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9 [24]
The Government
and Fiscal Policy
Appendix B: The Case in Which Tax Revenues Depend on Income p. 183 [503]
Explain why the multiplier falls when taxes depend on income.
Visit www.myeconlab.com for current examples, news articles, and teaching tips.
117
Copyright © 2017 Pearson Education, Inc.
118 Case/Fair/Oster, Principles of Macroeconomics, 12th Edition
B. Government Purchases (G), Net Taxes (T), and Disposable Income (Yd)
1. Definitions
a. Net taxes (T) are taxes paid by firms and households to the
government minus transfer payments made to households by the
government. Net taxes equals tax revenue less transfer payments.
TEACHING TIP: Students may be confused as to why transfer payments are deducted from tax
revenue. The logic is simple. The government drains tax revenue from the household sector.
Some of this tax revenue is returned to households in the form of transfer payments (welfare,
social security, unemployment insurance, etc.). These transfer payments are funds taken from
one household and given to another. It’s like the government never collected this revenue at all.
Subtracting transfer payments from tax revenue gives the government’s net drain of income from
households.
Another explanation that may help some students: transfer payments are negative taxes.
TEACHING TIP: As in the previous chapter, there is a simple (and very visual) way to show
students the equivalence of the two equilibrium conditions Y = C + I + G and S + T = I + G.
Draw a rectangle representing some given level of output, and remind students that output and
income are equal, so the next rectangle representing total income in the economy should be the
same size. Ask: What happens to this income? With the government sector included, there are
only three things households can do with their income: spend it, pay it out in taxes, or save it.
Draw a third rectangle—smaller than the first or second—indicating the value of consumption
spending. Above this rectangle, show saving and taxes as leakages and investment and
government spending as injections. The last rectangle—aggregate expenditure or total spending—
shows the net result of subtracting saving and taxes from income and adding investment and
government spending.
Leakages Injections
T G
G
S I
I
C C
Compare the first and fourth rectangles. The first indicates output; the fourth indicates
aggregate expenditure. Equilibrium requires these two rectangles to be the same size. When will
this occur? As can be seen in the diagram, only when total leakages equal total injections, or
S + T = I + G.
2. Output will rise again and so will income, etc. This is the multiplier in
action. The government spending multiplier is the same as the investment
multiplier,
1 1
government spending multiplier = =
MPS 1- MPC
3. The government spending multiplier is the ratio of the change in the
equilibrium level of output to a change in government spending.
4. Suppose the economy is in equilibrium at Y = 900 (as in Fig. 9.2 [24.2].
a. To achieve full employment, the government wants to raise income
to 1,100. By how much should government spending change to
achieve this new equilibrium output?
b. The desired change in Y is 1,100 – 900 = 200. The income-
expenditure multiplier is 4. Therefore,
DY = +200
DY
=4
DG
DY
= DG
4
DG = 50
TEACHING TIP: The data from Table 9.2 [24.2] is in the Excel workbook for this chapter.
3. A Warning
a. The story about the multiplier is still incomplete and
oversimplified. One omission, income taxes, is discussed in
Appendix B to this chapter. The other omitted factor that reduces
the size of the multiplier, of course, is induced imports.
b. We are still assuming there are no assets markets or markets for
factors of production. The practical effect of omitting these
markets is to treat the price level and interest rate as constant.
Correcting those two omissions reduces the size of the multiplier
considerably.
TEACHING TIP: Table 9.4 [24.4] is an excellent summary of the three multipliers.
TEACHING TIP: Updated federal government budget data is available in the Excel workbook for
this chapter.
3. Personal income taxes were 41.6 percent of government receipts. But that
does not include the payroll tax (contributions for social insurance),
another 34.8 percent.
TEACHING TIP: If you mention the payroll tax, be prepared for at least one student to state that
half the payroll tax is paid by employers. This merits a two-part response. First, self-employed
people pay the entire tax themselves. Second, economic research has consistently shown that
workers pay the entire payroll tax. The employer contribution just creates lower wage rates.
4. The federal surplus (+) or deficit (−) equals federal government receipts
minus expenditures. Also called federal government saving.
C. Fiscal Policy Since 1993: The Clinton, Bush, and Obama Administrations
1. Tax policy
a. The average tax rate rose significantly during the Clinton years
(from about 10 percent to 13 percent).
b.. The Bush tax cuts reduced this percentage to less than 9 percent in
2003.
c. The Obama administration kept the average tax rate low, although
the rate rose once the stimulus ended.
