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Additional Issues for Classroom Discussion
1. Should the Tax System Be Reformed?
People spend a huge amount of resources both paying taxes and preparing tax returns. Should the U.S. tax
system be fundamentally reformed? If so, how?
To organize the discussion of this issue, you may want to ask your students to think about the following
issues:
2. Should the Social Security System Invest in the Stock Market?
One solution to the coming crisis in the Social Security system is to allow the trust fund to invest in the
stock market, which has a higher return, on average, than the government bonds that the fund currently
buys. Should we allow the fund to invest in stocks?
The advantage of investing in the stock market is that the returns have been substantially larger to stocks
1. The major sources of government outlays are government purchases, transfer payments, and net
interest payments. The major sources of government revenues are personal taxes, contributions for
social insurance, indirect business taxes, and corporate taxes. The federal government’s outlays and
revenues differ from those of state and local governments in that: (1) most spending on nondefense
2. The overall budget deficit equals the primary budget deficit plus net interest payments. Both concepts
are useful. The overall deficit tells how much the government must borrow currently to pay for its
outlays. The primary deficit tells whether current revenues are sufficient to pay for current programs.
Net interest payments are ignored in the primary deficit because they are due to the borrowing for
expenditures in the past.
3. The government deficit is the change in the government debt. A large change in the debt-GDP ratio
can be caused by: (1) a high deficit relative to GDP, and (2) a slow growth rate of nominal GDP.
4. Fiscal policy affects the macroeconomy in three ways: (1) aggregate demand effects, (2) government
capital formation, and (3) incentive effects.
The aggregate demand channel affects the macroeconomy because expansionary fiscal policy
shifts the IS curve up and to the right, causing the AD curve to shift up and to the right as well.
Both classicals and Keynesians agree that an increase in government spending shifts the IS and AD
5. An automatic stabilizer is a provision in the budget that causes government spending to rise or taxes
to fall automatically (without legislative action) when GDP falls. An example is unemployment
6. An example would be no tax on income below $15,000, then a tax at 20% on income above $15,000.
Someone with income of $30,000 would pay taxes of .20($30,000 $15,000) $3000. The average
7. Increasing the tax rate increases distortions by more than reducing the tax rate (by the same amount)
reduces distortions. Varying between a high and low tax rate leads to a greater average distortion than
8. Government debt is a potential burden on future generations in two ways. First, if tax rates must be
raised in the future to pay off the debt, then the economy will operate less efficiently in the future
because of the increased distortions from the higher tax rates. Second, government deficits may
reduce national saving, so the economy accumulates less capital and future output will be lower.
9. Ricardian equivalence might not hold if people face borrowing constraints, if they are shortsighted,
if they fail to leave bequests, or if taxes aren’t lump sum.
10. The inflation tax, or seignorage, arises when the government raises revenue by printing money.
The inflation tax is equal to the inflation rate times the real money supply in an all-currency economy
in which the money multiplier equals 1. (More generally, the inflation tax collected by the
government equals the inflation rate multiplied by the monetary base.) The government collects the
1. The following table shows the categories of the budget:
Transfer payments 100 50 150
Grants in aid 100 0 100
Net interest paid 90 30 60
Total Outlays 490 170 660
0.10 100 in interest on its debt. Of this amount, since provincial governments hold debt of 200,
they get 200 0.10 20 in interest, while the private sector gets the other 80 in interest payments.
2. In the year in which the transfer is made, both the deficit and the primary deficit increase by $1 billion.
In the next year, the deficit increases by the amount of the increased interest payments, which total
3. Deficit G TR INT T 1800 (800 0.05Y) 100 (1000 0.1Y) 1700 0.15Y.
The full-employment budget deficit is the deficit that would occur if the economy were
1700 (0.15 10,000) 200.
(a) When Y 12,000, the deficit is 1700 (0.15 12,000) 100. This is smaller than the full-
employment deficit of 200.
(b) When Y 10,000, the deficit is 200 (as calculated above), which is equal to the full-employment
4. (a) In this situation, someone earning income Y between $8000 and $20,000 pays a total
tax of T 0.25 (Y $8000), while someone earning between $20,000 and $30,000 pays
tax of T $3000 0.30 (Y $20,000).
Someone with income of $16,000 then pays tax of 0.25($16,000 $8000) $2000. This
gives an average tax rate of $2000/$16,000 12.5%, while the marginal tax rate is 25%.
5. If workers value their leisure at 90 goods per day, then 90 goods per day must be the equilibrium
value of the after-tax real wage.
