Time lags in fiscal policy

3. Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy’s built-in stability?

Built in stabilizers increase the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers. When an economy is growing and GDP is rising, tax receipts are high because of the progressive tax system. Personal income tax, corporate tax, sales taxes and all types of taxes decline during recession. This is an automatic tax cut that helps in time of recession. If households still had to pay the same level of taxes during the recession, the economic fluctuation would be so much worse, that type is proportional tax. The last type is regressive, this is when the average tax rate decreases as the taxpayer’s income increases and increases as the taxpayer’s as the taxpayer’s income decreases.

4. Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. How might “politics” complicate fiscal policy? How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowdingout effect and why might it be relevant to fiscal policy?

A time lag refers to the time it takes for a policy to take effect- the time between a policy measure is announced and its effects are visible. When this lag is large the government may not make a sound decision. It may take a decision that yields quicker results which it can show off to voters and get back into power. This decision maybe suboptimal for the economy, but optimal for the political party. Expectations about future policy reversals keeping politics in mind can dent the effect of any announced policy. if it is expected that tax rates will be lowered in future due to political considerations of winning an election, then a current policy of higher tax rates is not effective, making the fiscal policy weak.

Crowding out refers to the dampening of the effect of a rise in government expenditures on GDP. G rises to raise GDP, but the simultaneous rise in interest rates cause a fall in investment. The later reduces GDP. The overall effect of a rise in G is therefore dampened/ muted as it gets crowded out by rising interest rates.

7. Why did the budget surpluses in 2000 and 2001 give way to a series of budget deficits beginning in 2002? Why did those deficits increase substantially beginning in 2008?

The budget surplus story was due to the stock bubble, not tax cuts and budget restraint. Bubbles are not sustainable, by definition. The stock bubble began to burst in 2000. By the summer of 2002 stocks had fallen to roughly half of their peak values destroying $10 trillion in wealth. This gave us a recession which, although officially short and mild, led to the longest period without net job creation since the Great Depression (until the current downturn). The ending of this bubble was the biggest factor turning the surplus into a deficit. Also previous administration tax cuts were very much secondary in this picture, as were wars and the Medicare drug plan. The end of the stock bubble was the end of the budget surpluses.

8. Distinguish between the total U.S. debt and the debt held by the public? Why is the debt as percentage of GDP more relevant than the total debt? Contrast the effects of paying off an internally held debt and paying off an externally held debt.

The total U.S. debt represents the total amount of money the Federal government owes to the owners of government securities. However, only a portion of that (58 percent in 2004) is held by the public; the remaining 42 percent is held by the Federal government – the government owes the money to itself. Debt as a percentage of GDP is more relevant because it is a better measure of an economy’s, or government’s ability to manage that debt. It is analogous to an individual household: the level of mortgage and other debt is only a problem if the household does not have sufficient income (GDP) to keep up with monthly payments. A $10,000 debt is a problem for someone with no income; it is not a significant burden on someone earning $100,000 per year. Paying off internally held debt is like the left hand paying the right hand; dollars are redistributed, but there is no domestic loss of wealth. Paying off externally held debt represents an outflow of wealth from the country. Note that this isn’t necessarily bad if the external debt was incurred to bring in goods or assets that facilitate domestic economic growth or serve other important priorities.