2. Government expenditure policy
a. As a percentage of GDP, government spending and transfers both
fell during the Clinton administrations, helped by the dot-com
boom of 1995 – 2000.
b. Both rose under the Bush administrations. Government
expenditures rose because of the Afghanistan and Iraq wars. The
increase in transfer payments was caused mainly by increased
Medicare spending. The new prescription drug benefit contributed
to the Medicare increase.
c. Spending continued to increase during the first five years of the
Obama administration. Transfer payments increased sharply, due
to the deep recession and the stimulus bill. Spending on the war in
Afghanistan was also a contributing factor.
3. From 1998–2001 the federal government ran a budget surplus. The
remaining years from 1993 – 2012 saw budget deficits. The federal
government budget deficit increased sharply during the Obama
administration, reaching 9.5 percent of U.S. GDP by the second quarter of
2009.
TEACHING TIP: The data and graphs for Figures 9.4 [25.4], 9.5 [25.5] and 9.6 [25.6] are included
in the Excel workbook for this chapter. Data may not match the textbook exactly due to
revisions and the use of different data sources.
The Congressional Budget Office estimates that the government debt will exceed 100 percent of
GDP by 2039. The main reason is the retirement and aging of the baby boom generation.
Retirement means they collect Social Security and enroll in Medicare. Aging means higher
medical care spending. If nothing changes, this is bad news.
3. Fiscal drag is the negative effect on the economy that occurs when
average tax rates increase because taxpayers have moved into higher
income brackets during an expansion. Since federal tax brackets were
indexed for inflation in 1982, fiscal drag has been much less of a problem.
TEACHING TIP: This is a good opportunity to talk about the interaction between the budget and
inflation. Before 1982, federal tax brackets were based on nominal incomes. When inflation was
high, people found themselves paying higher taxes even though their real incomes had not
changed. In 1982 federal tax brackets were indexed to inflation. In addition to being fairer to
taxpayers, indexing the brackets also means the government doesn’t gain from inflation.
C. The Full-Employment Budget is what the federal budget would be like if the
economy were producing at the full-employment level of output.
1. The full-employment budget is used as a benchmark to evaluate fiscal
policy. Most economists use it to compare fiscal policy in different years.
2. The structural deficit is the deficit that remains at full employment. A
structural deficit implies that the structure of tax and/or spending programs
is out of alignment.
3. The cyclical deficit is the deficit that occurs because of a downturn in the
business cycle.
4. Of the $582.3 billion U.S. government budget deficit in 2014, at least part
was cyclical deficit since the economy was not quite at full employment.
TEACHING TIP: Explain to students that much of the budget surplus of the late 1990s was a
“windfall” caused by the prosperous economy. Point out that with more people working more
taxes are paid to and less transfers are received from the government.
The U.S. Debt Clock has become a fixture on the internet (http://www.usdebtclock.org/). As of
22:20 GMT December 24, 2015 total debt was $18.8 trillion dollars.
Question: The debt clock shown above says the "U.S. National Debt" is $18.8 trillion dollars.
However, according to the Treasury Department's "Monthly Statement of the Public Debt" for
November 30, 2015, $13.59 trillion is debt held by the public. What's the difference?
Answer: The total debt on the debt clock includes state and local government debt as well as
intragovernmental holdings of debt. The Excel workbook for this chapter includes the public debt
statement as well as a worksheet that does the calculations shown below:
Extended Application
Application 1: Fiscal Policy Choices
When it comes to numerical examples that show how multipliers are used, the more the
better. The following classroom presentation not only reinforces the material on the
various multipliers, but also adds some realistic constraints to fiscal choices.
Suppose the authorities wish to increase Y by $400 billion in an economy with an MPC of
0.75. The government spending multiplier is
1 (1 − MPC) = 4 ,
the tax multiplier is MPC (1 − MPC) = −3 , and the balanced-budget multiplier, as always,
is 1. This suggests three choices for increasing Y by the required amount as shown in the
following table:
Required Impact on
Policy Options Multiplier Change Deficit
1. Increase G 4 100 +100
2. Decrease T –3 –133 +133
3. Increase G and T by equal amounts 1 400 no change
Notice that all three policies increase output by the required $400 billion. But given the
results in the table, it looks like the preferred choice should always be option 3 because it
alone leaves the budget deficit unchanged. It is important to flag this result for students:
Fiscal expansion does not require an increase in the budget deficit.
But the table presents only part of the story. Output changes are composed of changes in
C, I, and G. The impact on C can be calculated as MPC (Y − T ) or, with lump sum taxes
only, MPC(Y − T ) . In this example, there is no change in I, so one needs to list only the
impacts on C and G:
Policy Options Impact on C Impact on G
1. Increase G +300 +100
2. Decrease T +400 0
3. Increase G and T by equal amounts 0 +400
Viewed from the perspective of the above table, these three policies look very different.
