Macroeconomics - Fiscal Policy Basics

Basics

What is fiscal policy?
Fiscal policy is the use of government taxation, spending and borrowing to satisfy macroeconomic goals.

Potential GDP
The GDP that results from an economy operating at full employment with full utilization of capital is called potential GDP.

A reduction in after-tax wages will occur with the enactment of an income tax. The supply curve of labor will therefore shift up and to the left. The new equilibrium quantity of labor hired will be less than what would have occurred with potential GDP. There will be a "wedge" between before-tax and after-tax wage rates. Taxes on expenditure increase the size of the "wedge" and further reduce employment.

Keynesians argue that if output is less than what would occur at full employment, fiscal policy should be used to stimulate aggregate demand.

There are three major ways in which fiscal policy affects aggregate demand:

1.Business Tax Policy - Business taxes can change the profitability of businesses and the amount of business investment. Lowering business taxes will increase aggregate demand and business investment spending.

2.Government Spending - Government can directly increase aggregate demand by increasing its spending.

3.Tax Policy for Individuals - Lowering taxes will increase disposable personal income and increase consumption spending.

From the Keynesian viewpoint, fiscal policy should be used to increase aggregate demand when an economy is operating at below full-employment levels. Ideally, the economy will be guided to output at the level of full employment.

If aggregate demand exceeds aggregate supply and output is at full-employment levels, fiscal policy should be used to reduce aggregate demand. This will push the economy to a point of noninflationary equilibrium.

The Supply Side Model is an economic theory holding that bolstering an economy's ability to supply more goods is the most effective way to stimulate economic growth. Supply-side theorists advocate income tax reduction because it increases private investment in corporations, facilities, and equipment.

The Laffer curve shows the relationship between tax rates and tax revenue.

Figure 4.6: The Laffer Curve

This graph shows that as the tax rate increases from zero, the amount of tax revenue collected will increase. At point T*, however, increases in the tax rate lead to decreases in the tax revenue collected. High tax rates also produce a loss to society in the sense that productive economic activity is being discouraged.

Governments would like to be at point T*, because it is the point at which the government collects maximum amount of tax revenue while people continue to work hard. This would theoretically be the point at which potential GDP is maximized.

Supply-side economists believe that high marginal tax rates, such as those experienced in the U.S. in the 1970s, diminished aggregate production without raising substantial amounts of additional tax revenue. Tax cuts during the 1980s (the Reagan presidency) are believed to have induced strong increases in supply, particularly with regards to high-income earners. Supporters of the 2001 U.S. tax cuts, which reduced the top marginal tax rates, believe that the cuts have increased economic growth through better supply-side incentives.

Tax policy also has consequences at a global level. Ireland has significantly reduced its personal and corporate tax rates; during the 1990s its growth rate was much higher than the rest of Europe. There is an association with high European tax rates and slow rates of economic growth.

Effects of Fiscal Policy
Related Articles
  1. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  2. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  3. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  4. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
  5. Godfather Offer

    An irrefutable takeover offer made to a target company by an acquiring company. Typically, the acquisition price's premium ...
Trading Center