EC103-Topic #5: Fiscal Policy

Part of the allure of using fiscal policy to stabilize the economy is that the government can use ‘automatic stabilizers’ such as the federal progressive income tax, the corporate income tax, and unemployment insurance. When the economy is booming, taxes rise since they are an increasing percentage of income or profits in the case of corporations. Unemployment insurance, as well as the income tax works to increase consumption during recessions as taxes fall and consumption is supported by unemployment benefits. Over the past 50 years tax rates have converged between the high and low-income groups.

The possibility of tax reform and unemployment benefit expansion is always a possible political/economic debate. Many economists (like Robert H. Frank) and politicians (like Ron Paul) advocate changing the income tax system to a flat-tax system or a consumption tax. Other groups advocate expanding unemployment insurance to help lower-income workers during downturns.

I would like you to think about the usefulness of the current policies and the impact of the proposed changes on the economy.

Questions you might try to answer:

  • If taxes were only based on consumption, would this help to stabilize the economy in the same way that income taxes are currently designed to help?
  • If unemployment benefits are expanded, what would be the immediate and long run impact on the economy if the Keynesian model?
  • If taxes were flat rather than progressive, what impact would this have on the economy?

Remember… I would like your statements to be as subjective as possible, or in jargon terms, positive and not normative in nature. Also, remember, I want you to keep your descriptions short, basic, and related to classroom content. Read other students comments before posting, and please leave your name with your posting.

16 thoughts on “EC103-Topic #5: Fiscal Policy”

  1. What is beneficial to consumers at the micro level is not necessarily beneficial to the economy at the macro level. This is the main problem with the “unlimited savings allowance” or progressive consumption tax system. The proposed system encourages saving, however, if all people save additional income, consumption decreases, causing firms to scale back production as inventories increase and causing output (real GDP) to decrease below full capacity. In order to stimulate demand/consumption, the government must increase spending despite the fact that they are in an ever growing budget deficit. As Robert H. Frank points out, middle-class families bear the greatest burden in the current income tax system. The wealthiest 1% pay the largest share of taxes but have also experienced the greatest rise in income, so they have a significantly greater disposable income. Even under the consumption system, they would have a greater amount of income to save and spend on lavish lifestyles, which places upward pressure on the standard of living. Although the consumption tax would give middle-class families more incentive to save, they must spend more to live in expensive neighborhoods in order send their children to better schools.

  2. If taxes were based on consumption, the overall stability of the economy would increase in the same, if not better, way. Al Ehrbar, former senior editor of Fortune magazine, has written that consumption taxes are superior to income taxes because of the “temporal neutrality” economic principle. Since the consumption tax would be applied to all goods and services, the tax can be considered neutral, meaning that it does not “alter spending habits or behavior patterns and thus does not distort the allocation of resources,” (The Concise Encyclopedia of Economics- Consumption Tax). In fact, the consumption tax could cause an increase in savings. This tax encourages capital formation, or an increase in the value of capital stock, which would increase productivity and economic activity.According to the American Heritage New Dictionary of Cultural Literacy, a flat tax is a single tax rate that applies to everyone obligated to pay the tax. Flat taxes usually adhere to income taxes, but can also be applied to consumption taxes. If taxes were flat, rather than progressive, there would be an increase in tax revenues. Flat taxes provide a much simpler tax code, which reduces the risk of mistakes in tax forms, as well as removes loopholes large corporations and wealthy families take advantage of to reduce the amount of taxes paid. With a simpler tax code, the government cost of processing tax returns would be lower, thus allowing the government to allocate more money to expenditures more important than analyzing paper work.

  3. A tax based on consumption, while sounding very idealistic in theory can have many nasty side effects. Not only will it affect people’s behavior when it comes to consuming goods, but it is also very possible that this new tax will be able to make up for the old tax. Since people will now be having their taxes come from their consumption, what could this do to people’s desire to consume? From a microeconomic standpoint, this of course would cause a leftward shift in the demand curve causing our desire to purchase goods at a certain price to go down. From a macroeconomics standpoint, this new tax could have much worse effects. With our desire to purchase goods going down this new tax could have the potential to reduce our nominal GDP. While it can be said that with this consumption tax would encourage savings, for me it would be just to great a risk to switch from income taxes to consumption taxes.

