fiscal policy for the
is the marginal propensity to consume? What is the mul-
economy described in Test Yourself Question 1. There is
tiplier? What would happen to equilibrium GDP if gov-
an inflationary gap, and you want to reduce income by
ernment purchases were reduced by $60 and the price
$120. What specific actions can you take to achieve this
level remained unchanged?
goal?
2. Consider an economy similar to that in the preceding
5. Now put yourself in charge of the economy in Test Your-
question in which investment is also $200, government
self Question 2, and suppose that full employment
purchases are also $500, net exports are also $30, and the
comes at a GDP of $1,840. How can you push income up
price level is also fixed. But taxes now vary with income
to that level?
and, as a result, the consumption schedule looks like the
following:


DI C
GDP Taxes
$1,360 $320 $1,040 $810
1,480 360 1,120 870
1,600 400 1,200 930
1,720 440 1,280 990
1,840 480 1,360 1,050




| DISCUSSION QUESTIONS |
1. The federal budget for national defense has increased 5. (More difficult) Advocates of lower taxes on capital
substantially to pay for the Iraq war. How would GDP gains argue that this type of tax cut will raise aggregate
in the United States have been affected if this higher de- supply by spurring business investment. Compare the
fense spending led to effects on investment, aggregate supply, and tax rev-
enues of three different ways to cut the capital gains tax:
a. larger budget deficits?
a. Reduce capital gains taxes on all investments, includ-
b. less spending elsewhere in the budget, so that total
ing those that were made before tax rates were cut.
government purchases remained the same?
b. Reduce capital gains taxes only on investments made
2. Explain why G has the same multiplier as I, but taxes
after tax rates are cut.
have a different multiplier.
c. Reduce capital gains taxes only on certain types of in-
3. If the government decides that aggregate demand is ex-
vestments, such as corporate stocks and bonds.
cessive and is causing inflation, what options are open
to it? What if the government decides that aggregate de- Which of the three options seems most desirable to you?
mand is too weak instead? Why?
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.




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

Chapter 11 235
Managing Aggregate Demand: Fiscal Policy



| APPENDIX A | Graphical Treatment of Taxes and Fiscal Policy
Most of the taxes collected by the U.S. government” F I GU R E 9
indeed, by all national governments”rise and fall The Consumption Schedule with Fixed versus
with GDP. In some cases, the reason is obvious: Per- Variable Taxes
sonal and corporate income-tax collections, for example,
depend on how much income there is to be taxed. C1
Sales tax receipts depend on GDP because consumer




Real Consumer Spending
spending is higher when GDP is higher. However, C2
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 Real GDP
schedule shifts downward in a parallel manner, as was
depicted in Figure 1 in the chapter (page 223). case in which the government collects taxes equal to
But many tax policies actually change disposable 20 percent of GDP. Notice that C2 is flatter than C1. This
income by larger amounts when incomes are higher. is no accident. In fact, as pointed out in the chapter:
That is true, for example, whenever Congress alters
Variable taxes such as the income tax flatten the con-
the tax rates imposed by the personal income tax, as it
sumption schedule in a 45° line diagram.
did in 2001 and 2003. Because higher tax rates de-
crease disposable income more when GDP is higher, the We can easily understand why. Column (1) of Table 1
C schedule shifts down more sharply at higher income shows alternative values of GDP ranging from $4.5
levels than at lower ones, as depicted in Figure 8. The trillion to $7.5 trillion. Column (2) then indicates that
same relationships apply for tax decreases, as the up- taxes are always one-fifth of this amount. Column (3)
ward shift in the figure shows. subtracts column (2) from column (1) to arrive at dis-
posable income (DI). Column (4) then gives the
F I GU R E 8 amount of consumer spending corresponding to each
level of DI. The schedule relating C to Y, which we
How Variable Taxes Shift the Consumption Schedule
need for our 45° line diagram, is therefore found in
columns (1) and (4).
Variable tax cut

<<

. 69
( 126 .)



>>