90 250 N, or N 160. Output is Y 250N 0.5N2 (250 160) (0.5 1602) 27,200. The
after-tax real wage equals (1 t) pre-tax real wage; so 90 (1 0) pre-tax real wage; so the
24,050. The cost of the distortion in terms of lost output is 27,200 24,050 3150.
(c)The after-tax real wage equals (1 t) pre-tax real wage; so 90 (1 0.5) pre-tax real wage; so the
pre-tax real-wage 90/0.5 180. Setting the pre-tax real wage equal to the marginal product of
labor gives 180 250 N, or N 70. Output is Y (250 70) (0.5 702) 15,050. The cost
6. (a) To find the largest nominal deficit that the government can run without raising the debt-GDP
ratio, use Eq. (15.4) and set the change in the debt-GDP ratio equal to zero. The equation is:
Change in debt–GDP ratio deficit/nominal GDP [(total debt/nominal GDP) growth rate of
nominal GDP]. Plugging in the values of the known variables and setting the change in the debt-
GDP ratio equal to zero gives: 0 (deficit/nominal GDP) [(1000/nominal GDP) 0.10].
0 (deficit/10,000) [(6,000/10,000) 0.05], so deficit 300.
7. (a) The debt-GDP ratio is .10 at the start. After n years it is .10(1.07/1.05)n. After one year it is .102,
after two years it is .104, after five years it is .110, and after ten years it is .121.
If after n years the debt-GDP ratio is 10, we want to find n such that .10(1.07/1.05)n 10. Taking
logarithms of both sides of this equation and solving shows that the debt-GDP ratio exceeds 10
8. L 0.2Y 500i 0.2Y 500r 500. With Y 1000, L 200 500r 500.
(a) When r 0.04, equating real money supply to money demand gives: M/P L 200 (500
0.04) 500 180 500. Real seignorage revenue R M/P 180 5002. The following
table shows seignorage revenue (R) for inflation rates between 0 and 0.30. These values are
0.00 0.0
0.02 3.4 0.12 14.4 0.22 15.4
0.04 6.4 0.14 15.4 0.24 14.4
0.06 9.0 0.16 16.0 0.26 13.0
0.08 11.2 0.18 16.2 0.28 11.2
0.10 13.0 0.20 16.0 0.30 9.0
(b) Seignorage is maximized at 0.18.
0.08) 500 160 500. Real seignorage revenue R M/P 160 5002. The following
table shows seignorage revenue (R) for inflation rates between 0 and 0.30. These values are
0.00 0.0
0.02 3.0 0.12 12.0 0.22 11.0
0.04 5.6 0.14 12.6 0.24 9.6
0.06 7.8 0.16 12.8 0.26 7.8
0.08 9.6 0.18 12.6 0.28 5.6
0.10 11.0 0.20 12.0 0.30 3.0
The maximum seignorage of 12.8 is attained when 0.16.
9. (a) The monetary base is growing at a 10% rate, so it increases by 0.1 $250 $25. The nominal
value of seignorage over the year is $25.
(b) Deposit holders pay the inflation tax on their non-interest-bearing deposits of $600 0.10 $60.
This amount is received by banks. Banks pay the inflation tax on their non-interest-bearing
reserves of $50 0.10 $5. Currency holders pay the inflation tax on their non-interest-bearing
1. The main reason for having a system of grants in aid from the federal government to state and local
governments is that there are nationwide benefits to education, transportation, and welfare programs,
but these programs are most efficiently administered at the state and local level. Since the benefits are
nationwide, the programs should be paid for at the national level. However, since it takes local
2. This program has very bad incentive effects. For income (y) below $10,000, a person gets a
transfer equal to $10,000 y. So for every dollar of income a person earns, he or she loses a dollar of
2000 hours per year at a wage of $4 per hour, to get labor income of $8000, the subsidy would
increase the person’s wage by 25% to $5 per hour, so he or she would earn $10,000 per year.
Unlike the first program, which increased the effective marginal tax rate on labor income to 100%,
this program increases the after-tax real wage rate by 25%, encouraging work effort.
3. (a) Begin with Eq. (15.4): Change in debt–GDP ratio deficit/nominal GDP [(total debt/nominal
GDP) growth rate of nominal GDP]. To make things easier, replace the words with symbols,
where the debt-GDP ratio B/PY, with debt B, nominal GDP PY, let i nominal interest
rate, and the primary deficit is Bp. Then Eq. (15.4) is (B/PY) B/PY [(B/PY) (PY/PY)].