  4. If taxes were only base on consumption, it sounds very beneficial to the people that are employed. Now, they have the incentive to work longer hours to earn more money since all their incomes goes to them. When they have more incomes, they have the incentive to consume more goods. But at the same time, they have to pay a higher tax on the goods. With a high tax on the goods, consumers will cut back on their consumptions since the price of the goods seem much higher than before. It creates a conflict of whether the consumers should purchase more due to their increase on incomes, or should they cut back on consumption due to the increase of taxes on consumption. Also when taxes were only base on consumption, it doesn’t grantee that the government will collect more tax revenues or collect enough to cover their expenditures at the current year. There is no grantee that consumers will increase their consumption when taxes on consumption are high. Furthermore, what would the government do if there is a recession in the market? Consumption will fall as people lost their jobs; when consumption is low, tax revenues also fall. Where can the government get the money to cover all their expenditures like unemployment benefits, social security, education programs and all other government funded programs? Well the government can borrow more money and issue more bonds, but at the same time the government is increasing it budget deficits.

  5. The current deficit that the United States currently faces has caused many economic debates. One theory is to create a tax based on consumption. The idea is that on top of the existing income tax, an individual’s savings would be assessed. If the family had consumption of $20,000 and a consumption tax of 10% existed, the family would pay $2,000 in consumption taxes. Such a tax would appear to be greatly detrimental to the economy. If individuals have to pay money based on their consumption, they are going to be more likely to consume less and save more. This could cause a great leftward shift in consumption and greatly decrease GDP. However, a progressive consumption tax could be slightly less detrimental. This tax would place the burden more on the wealthy. The amount a family chooses to spend on an individual project or purchase determines the tax. So if the tax is 5%, a family who spends $1,000 gets taxed $50; the national debt is thus reduced $50. If a family with a larger disposable income spends a large sum of money at one time, the national debt can be reduced by millions of dollars.

  6. Some economists argue that consumption tax would help the economy by reducing consumption or by consumers. The argument is that consumers may then save more of their disposable income as savings (which can then be spent on investments) will not be taxed when the consumption taxes are used. A consumption tax could help to cool down an overheating economy, especially during blooms by shifting AD leftwards and bringing down the price level. Currently, income taxes reduce individuals’ disposable income such that consumers that are heavily taxed are left with less money to consume.Expanding unemployment benefits can be disastrous for the economy in the long run. Most EU countries have high unemployment rates compared to the USA because these benefits reduce the incentive to look for jobs among individuals. People can always postpone job seeking when they know that they will get payments form the government anyway. This could shift the LRAS of a country inward thus reducing the productive potential of the economy.Flat taxes on the other hand could result to increased incentives among people to do high earning jobs as they will have to pay a less proportion of their incomes to taxes. Progressive tax may discourage people from doing these high earning jobs as most people hate having these deductions in their income dues to taxes. I also think that a flat tax is easier to implement in a country and may have less flaws and maybe it could be easier to catch even tax evaders if everybody has to pay the same amount of tax.Siphiwe

  7. If taxes were solely based on consumption then logically there would be less consumption that would occur. As Chris Malker stated in his article, “Such a system would clearly encourage Americans to save more money.” By saving money people would not be import their earnings into the economy, therefore possibly hurting the economy. But if “a progressive consumption tax were phased in gradually, its main effect would be to shift spending from consumption to investment, causing productivity and incomes to rise faster” (Frank). This disproves the theory that the economy would be hurt by showing that with a progressive consumption tax that is incorporated into the economy slowly, that the economy would stay the same because total spending determines the output and employment of an economy, not just consumption.

  8. Taxes based on consumption would probably not act the same as do income taxes are designed to. Taxing based on income works in a way that the higher earning workers pay more taxes. Having taxes based on consumption would mean that everyone would have to pay the same tax no matter how much they make. If consumption taxes were flat rather than progressive consumers would begin to slow down their consumption. Consumption based taxes would start making people save more of their money, therefore what would seem like stabilization in the economy. But for how long could this last? For a period of time people will purchase less goods and services and save more. Goods will still be available and people will still demand things so people are still going to buy goods. A flat rate would only make things worse for the consumers in the low income bracket. This would seem unfair and a flat rate would cause some issues with much of the population since a flat tax would not cripple a much wealthier person’s savings.

