Budget and Fiscal Policy

Budget and Fiscal Policy

Income Tax Structure

Ø  Progressive Income Tax – An income tax system in which one’s tax rate rises as one’s taxable income rises (up to some point).

Ø  Proportional Income Tax – An income tax system in which one’s tax rate is the same no matter what one’s taxable income is.

Ø  Regressive Income Tax – An income tax system in which one’s tax rate declines as one’s taxable income rises.

Income Tax Structure In Bangladesh

Three Income Tax Structures

Structural and Cyclical Deficits

Ø Structural Deficit – The part of the budget deficit that would exist even if the economy were operating at full employment.

Ø Cyclical Deficit – The part of the budget deficit that is a result of a downturn in economic activity.

Public Debt

The total amount the federal government owes its creditors.

Self-test Questions

ØExplain the differences among progressive, proportional, and regressive income tax structures.

ØWhat percentage of all income taxes was paid by the top 5 percent of income earners in 2005? What percentage of total income did this income group receive in 2005?

ØWhat three taxes account for the bulk of federal tax revenues?

ØWhat is the cyclical budget deficit?

Fiscal Policy

Changes in government expenditures and/or taxes to achieve particular  economic goals, such as low unemployment, stable prices, and economic growth.

Fiscal Policy

Ø   Expansionary Fiscal Policy – Increases in government expenditures and/or decreases in taxes to achieve particular economic goals.

Ø   Contractionary Fiscal Policy – Decreases in government expenditures and/or increases in taxes to achieve particular economic goals.

Ø   Discretionary Fiscal Policy- Deliberate changes of government expenditures and/or taxes to achieve particular economic goals.

Ø   Automatic Fiscal Policy – Changes in government expenditures and/or taxes that occur automatically without (additional)  congressional action.

Fiscal Policy Assumptions

Ø Consider discretionary fiscal policy only

Ø Government spending is due to a change in government purchases and not to a change in transfer payments

Expansionary Fiscal Policy
for a Recessionary Gap

Contractionary Fiscal Policy
for an Inflationary Gap

Crowding Out I

The decrease in private expenditures that occurs as a consequence of increased government spending (direct effect) or the financing needs of the budget deficit (indirect effect).

Crowding Out II

Ø  Complete Crowding Out – A decrease in one or more components of private spending completely offsets the increase in government spending.

Ø  Incomplete Crowding Out – The decrease in one or more components of private spending only partially offsets the increase in government spending.

Crowding Out III

Expansionary Fiscal Policy
Crowding Out, and Changes in Real GDP and the Unemployment Rate

Lags and Fiscal Policy

Ø The data lag. Policymakers are not aware of changes in the economy as soon as they happen.

Ø The wait-and-see lag. After policymakers are aware of a downturn in economic activity they rarely enact counteractive measures immediately. They want to be sure that the observed events are not just short-run phenomena.

Lags and Fiscal Policy

Ø The legislative lag. After policymakers decide that some type of fiscal policy measure is required, the government will have to propose the measure, build political support for it, and get it passed.

Ø The transmission lag. After enacted, a fiscal policy measure takes time to be put into effect.

Ø The effectiveness lag. After a policy measure is actually implemented, it takes time to affect the economy.

Fiscal Policy May Destabilize the
Economy

Fiscal Policy May Destabilize the
Economy

Self-test Questions

Ø How does crowding out question the effectiveness of expansionary demand-side fiscal policy?

Ø How might lags reduce the effectiveness of fiscal policy?

Ø Give an example of the indirect effect of crowding out.

Supply-Side Fiscal Policy

Laffer Curve

Ø  The curve, named after Arthur Laffer, that shows the relationship between tax rates and tax revenues.

Ø  According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall with further increases in tax rates.

Laffer Curve

Ø  When the tax rate is either 0 or 100 percent, tax revenues are zero.

Ø  Starting from a zero tax rate, increases in tax rates first increase (region A to B) and then decrease (region B to C) tax revenues

Tax Rates, the Tax Base, and Tax Revenues

Ø   Tax revenues equal the tax base times the (average) tax rate.

Ø   If the percentage reduction in the tax rate is greater than the percentage increase in the tax base, tax revenues decrease (Case 1).

Ø   If the percentage reduction in the tax rate is less than the percentage increase in the tax base, tax revenues increase (Case 2). All numbers are in billions of dollars.

Self-test Questions

Ø Give an arithmetic example to illustrate the difference between the marginal and average tax rates.

Ø If income tax rates rise, will income tax revenues rise too?

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