Although all three raise output by $400 billion, options 1 and 2 do so mostly by
increasing the output of consumption goods, whereas option 3 relies entirely on an
increase in government sector output. And here is the problem: Real-world economies—
unlike the economy of the simple mathematical model—have a productive infrastructure
(factories, capital equipment, human capital, retail outlets, etc.) suited to a particular mix
of output. To suddenly and radically change the actual mix of output can be dislocating to
the economy, causing shortages in the expanding sector without alleviating
unemployment in the depressed sectors. When the economy goes into recession, the
decrease in output occurs in the private sector. Thus the least dislocating policies would
rely heavily on an expansion of private-sector output. In this way, not only would the
economy be restored to its previous output level, but also to its previous output mix.
Only options 1 and 2 rely on the expansion of private sector output, and both policies
increase the deficit. Hence, although fiscal expansion does not require deficit spending, a
smooth fiscal expansion might require a deficit.
On the following day I was taken before the Kadis, with whom
was the Khaleefa and Slatin. I was asked, “Why have you come to
Omdurman?” to which I gave the same reply as I had given to Nur
Angara. The letter of General Stephenson was exhibited to me, and I
was asked, “Is this your firman?” to which I replied that it was no
firman, but a letter from a friend about business, and that it had
nothing to do with the Government. Slatin was told to translate it,
but, fortunately, did not translate it all. On his being asked his
opinion of me, he told the Khaleefa that from the papers found in
my wallet, I appeared to be a German and not an Englishman, but
that I had the permission of the English Government |77| to go to
Kordofan on merchant’s business. He also said that Sheikh Saleh’s
name was mentioned, but only in connection with business of no
consequence. I was then asked if I wished to send any message to
my family. Naturally I did, and pen and paper being given me, I
commenced a letter in German to my manager at Assouan; but,
after a few lines had been written, the Khaleefa said the letter had
better be written in Arabic. The letter, when finished, was handed to
me to sign; but, not knowing the contents, I scrawled under the
signature, as a flourish, “All lies,” or something to this effect.
The letter was sent down by one of the Khaleefa’s spies, and was
delivered to the Commandant at Assouan. The word “Railway”
appearing as part of the address, it was sent to Mankarious Effendi,
the stationmaster, who, after taking a copy of it for reference,
returned it to the commandant, with the address of my manager.
Mankarious Effendi, having heard of my recent arrival in Cairo, has
come to me with the original copy of the letter taken in June, 1887.
The following is a literal translation of it:―
“In the name of the most merciful God, and prayers be unto our Lord
Mohammad and his submissive adherents.
“From the servant of his lord Abdallah el Muslimani the Prussian whose former
name was Charles Neufeld, to my manager Möller the Prussian in the Railway
Assouan.
“I inform you that after departing from you I have come to the Soudan with the
men of Saleh Fadlallah Salem el Kabbashi, who were carrying with them the arms
and ammunition and other articles sent to Saleh by the Government.
“On our march from Wadi Halfa, notwithstanding our |78| precautions and care
for the things in our charge, we arrived at the so-called Selima Wells, where we
took sufficient water, and proceeded on our journey. Suddenly we were met by six
of the adherents in the desert; they attacked us, and we fought against them. Our
number was fifty-five men. At the same time, a number of men from Abdel
Rahman Nejoumi came up; they reinforced the six men and fought us, and in the
space of half an hour we were subdued by them. Some were killed, and the rest
were captured with all the baggage we had. Myself, my servant Elias and my
maidservant Hasseena were among the captives. All of us were taken to Abdel
Rahman Nejoumi at Ordeh, and by him sent to the Khalifat el Mahdi, peace be
unto him, at Omdurman. On our arrival at Omdurman, we were taken to his
presence, where we were found guilty and sentenced to immediate death; but the
Khalifat el Mahdi, peace be unto him, had mercy upon us, and proposed unto us
to take the true religion, and we accepted El Islam, and pronounced the two
creeds in his presence: ‘I testify (bear witness) that there is none but God, and
Mohammad is his prophet’; and then, ‘I believe in God and his Prophet
Mohammad, upon whom God has prayed and greeted; and in the Mahdi, praise,
peace be upon him and upon his Khaleefa.’ I further requested the Mahdi to grant
me the ‘bai'a’ (oath of allegiance) which he was pleased to grant me, and
thereupon shook hands with me. He then named me Abdallah, after embracing
the true religion. Therefore I was pardoned by the Khalifat-el-Mahdi from the
execution which I have deserved. He pardoned me because he is gracious, and for
the sake of the religion of Mohammad which I now adhere to. So I thought it well
to inform you all about these events, and I inform you further that Dufa'allah
Hogal, although he deceived me, I cannot sufficiently thank him, because his
deceiving me has resulted in the great mercy and good which has come to me.