  9. According to investopedia.com, fiscal policy is the government spending policy that influences macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control the economy. Currently, Bush has made tax cuts that “have led to a strong economy and surging revenue growth” but at the same time, “if spending had grown only at the same rate as the economy, the nation would be near surplus today” (http://www.heritage.org/Research/Budget/wm1325.cfm). There are many alternatives to improve the current economy. One way is through increasing unemployment insurance which does in fact improve the economy because it lowers costs, but it can not be the only course of action. If all the economy does is help the unemployment insurance, it only covers a small portion of society. This route also runs into the dilemma of who will end up paying taxes?Another option is to have a progressive consumption tax that, if “phased in gradually, its main effect would be to shift spending from consumption to investment, causing productivity and incomes to rise faster” (http://www.nytimes.com/2007/10/07/business/07view.html?_r=3&ex=1349409600&en=83030f6e19116240&ei=5090&partner=rssuserland&emc=rss&oref=slogin&oref=slogin&oref=slogin). This helps out a bigger portion of the population- the middle-class, as opposed to just the unemployed or another policy that works in theory- to tax the rich, a small demographic, to give to the poor.In order for the economy to improve and maintain a general stability, all demographics of the population must be covered, if not, the demographic that has the most- the middle-class. The economy must keep in mind everyone’s well being in order to be successful.

  10. If tax is based on income, for example: suppose that $1,000 income needs to impose 10% taxes and $1,005 needs to impose 15% taxes, then people have less incentive to make that extra $5. But if one can make $3,000 and the tax is 30%, although it is more than tax of 15%, but the income of $3,000 after tax is more than the $1,000. Therefore, people have incentive to make more money if they can make more within the “marginal tax rate.” But if tax is based on consumption, it’s good for individuals because they can make more money without burden any taxes or extra taxes. For tax based on income, when incomes grow rapidly, the average of personal tax liability of individuals rise. “With rising incomes, more people will find their income above the no tax due cutoff. Others will jump up into higher tax bracket.” Therefore, during this economic expansion, personal income tax revenue rises more rapidly than income. When tax is based on consumption, if income grows rapidly, tax liability of individuals will still increase because people will consume more than before. However, during this expansion, the average personal of personal income tax revenue will rise less than the income because they have incentive to make more money, but to spend less and saving more. Although tax based on consumption is bad for government, it will still stabilize the economy in the same way that income taxes are currently designed to help.

  11. Over the history of the economy one of the main aim of governments is to stabilize the economy, so that it can, in short or long run, achieve its macroeconomics components, stabilize unemployment rate, rate of in inflation and its monetary policy over a period of recession or during an economic boom. Thereby, governments recur to means of fiscal policy.In a period of recession, for instance, government stimulate aggregate demand by apply the expansionary fiscal policy, an increase in government expenditure. Correspondingly, government would decrease expenditure in a period of economic boom. Over a recession, the additional money borrowed to increase budget deficit would cause a raise in consumption, and consequently, a rise income taxes. However, if government increase unemployment benefits, in the long run unemployment expand, since will be more people without jobs. Also, corporate profit taxes would decline, expanding the size of budget deficit.In the light of the consequences, those policies happen a dual impact : positive if macroeconomic components are met, and negative, if the side effect are greater than the benefits.

  12. I don’t consider that the progressive consumption tax that Robert Frank proposes should replace the income tax because its distortionary effects on the patterns of savings and consumption could cause unintended disruptions in the economy. The introduction of the consumption tax would encourage a higher level of saving at the expense of consumption (a decision previously based on individual preferences, not on incentives by government). Even though investment is supposed to lead to more economic growth in the long run (may take up to a decade), the short run adjustment effects include a rise in the after-tax interest rate by the amount of the tax (according to Martin Feldstein’s findings in “The Effect of a Consumption Tax on the Rate of Interest”), a decline in the value of the capital stock relative to the price of consumption goods (as more people want to buy stocks, they are worth less), a decline in the value of housing (investment will shift away from housing to other forms of capital), and a rise in the price level (because the purchasing power of wages needs to be adjusted after tax and wages are stickier than prices, and therefore less likely to be lowered as much as prices will be increased).Overall, the consumption tax may not benefit the economy as much as its adepts advocate. Perhaps a better approach to reforming the taxation is not alter its level, not its form.

