Government Budgets and Fiscal Policy

This is Unit Fourteen of Principles of Macroeconomics, part one of two: government budgets and fiscal policy. Unit thirteen followed one currency out into the world. This unit turns to what a government spends and how it pays for it. Carry one idea through. This subject is measured in quantities that are easy to confuse — a flow against a stock, a share against a sum, a marginal rate against an average one — and most of the errors here are errors about which quantity is being discussed. And where the model does speak, it gives a direction and never an instrument: whether to expand by spending more or taxing less is a political question wearing an economic costume, and the course says so rather than pretending otherwise. By the end you will compute deficits and the debt, say why a debt ratio can fall while debt rises, classify a tax from a table, name a fiscal action and the direction demand moves, and tell discretionary policy from an automatic stabiliser.

Four entries on the budget quantities themselves, and the distinction students lose most often.

The three budget states.

MAC 1301 Deficit, Surplus, Balanced Budget

A government runs a budget deficit when spending exceeds revenue in a year, a budget surplus when revenue exceeds spending, and a balanced budget when the two are equal. All three describe one year, not a stock of anything. The minus sign is usually dropped when a deficit is reported.

The distinction most often lost.

MAC 1302 The Deficit Is Not the Debt

The deficit is one year's gap between spending and revenue. The debt is the accumulation of every past deficit less every past surplus. One is a flow and the other is a stock. Borrowing ten thousand a year for four years is a ten-thousand deficit and a forty-thousand debt. A falling deficit still adds to the debt, and only a surplus reduces it.

Doing that arithmetic.

MAC 1303 Computing Deficits and the Debt

Given a run of years, compute each year's balance and the debt at the end, taking the years one at a time and carrying the debt forward: add a deficit, subtract a surplus. The debt is the running total, and the deficit is never the total. Start with a debt of five hundred billion. A deficit of a hundred and twenty takes it to six hundred and twenty. A deficit of ninety takes it to seven hundred and ten. A deficit of forty takes it to seven hundred and fifty. Then a surplus of thirty brings it down to seven hundred and twenty. Read the pattern: the deficit shrank across three years and the debt rose in every one of them, and only when the balance turned positive did the debt fall. A shrinking deficit is often reported as the debt improving, and those are different claims — a government can honestly announce a smaller deficit while its debt reaches a record.

The denominator that matters.

MAC 1304 Measuring Against GDP

Budget figures are compared across years and countries as shares of GDP, not as sums of money, because a given deficit means something different in a large economy than in a small one, and prices change over time. This is unit three's real-against-nominal problem applied to budgets. A record deficit in dollars may be modest as a share of output.

Three entries on what the money buys, the governments that cannot borrow, and a ratio that can fall while the debt grows.

What the money buys.

MAC 1305 Where the Money Goes

Federal spending concentrates in four places: national defence, retirement benefits, health programmes, and interest on the debt. Defence has fallen as a share of output over decades while retirement and health have risen. Interest is the one item bought by past borrowing rather than by current choice. No share is voiced here, because the anchor's own text and summary disagree on the totals.

Governments that cannot borrow.

MAC 1306 State and Local Budgets Work Differently

State and local governments spend heavily on education, and nearly all of them operate under balanced-budget rules, so they must close gaps in the same year by raising taxes or cutting spending. That forces contraction exactly when a recession has opened the gap, so one level of government can work against another's stabilisation.

A ratio that can fall.

MAC 1307 The Debt Ratio Can Fall While Debt Rises

Compute the debt-to-GDP ratio across years and see what governs it. The ratio has a numerator and a denominator and both move, so a country can run a deficit every year and still watch the ratio fall, provided output grows faster than the debt. Take a debt of seven hundred and twenty billion against GDP of three thousand billion, a ratio of twenty-four percent. A deficit of sixty takes the debt to seven hundred and eighty. If GDP grows five percent to three thousand one hundred and fifty, the ratio rises to about twenty-four point eight percent. With GDP growing ten percent to three thousand three hundred, the ratio falls to about twenty-three point six. The borrowing was identical; growth decided the direction. This is why growth appears in every serious discussion of debt, and it cuts both ways: growth is not a lever that can be pulled at will, and a recession moves both terms the wrong way at once.

Five entries on how the revenue is raised, and two confusions that follow.

Three tax structures.

MAC 1308 Three Tax Structures

A tax is progressive if it takes a larger share of income as income rises, proportional if it takes the same share at every income, and regressive if it takes a smaller share as income rises. The test is always the share of income paid, never the amount. A regressive tax can still collect more dollars from a richer payer.

Sorting one from a table.

MAC 1309 Classifying a Tax from a Table

Given incomes and tax paid, compute tax as a share of income at each level and read the direction of the shares: rising means progressive, constant means proportional, falling means regressive. Take incomes of twenty thousand, fifty thousand and a hundred thousand. A tax collecting two, five and ten thousand takes ten percent at every level, so it is proportional. One collecting one, four and twelve thousand takes five, eight and twelve percent, so it is progressive. One collecting sixteen hundred, three thousand and four thousand takes eight, six and four percent, so it is regressive. Notice the dollars collected rise with income under all three, including the regressive one. That is the whole trap: the regressive tax took four thousand from the highest earner and sixteen hundred from the lowest, and it is still regressive, because four thousand is a smaller slice of a hundred thousand than sixteen hundred is of twenty thousand.