In symbols, the equation that the nominal deficit equals the nominal primary deficit plus nominal
4. A balanced-budget amendment might prove useful if the government otherwise had a tendency to run
a perpetual budget deficit. The amendment would provide a mechanism for fiscal discipline, forcing
policymakers to balance the budget. But there could be significant disadvantages, since fiscal policy
wouldn’t be as flexible. In particular, automatic stabilizers kick in during a recession to increase
spending and reduce taxes, creating a budget deficit but stimulating the economy; however, these
1 For an account, see Eugene M. Lerner, “Inflation in the Confederacy, 186165,” in Milton Friedman, ed., Studies in the Quantity Theory of
Money, Chicago: University of Chicago Press, 1956.
2. The overall budget deficit equals the primary budget deficit plus net interest payments. Both concepts
are useful. The overall deficit tells how much the government must borrow currently to pay for its
outlays. The primary deficit tells whether current revenues are sufficient to pay for current programs.
Net interest payments are ignored in the primary deficit because they are due to the borrowing for
expenditures in the past.
3. The government deficit is the change in the government debt. A large change in the debt-GDP ratio
can be caused by: (1) a high deficit relative to GDP, and (2) a slow growth rate of nominal GDP.
4. Fiscal policy affects the macroeconomy in three ways: (1) aggregate demand effects, (2) government
capital formation, and (3) incentive effects.
The aggregate demand channel affects the macroeconomy because expansionary fiscal policy
shifts the IS curve up and to the right, causing the AD curve to shift up and to the right as well.
Both classicals and Keynesians agree that an increase in government spending shifts the IS and AD
5. An automatic stabilizer is a provision in the budget that causes government spending to rise or taxes
to fall automatically (without legislative action) when GDP falls. An example is unemployment
6. An example would be no tax on income below $15,000, then a tax at 20% on income above $15,000.
Someone with income of $30,000 would pay taxes of .20($30,000 $15,000) $3000. The average
7. Increasing the tax rate increases distortions by more than reducing the tax rate (by the same amount)
reduces distortions. Varying between a high and low tax rate leads to a greater average distortion than
8. Government debt is a potential burden on future generations in two ways. First, if tax rates must be
raised in the future to pay off the debt, then the economy will operate less efficiently in the future
because of the increased distortions from the higher tax rates. Second, government deficits may
reduce national saving, so the economy accumulates less capital and future output will be lower.
9. Ricardian equivalence might not hold if people face borrowing constraints, if they are shortsighted,
if they fail to leave bequests, or if taxes aren’t lump sum.
10. The inflation tax, or seignorage, arises when the government raises revenue by printing money.
The inflation tax is equal to the inflation rate times the real money supply in an all-currency economy
in which the money multiplier equals 1. (More generally, the inflation tax collected by the
government equals the inflation rate multiplied by the monetary base.) The government collects the
1. The following table shows the categories of the budget:
Transfer payments 100 50 150
Grants in aid 100 0 100
Net interest paid 90 30 60
Total Outlays 490 170 660
0.10 100 in interest on its debt. Of this amount, since provincial governments hold debt of 200,
they get 200 0.10 20 in interest, while the private sector gets the other 80 in interest payments.
2. In the year in which the transfer is made, both the deficit and the primary deficit increase by $1 billion.
In the next year, the deficit increases by the amount of the increased interest payments, which total
3. Deficit G TR INT T 1800 (800 0.05Y) 100 (1000 0.1Y) 1700 0.15Y.
The full-employment budget deficit is the deficit that would occur if the economy were
1700 (0.15 10,000) 200.
(a) When Y 12,000, the deficit is 1700 (0.15 12,000) 100. This is smaller than the full-
employment deficit of 200.
(b) When Y 10,000, the deficit is 200 (as calculated above), which is equal to the full-employment
4. (a) In this situation, someone earning income Y between $8000 and $20,000 pays a total
tax of T 0.25 (Y $8000), while someone earning between $20,000 and $30,000 pays
tax of T $3000 0.30 (Y $20,000).
Someone with income of $16,000 then pays tax of 0.25($16,000 $8000) $2000. This
gives an average tax rate of $2000/$16,000 12.5%, while the marginal tax rate is 25%.
5. If workers value their leisure at 90 goods per day, then 90 goods per day must be the equilibrium
value of the after-tax real wage.
90 250 N, or N 160. Output is Y 250N 0.5N2 (250 160) (0.5 1602) 27,200. The
after-tax real wage equals (1 t) pre-tax real wage; so 90 (1 0) pre-tax real wage; so the
24,050. The cost of the distortion in terms of lost output is 27,200 24,050 3150.
