Notes
Taxes
- Principles: benefits-received and ability-to-pay. Good taxes aim for equity, simplicity and efficiency.
- Progressive taxes take a larger share of higher incomes; proportional taxes take the same share; regressive taxes take a larger share of lower incomes.
- Federal: individual income tax (largest source), payroll taxes for Social Security and Medicare, corporate, excise, estate and tariffs. State and local: sales, property and state income taxes.
- Marginal rate = rate on the last dollar; average rate = total tax ÷ total income.
Spending and the budget
- Mandatory spending (Social Security, Medicare, Medicaid) is the larger share; discretionary spending (defense, education) is set yearly. The President proposes; Congress passes appropriations. Fiscal year: October 1 to September 30.
Fiscal policy
- Expansionary (more spending, lower taxes) fights recession; contractionary (less spending, higher taxes) fights inflation.
- Multiplier $\displaystyle = \frac{1}{1 - MPC}$. Automatic stabilizers adjust on their own.
Deficits and debt
- Deficit: spending > revenue in one year. Debt: the total owed. The government borrows by selling Treasury securities.
- Views differ: Keynesians favor active policy in recessions; others warn of crowding out and debt costs; supply-siders stress lower tax rates. Time lags complicate timing.
Topics in this unit
Each topic has its own short notes and practice.
Practice
The share of income paid rises as income rises.
$0.10 \times 20{,}000 + 0.25 \times 40{,}000 = 2{,}000 + 10{,}000 = 12{,}000$, and $\displaystyle \frac{12{,}000}{60{,}000} = 20\%$.
Contractionary fiscal policy reduces total demand.
Multiplier $\displaystyle = \frac{1}{0.2} = 5$, and $10 \times 5 = 50$.
Each deficit adds to the debt: $20 + 1.2 + 1.5 = 22.7$.
Supply-siders focus on how tax rates affect incentives to produce.
Free response
Write your answer first, then open the scoring guide.
Free-response question
The economy has entered a recession. Unemployment is rising and real GDP has fallen for two quarters. Economists estimate that the marginal propensity to consume is 0.9.
(a) Identify the type of fiscal policy that could fight the recession, and describe TWO actions the government could take.
Show the answer and scoring guide
Expansionary fiscal policy. The government could increase spending, for example on roads or schools, and it could cut taxes so households and businesses have more money to spend.
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(b) Congress passes $30 billion in new spending. Calculate the multiplier and the largest possible effect on total spending, and explain why the effect is larger than $30 billion.
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Multiplier $\displaystyle = \frac{1}{1 - 0.9} = \frac{1}{0.1} = 10$. The largest possible effect is $30 \times 10 = 300$ billion dollars. Each dollar the government spends becomes someone's income, and they spend 90 cents of it, which becomes another person's income, and so on.
Check off the points you earned:
(c) Explain how this policy is likely to affect the budget deficit, and describe ONE argument economists make for it and ONE argument against it.
Show the answer and scoring guide
More spending (and lower tax revenue during a recession) increases the deficit, which adds to the national debt. Argument for: Keynesian economists say spending during a recession can restore demand, output and jobs faster than waiting for markets to recover. Argument against: other economists warn that more borrowing can crowd out private investment, raise future interest costs, and take effect too late because of time lags.
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