A second confusion about rates.

MAC 1310 Marginal Is Not Average

A marginal tax rate applies to the next dollar earned, not to every dollar. Moving into a higher bracket raises the rate on the income above the threshold only, so the average rate paid stays below the marginal rate. This is the same marginal-against-average distinction as unit nine's propensity to consume. A raise cannot leave someone worse off through brackets alone.

Where the revenue comes from.

MAC 1311 Where Federal Revenue Comes From

Two taxes dominate federal revenue: the individual income tax, which is the largest single source, and the payroll tax that funds retirement and health programmes. Most households pay more in payroll tax than income tax. Corporate income, excise and estate taxes make up the remainder. No rate or threshold is voiced here, because the anchor's are out of date.

How taxes reach the economy.

MAC 1312 Taxes Reach the Economy Three Ways

Taxes act on the economy through three channels. They change disposable income and so consumption. They change after-tax profits and so investment. And payroll taxes change the cost of hiring and so employment. Each channel enters aggregate demand at a different component, so a tax change can have effects the headline rate does not show.

Four entries on using the budget deliberately, and on what the model will not decide for you.

Using the budget deliberately.

MAC 1313 Fiscal Policy Shifts Aggregate Demand

Fiscal policy is the deliberate use of spending and taxation to move aggregate demand. Expansionary policy shifts it right to close a recessionary gap; contractionary policy shifts it left to close an inflationary gap. The target is the gap between actual output and potential. Most government spending and taxing is done for reasons other than stabilisation.

The three ways to expand.

MAC 1314 Three Expansionary Channels

Expansionary fiscal policy has three routes. Raise household disposable income through tax cuts or transfers, so consumption rises. Raise after-tax profits through business tax measures, so investment rises. Or raise government purchases directly, which is how grants to state and local governments work. Contractionary policy runs all three in reverse.

What the model will not decide.

MAC 1315 Spending or Taxes: The Model Does Not Choose

The model says a recessionary gap calls for expansion. It does not say whether to expand by spending more or taxing less, because both shift aggregate demand right, and that choice turns on what people think government should do. Both sides of that argument use the same diagram, correctly. This is a political question wearing an economic costume, and the course says so.

Reading the situation first.

MAC 1316 Which Action, and Which Way

From a description of the economy, name an appropriate fiscal action and the direction aggregate demand moves, in two steps: locate output against potential, then choose the direction. Only after that does the instrument arise, and the model is silent on it. Output below potential with high unemployment is a recessionary gap, so the action is expansionary and demand shifts right. Output above potential with inflation rising is an inflationary gap, so the action is contractionary and demand shifts left. Now the harder case: output below potential while inflation is also rising, which unit eight identified as a supply shock. Expanding demand raises output and worsens inflation; contracting does the reverse. Fiscal policy moves aggregate demand, so it can address a problem caused by aggregate demand — when the trouble came from the supply side, every available move improves one half and worsens the other.

Three entries on how much a measure moves, what it cannot do, and the school that aims elsewhere.

Why the two routes differ.

MAC 1317 A Spending Change Moves More

An equal-sized spending change and tax change do not move output equally. Government purchases enter demand in full, while a tax cut reaches households as income and only a fraction is spent. Unit nine worked this: the ratio between the two effects is the propensity to consume. Transfer payments behave like tax cuts here, for the same reason.

What fiscal policy cannot do.

MAC 1318 The Limit of Fiscal Policy

Fiscal policy can move output toward potential. It cannot push output past potential for long, because beyond that point extra demand meets a supply limit and raises the price level instead, so the gap is both the target and the ceiling. Demand policy also cannot restore jobs in a sector that has permanently shrunk.

The school that aims elsewhere.

MAC 1319 Supply-Side Economics

Supply-side economics is a school arguing that fiscal policy should aim at long-run aggregate supply rather than demand, using lower tax rates to encourage work and investment incentives to build capital. On its account both supply curves shift right, so potential output itself rises. How large those effects are against demand-side ones is disputed, and the course leaves it disputed.

Two entries on the fiscal policy that needs no decision at all.

Policy that needs no decision.

MAC 1320 Discretionary and Automatic

Discretionary fiscal policy requires a new decision and a new law. Automatic stabilisers are already written into existing law and respond on their own as the economy moves, with no decision by anyone. Income taxes and unemployment benefits are the two main ones. Both change the budget balance, and only one of them was chosen this year.

How the automatic kind works.

MAC 1321 How Stabilisers Work

In a downturn, incomes fall so tax collections fall automatically, and more people qualify for benefits so transfer spending rises. Both cushion disposable income, and both widen the deficit without any new legislation. In a boom the same mechanisms run backwards and narrow the deficit. They act immediately, which is their advantage over every discretionary measure.

Look at what you can now do. You can compute deficits and the debt across a run of years, and say why a falling deficit and an improving debt are different claims. You can say why a debt ratio can fall while the debt rises, because growth moves the denominator. You can classify a tax from a table by reading shares rather than dollars, since the dollars rise under all three structures. You can locate output against potential, name a fiscal action and say which way demand moves — and say when a supply shock makes every move improve one half of the problem. And you can tell discretionary policy from an automatic stabiliser, by asking whether anyone had to decide. Part two measures the two apart, and asks why the deliberate kind so often disappoints.