(c)The after-tax real wage equals (1 t) pre-tax real wage; so 90 (1 0.5) pre-tax real wage; so the
pre-tax real-wage 90/0.5 180. Setting the pre-tax real wage equal to the marginal product of
labor gives 180 250 N, or N 70. Output is Y (250 70) (0.5 702) 15,050. The cost
6. (a) To find the largest nominal deficit that the government can run without raising the debt-GDP
ratio, use Eq. (15.4) and set the change in the debt-GDP ratio equal to zero. The equation is:
Change in debt–GDP ratio deficit/nominal GDP [(total debt/nominal GDP) growth rate of
nominal GDP]. Plugging in the values of the known variables and setting the change in the debt-
GDP ratio equal to zero gives: 0 (deficit/nominal GDP) [(1000/nominal GDP) 0.10].
0 (deficit/10,000) [(6,000/10,000) 0.05], so deficit 300.
7. (a) The debt-GDP ratio is .10 at the start. After n years it is .10(1.07/1.05)n. After one year it is .102,
after two years it is .104, after five years it is .110, and after ten years it is .121.
If after n years the debt-GDP ratio is 10, we want to find n such that .10(1.07/1.05)n 10. Taking
logarithms of both sides of this equation and solving shows that the debt-GDP ratio exceeds 10
8. L 0.2Y 500i 0.2Y 500r 500. With Y 1000, L 200 500r 500.
(a) When r 0.04, equating real money supply to money demand gives: M/P L 200 (500
0.04) 500 180 500. Real seignorage revenue R M/P 180 5002. The following
table shows seignorage revenue (R) for inflation rates between 0 and 0.30. These values are
0.00 0.0
0.02 3.4 0.12 14.4 0.22 15.4
0.04 6.4 0.14 15.4 0.24 14.4
0.06 9.0 0.16 16.0 0.26 13.0
0.08 11.2 0.18 16.2 0.28 11.2
0.10 13.0 0.20 16.0 0.30 9.0
(b) Seignorage is maximized at 0.18.
0.08) 500 160 500. Real seignorage revenue R M/P 160 5002. The following
table shows seignorage revenue (R) for inflation rates between 0 and 0.30. These values are
0.00 0.0
0.02 3.0 0.12 12.0 0.22 11.0
0.04 5.6 0.14 12.6 0.24 9.6
0.06 7.8 0.16 12.8 0.26 7.8
0.08 9.6 0.18 12.6 0.28 5.6
0.10 11.0 0.20 12.0 0.30 3.0
The maximum seignorage of 12.8 is attained when 0.16.
9. (a) The monetary base is growing at a 10% rate, so it increases by 0.1 $250 $25. The nominal
value of seignorage over the year is $25.
(b) Deposit holders pay the inflation tax on their non-interest-bearing deposits of $600 0.10 $60.
This amount is received by banks. Banks pay the inflation tax on their non-interest-bearing
reserves of $50 0.10 $5. Currency holders pay the inflation tax on their non-interest-bearing
1. The main reason for having a system of grants in aid from the federal government to state and local
governments is that there are nationwide benefits to education, transportation, and welfare programs,
but these programs are most efficiently administered at the state and local level. Since the benefits are
nationwide, the programs should be paid for at the national level. However, since it takes local
2. This program has very bad incentive effects. For income (y) below $10,000, a person gets a
transfer equal to $10,000 y. So for every dollar of income a person earns, he or she loses a dollar of
2000 hours per year at a wage of $4 per hour, to get labor income of $8000, the subsidy would
increase the person’s wage by 25% to $5 per hour, so he or she would earn $10,000 per year.
Unlike the first program, which increased the effective marginal tax rate on labor income to 100%,
this program increases the after-tax real wage rate by 25%, encouraging work effort.
3. (a) Begin with Eq. (15.4): Change in debt–GDP ratio deficit/nominal GDP [(total debt/nominal
GDP) growth rate of nominal GDP]. To make things easier, replace the words with symbols,
where the debt-GDP ratio B/PY, with debt B, nominal GDP PY, let i nominal interest
rate, and the primary deficit is Bp. Then Eq. (15.4) is (B/PY) B/PY [(B/PY) (PY/PY)].
In symbols, the equation that the nominal deficit equals the nominal primary deficit plus nominal
4. A balanced-budget amendment might prove useful if the government otherwise had a tendency to run
a perpetual budget deficit. The amendment would provide a mechanism for fiscal discipline, forcing
policymakers to balance the budget. But there could be significant disadvantages, since fiscal policy
wouldn’t be as flexible. In particular, automatic stabilizers kick in during a recession to increase
spending and reduce taxes, creating a budget deficit but stimulating the economy; however, these
1 For an account, see Eugene M. Lerner, “Inflation in the Confederacy, 186165,” in Milton Friedman, ed., Studies in the Quantity Theory of
Money, Chicago: University of Chicago Press, 1956.
