Overview
Purpose:
To show that a key element of Keynes’ contribution is that, at least in theory, the government can fine-tune tax and spending policies to reduce the severity of business cycle fluctuations.
Objectives:
1. Government spending on goods and services is an injection into the circular flow of the economy. As government purchases rise the demand for GNP rises and, assuming that the economy is below full capacity, GNP produced will rise. The rise in GNP is larger than the rise in government spending. In fact, it is equal to the rise in government spending times the multiplier.
2. Taxes have a similar but opposite effect on GNP. Moreover, the impact of taxes is indirect. A tax cut results in an increase in disposable or after-tax income. This additional income can either be saved or spent. Only that portion of the tax cut which is spent is considered an injection into the circular flow. Consequently, a tax cut of the same magnitude as a spending increase will usually have a smaller impact on GNP than the spending increase. Rises in transfer payments such as social security and welfare payments have the same impact on GNP as a tax cut.
3. Generally speaking, the larger the government deficit (taxes less spending) the larger will be the net injections into the circular flow and the larger will be the volume of the flow (GNP). The opposite is true for surpluses. Thus by changing the spending and tax policies the government can, in the abstract, stimulate growth in the economy or slow the economy down.
4. The U.S. economy also has a number of built-in stabilizers which raise the deficit (lower the surplus) in recessions and lower the deficit (raise the surplus) in recoveries. These include unemployment benefits and welfare payments which rise when GNP is falling and vice versa. The progressive structure of the U.S. tax structure also serves as a stabilizer. In a recession tax receipts are lower because of higher unemployment. This means that the deficit is larger. The reverse is true in periods of high growth.
| Key Economic Concepts aggregate demand management, budget surplus and deficit, lump-sum tax, proportional tax
progressive tax, recessionary and inflationary gaps, automatic stabilizers, balanced budget multiplier, government purchases, government transfers. |
| Contemporary Issues The 2001 recession in the U.S. was one of the mildest in the post-war period. The mildness of this downturn was in part due to aggressive interest rate cuts by the Fed. However, fiscal policy also played a big role. Tax cuts that took effect in mid-2001 helped, as the did the increase in spending on defense and homeland security in the wake of the terrorist attacks of September 11 of that year. How do tax cuts and increases in defense spending boost GDP? Dollar-for-dollar which has a bigger impact on the economy? |
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