Tax and Fiscal Policy: Fiscal Policy

Taxes and Government Spending

Fiscal policy describes two governmental actions by the government. The first is taxation. By levying taxes the government receives revenue from the populace. Taxes come in many varieties and serve different specific purposes, but the key concept is that taxation is a transfer of assets from the people to the government. The second action is government spending. This may take the form of wages to government employees, social security benefits, smooth roads, or fancy weapons. When the government spends, it transfers assets from itself to the public (although in the case of weaponry, it is not always so obvious that the population holds the assets). Since taxation and government spending represent reversed asset flows, we can think of them as opposite policies.

In the first macroeconomic SparkNote on measuring the economy we learned that output, or national income, can be described by the equation Y = C + I + G + NX where Y is output, or national income, C is consumption spending, I is investment spending, G is government spending, and NX is net exports. This equation can be expanded to represent taxes by the equation Y = C(Y - T) + I + G + NX. In this case, C(Y - T) captures the idea that consumption spending is based on both income and taxes. Disposable income is the amount of money that can be spent on consumption after taxes are removed from total income. The new form of the output, or national income, equation reflects both elements of fiscal policy and is most useful for analysis of the effects of fiscal policy changes.

Types of Fiscal Policy

The government has control over both taxes and government spending. When the government uses fiscal policy to increase the amount of money available to the populace, this is called expansionary fiscal policy. Examples of this include lowering taxes and raising government spending. When the government uses fiscal policy to decrease the amount of money available to the populace, this is called contractionary fiscal policy. Examples of this include increasing taxes and lowering government spending.

There is another way to interpret the terms expansionary and contractionary when discussing fiscal policy. If we look at the effects of fiscal policy on the economy as a whole rather than on the individual, we see that expansionary fiscal policy increases the output, or national income, while contractionary fiscal policy decreases the output, or national income. Thus, there are two basic classes of effects of fiscal policy, those that deal with the individual and those that deal with the economy at large.

Let us first work through how expansionary fiscal policy functions. Recall that lowering taxes and raising government spending are both forms of expansionary fiscal policy. When the government lowers taxes, consumers have more disposable income. In terms of the economy as a whole, this is represented in the output equation Y = C(Y - T) + I + G + NX, where a decrease in T, given a stable Y, leads to an increase in C, and ultimately to an increase in Y. Raising government spending has similar effects. When the government spends more on goods and services, the population, which provides those goods and services, receives more money. In terms of the economy as a whole, this is again represented by Y = C(Y - T) + I + G + NX, where an increase in G leads to an increase in Y. Thus, expansionary fiscal policy makes the populace wealthier and increases output, or national income.

Let us now work through how contractionary fiscal policy functions. Recall that raising taxes and lowering government spending are both forms of contractionary fiscal policy. When the government raises taxes, consumers are forced to put a larger portion of their income toward taxes, and thus disposable income falls. In terms of the economy as a whole, this is represented by Y = C(Y - T) + I + G + NX where an increase in T results in a decrease in Y, holding all other variables fixed. When the government reduces government spending, the recipients of government spending, the populace, have less disposable income. In terms of the economy as whole, this is represented by Y = C(Y - T) + I + G + NX where a decrease in G results in a decrease in Y. Contractionary fiscal policy makes the populace less wealthy and decreases output, or national income.

Fiscal Policy Multipliers

While expansionary and contractionary fiscal policy both directly affect the national income, the ultimate change in output is not always equal to the policy change. That is, there are factors that increase or decrease the efficacy of fiscal policy. These factors are called multipliers. In particular, there are two types of multipliers. There are tax multipliers and government spending multipliers. Each of these will be discussed in detail in the proceeding paragraphs.

Tax multipliers are based on the population's willingness to consume. The marginal propensity to consume, or MPC, is a measure of that willingness. It is defined as the amount of an additional dollar of income that a consumer will spend on goods and services. The MPC can have a value between 0 and 1. A small MPC represents a large amount of savings and a small amount of consumption. A large MPC represents a small amount of savings and a large amount of consumption. When a tax decrease occurs, consumers will spend part of the money and save part of it. Therefore, the actual change in national income as a result of a change in tax policy is equal to [(+ or -) change in taxes * - MPC] / (1 - MPC). The resulting number is called the tax multiplier.

There is also a multiplier for government spending. This multiplier is derived in a different way. When the government increases purchases, it directly increases output, or national income. But, there is a greater effect than just the actual amount of increase in government purchases. When the government spends more, the populace receives more. That is, because the population is the target of increased government spending, personal incomes, and thus consumption, increases. Once again, the size of this increase is based on the MPC. The total change in output as a result of a change in government purchases is equal to (change in government purchases) / (1 - MPC). This number is called the government spending multiplier.

Let us work through a couple of examples. The first one will deal with tax policy. What is the total change in output from a tax cut of $20 million if the MPC is 0.8? To solve this, simply plug these numbers into the tax multiplier, that is [(change in taxes) * -MPC] / (1 - MPC). This becomes [($-20 million) * -0.8] / (1 - 0.8) = $80 million. This means that a $20 million tax cut will yield an $80 million increase in output. What is the process this equation models? Simply put, when consumers have more disposable income, they spend some and save some. The money that they spend goes back into the economy and is saved and spent by somebody else. This process continues, and eventually the final change in output created by a tax cut is significantly larger than the initial tax cut itself.

The second example we will work through deals with government spending policy. What is the total change in output from an increase in government spending equal to $20 million if the MPC is 0.8? To solve this, simply plug these numbers into the government spending multiplier: (change in government purchases) / (1 - MPC). This becomes ($20 million) / (1 - 0.8) = $100 million. A $20 million increase in government spending will cause a $100 million increase in output. When government spending increases, the populace, as the recipient of this spending, has more disposable income. When consumers have more disposable income, they spend some and save some. The money that they spend goes back into the economy and is saved and spent by somebody else. This process continues. Eventually the final change in output created by a tax cut, as in the previous example, is significantly larger than the initial tax cut itself.

Interest Rates and Fiscal Policy

Fiscal policy has a clear effect upon output. But there is a secondary, less readily apparent fiscal policy effect on the interest rate.

Basically, expansionary fiscal policy pushes interest rates up, while contractionary fiscal policy pulls interest rates down. The rationale behind this relationship is fairly straightforward. When output increases, the price level tends to increase as well. This relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level rises, people demand more money to purchase goods and services. Given that there is no change in the money supply, this increased demand for money leads to an increase in the interest rate. The opposite is the case with contractionary fiscal policy. When output decreases, the price level tends to fall as well. Again, this relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level falls, people demand less money to purchase goods and services. Given that there is no change in the money supply, this decreased demand for money leads to a decrease in the interest rate. This is how fiscal policy affects the interest rate.

The next SparkNote presents a more complex and realistic explanation of the effects of fiscal policy on output in the short and long runs.

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