  13. If tax is based on income, for example: suppose that $1,000 income needs to impose 10% taxes and $1,005 needs to impose 15% taxes, then people have less incentive to make that extra $5. But if one can make $3,000 and the tax is 30%, although it is more than tax of 15%, but the income of $3,000 after tax is more than the $1,000. Therefore, people have incentive to make more money if they can make more within the “marginal tax rate.” But if tax is based on consumption, it’s good for individuals because they can make more money without burden any taxes or extra taxes. For tax based on income, when incomes grow rapidly, the average of personal tax liability of individuals rise. “With rising incomes, more people will find their income above the no tax due cutoff. Others will jump up into higher tax bracket.” Therefore, during this economic expansion, personal income tax revenue rises more rapidly than income. When tax is based on consumption, if income grows rapidly, tax liability of individuals will still increase because people will consume more than before. However, during this expansion, the average personal of personal income tax revenue will rise less than the income because they have incentive to make more money, but to spend less and saving more. Although tax based on consumption is bad for government, it will still stabilize the economy in the same way that income taxes are currently designed to help.

  14. Income taxes are derived from the income of individuals and firms. If taxes were only based on consumption the firms’ expenses and all operating purchases would be taxed along with the consumption of individuals. This type of tax would help to stabilize the economy but would be a decrease from what the current income tax generates for the government. People would want to consume less, producers would therefore produce less, GDP would decrease, unemployment would increase and a recession would occur. A consumption tax would be worse for the economy than the current progressive tax. If unemployment benefits are expanded more people would be unemployed for a longer period of time and government spending on unemployment compensation would increase. AD would shift to the right in the Keynesian model in the short run and SRAS would shift to the left in the long-run toward the natural rate of unemployment. A flat tax is a tax with a constant rate. Usually this would refer to household income, and possibly corporate profits as well, being taxed at one marginal rate. This tax would have a negative affect on the economy because less money would be taken from the rich. There would be no economic growth.

  15. Economists like Robert Frank believe taxing consumption would stabilize the economy the same way our current system of taxing income does. Like Robert Frank, I too believe this system could begin to rectify the federal deficit. Taxing consumption as opposed to income would encourage work and saving. Instead of people being punished for working harder and longer hours, consumers who chose to spend money would be penalized. Furthermore, implementing the consumption tax would benefit middle-class-working Americans. Paying taxes on one’s income taxes discourages future spending and saving. However, if a family is able to keep their workable income more money will be saved and hence spent in the future. The consumption tax is hardly a new idea invented by Robert Frank, and many people are concerned with the repercussions a new tax system would impose. However, Mr. Frank argues a consumption tax is neither radical nor impractical; in fact the benefits would surpass those of taxing income. “If a progressive consumption tax were phased in gradually, its main effect would be to shift spending from consumption to investment, causing productivity and incomes to rise faster.”

  16. A move toward consumption tax would boost saving, but could hurt the economy by decreasing consumption: consumers would be more inclined to save their money than spend it because they would encounter no financial penalty for saving money. Although a move toward consumption tax would not hurt wealthy individuals, it could cause problems for those in the middle and lower economic classes. While wealthier Americans can afford an increase in price of all goods consumed without it making a hazardous dent in their funds, middle and lower class consumers would experience a greater impact. In many respects, a move toward consumption tax would be beneficial to the economy, but its success would largely depend upon the economic stimulus that consumers generate. Because of the existing controversy concerning current income tax policies, it might be wise to try a consumption tax instead of an income tax. As Robert H. Frank writes in his New York Times article, Why Not Shift the Burden to Big Spenders? (October 7, 2007), “Should a recession occur, a temporary cut in consumption taxes would provide a much more powerful stimulus than the traditional temporary cut in income taxes can.”

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