Saleh Fadlallah Salem is deserting and hiding in the desert, for fear of his life. All
that I have informed you is pure truth. I am still living, thanks be to God for this
and my health. 17th Shaaban, 1304 (May 10, 1887).”
It is only now, November 25, 1898, that Mankarious has placed
me in possession of the real details. My manager, who when he
returned to Egypt a few |79| weeks ago, on hearing of my release,
denied ever having received any communication from me, on August
6, 1887, addressed a letter to my father, written on my own business
paper, saying that he had received the above letter, had had it
translated, and communicated to the Egyptian Gazette , which paper
published the letter in its issue of August.
Slatin I saw but once again during my long captivity, and then it
was only in the distance on one occasion when he called at the
prison to give some orders to the head-gaoler. The Khaleefa I saw
twice again, on occasions to be referred to later.
After signing the letter, I was taken back to the rukooba, where,
about sunset, a man carrying a long chain came to me and said he
had orders to remove my fetters. Passing the chain through one of
the anklets and round one of the posts, he took a short pole, and
used this as a lever to force the anklets open. Whilst still engaged in
removing the chains, the chief Kadi came in, and ordered the anklets
to be hammered back again, and the ends cold welded.
I remained in the rukooba for the night, and the following morning
was placed upon a donkey and taken to the prison. I was told that,
to save my life, Slatin had suggested this course being taken, using
as an argument that I could there be converted to the Mohammedan
religion, and devote all my time to my instructors.
CHAPTER VII
T H R O W N I N TO P R I S O N
My first spell in prison was one of four years. After nine months the
rings and chains were removed from my neck, but the fetters I wore
continuously—with the exception of thirteen days—during the whole
of my captivity. A day-to-day record of my experiences is out of the
question, besides being unnecessary, even were it possible to give
them. I must content myself with a general description of the life
passed there, and give an idea of the day’s routine.
When I reached Omdurman, the prison proper consisted of the
common cell already mentioned (“Umm Hagar”—the house of
stone), surrounded by a large zareeba of thorn trees and branches,
and standing about six feet high. There were thirty guardians, each
armed with a “courbag” (rhinoceros-hide whip) with which to keep
their charges in order. There were no sanitary arrangements, not
even of the most primitive description. All prisoners had to be fed by
their friends or relatives; if they had neither they starved to death,
as the prisoners, charitable as they were to each other in the matter
of food, had barely enough to eat to keep body and soul together,
for the |94| best, and greater part of the food sent in, was eaten by
the guardians.
At sunrise each morning the door of the common cell was opened,
and the prisoners were allowed to shuffle down to the banks of the
Nile, a few yards distant, for their ablutions and for water for
drinking. After this, we assembled for the first prayer of the day, in
which all had to join. When not working, we had to read the Mahdi’s
“ratib,” a description of prayer-book, containing extracts from the
Quoran with interpolations of the Mahdi. All the faithful were ordered
to learn this “ratib” off by heart,* and for this purpose each one had
either to purchase a copy or write one out. At noon the second
prayer was held, followed by another mid-time between noon and
sunset, and a fourth at sunset. We should have repeated the night
prayer when the night had set in, but as we were driven into the
“Umm Hagar” at sunset, the time which should have been given to
this prayer was fully taken up with brawls, fights, and those
comprehensive curses of the Arabs, commencing with the second
person’s father, going back for generations, and including all the
female ancestors.
* The “Ratib” occupied about three-quarters of an hour in recitation, and, by
the Mahdi’s orders had to be repeated daily by every one after the morning
and afternoon prayer; it ranked in importance with the five obligatory daily
prayers ordained by the Quoran. It was also looked upon as a sort of
talisman, and it was given out, after such fights as Toski, Ginniss, and the
Atbara, that those killed were those who had either not learned the Ratib or
had not a copy with them. The book was carried in a small leather case
suspended from the neck. A number of copies were printed on the old
Government press, but it was considered more meritorious to write out a copy
rather than to purchase one, and the Mahdi had hoped that this Ratib would
eventually become a sort of Quoran accompanied by its volumes of
“traditions,” hence his anxiety that every one should learn to write.
LEARNING THE MAHDI’S RATIB.
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