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Chapter 12
Fiscal Policy, Incentives, and Secondary Effects
OUTLINE
I. Fiscal Policy, Borrowing, and the Crowding-Out Effect
A. Crowding-out Effect indicates that the increased borrowing to finance a budget deficit
will increase real interest rates and thereby retard private spending. Thus, fiscal policy
is not very potent.
B. The implications of the crowding-out analysis are symmetrical. Restrictive fiscal
II. Fiscal Policy, Future Taxes, and the New Classical Model
A. The new classical view stresses that debt financing merely substitutes higher future
taxes for lower current taxes. Thus, budget deficits affect the timing of taxes, but not
their magnitude.
B. Argues that when debt is substituted for taxes, people will save the increased income
so they will be able to pay the higher future taxes. Thus, the budget deficit does not
stimulate aggregate demand.
III. Political Incentives and the Effective Use of Discretionary Fiscal Policy
A. Public choice analysis indicates that legislators are delighted to spend money on
programs that directly benefit their own constituents but are reluctant to raise taxes
because they impose a visible cost on voters.
IV. Is Discretionary Fiscal Policy an Effective Stabilization Tool?
A. Proper timing of discretionary fiscal policy is both difficult to achieve and crucially
important.
B. Automatic stabilizers reduce fluctuations in aggregate demand and help keep the
economy on track..
C. Fiscal policy is much less potent than the early Keynesian view implied
V. The Supply-Side Effects of Fiscal Policy
A. From a supply-side viewpoint, the marginal tax rate is of crucial importance. A
reduction in marginal tax rates increases the reward derived from added work,
investment, saving, and other activities that become less-heavily taxed.
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B. High marginal tax rates will tend to retard total output because they
will:
2. Adversely affect the rate of capital formation and the efficiency of
its use.
3. Encourage individuals to substitute less-desired tax-deductible goods for more
desired nondeductible goods.
C. Thus, changes in marginal tax rates, particularly high marginal rates, may exert an
impact on aggregate supply because the changes will influence the relative
attractiveness of productive activity in comparison to leisure and tax avoidance.
D. Impact of Supply-Side Effects
VI. Fiscal Policy and Recovery From Recessions
A. Will Fiscal Stimulus Speed Recovery?
1. Keynesians believe that increases in government spending financed by borrowing
will speed recovery from a severe recession because:
a. the expansion in government spending will offset reductions in private
2. Non-Keynesian critics argue that increased government spending and expanded
debt will adversely affect both recovery and long-term growth because:
a. The expansion in government debt will mean higher future interest payments
and tax rates that will retard future growth.
B. Tax Cuts Versus Spending Increases
1. Some argue that increases in government spending will expand GDP by more than
2. Tax cuts can generally begin to exert an impact on the economy more rapidly than
spending increases.
126 Chapter 12/Fiscal Policy, Incentives, and Secondary Effects
VII. U.S. Fiscal Policy: 1990-2013
A. Fiscal Policy Indicators, 1990-2013.
2. Both real government spending and federal spending as a share of GDP grew far
more rapidly during 2000 2010 than during the 1990s.
4. Thus, both government spending and the federal budget indicate that fiscal policy
B. Fiscal Policy During the Great Recession
1. As the economy dipped into the recession of 2008-2009, both the Bush and Obama
2. Was the expansionary fiscal policy effective?
C. Is the U.S. on the Path to a Debt Crisis?
1. Total federal debt as a share of GDP rose to more than 100% in 2012, its highest
level since World War II.
OBJECTIVES
The Keynesian perspective indicates that fiscal policy is highly potent, but there are alternative
views on this topic. The chapter discusses alterative views including the effects of interest rate
crowding-out, and the new classical model. The chapter also considers the political incentives
associated with discretionary fiscal policy and the role of fiscal policy as a stabilization tool.
While the chapter focuses on the demand-side effects of fiscal policy, the supply-side effects
are also integrated into the analysis. An overview of fiscal policy in the United States during the
past two decades is also presented.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Exhibit 1 presents the interest rate crowding-out theory of fiscal policy. According to this
theory, a budget deficit increases the demand for loanable funds and, during normal times,
2. Exhibit 3 provides a graphic illustration of the new classical theory. According to this view,
decision makers will anticipate the impact of the higher future taxes on their wealth. Thus, they
3. While macroeconomists have developed alternative theories of fiscal policy during recent
4. Note to students that one of the difficulties in implementing supply-side fiscal policy changes
is the difficulty of making binding long-term political commitments to the effect that the
incentives being improved today will stay improved tomorrow. If, say, taxes are only expected
5. Emphasize that supply-side economics is broader than just arguing for lower tax rates. It
argues that wherever incentives toward production and mutually beneficial exchange are most
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
4. The answer to this question is a point of contention among economists. Keynesians argue
that the answer to this -out and new classical economists
6. Today, most economists do not believe that persistent discretionary shifts in fiscal policy are
likely to help promote stability, particularly in a country like the United States with checks
and balances built into the political system. The problem is timing. If changes in fiscal policy
8. It will increase the amount of rent seeking and thus harm long-term economic growth. When
taxes take a larger share of income, the reward derived from innovation is reduced.
9. Keynesians believe that fiscal policy exerts a strong impact on aggregate demand, but both
the crowding-out and new classical economists disagree. The transition from budget deficits
11. The unemployment in 2011 was 8.9 percent. The growth rate in real GDP was -3.5% in 2009,
12. The lower marginal tax rates increased the share of taxes paid by high-income taxpayers. The