--- title: "Fiscal Policy" author: "Benjamin Posmanick, PhD" book: "Principles of Macroeconomics" chapter-number: 9 source-file: "originals/source/Chapters/Chapter_11_Fiscal_Policy.tex" conversion-status: "Faithful Markdown import with source-only figure context" included-in-original-book: true --- # Chapter 9: Fiscal Policy {#fiscal-policy} > The difference between death and taxes is death doesn’t get worse every time Congress meets.\ > —Will Rogers ## 9.1 Federal Government Revenue {#sec:federal_revenue} The federal government spends trillions of dollars each year on programs ranging from Social Security and national defense to highways, health care, and scientific research. Where does that money come from? The federal government receives revenue from several sources, but most federal revenue comes from taxes paid by individuals and businesses. Understanding these sources is important for evaluating fiscal policy. Statements such as “raise taxes,” “cut taxes,” or “government revenue increased” can refer to very different policies with very different economic effects. ::: definitionbox **Definition** **Federal revenue** is money received by the federal government from taxes and other sources. The largest sources of federal revenue are generally: - individual income taxes, - payroll taxes, - corporate income taxes. The federal government also receives smaller amounts from excise taxes, customs duties, fees, and other sources. ::: ### 9.1.1 The Major Sources of Federal Revenue Federal revenue does not come from a single tax. Several different taxes apply to different types of economic activity. The major categories include: 1. individual income taxes, 2. payroll taxes, 3. corporate income taxes, 4. excise taxes, 5. customs duties and other revenues. Individual income taxes and payroll taxes account for a particularly large share of federal revenue. It is therefore important to understand that these are different taxes. A worker may pay both: $$Individual\ Income\ Tax$$ and: $$Payroll\ Tax$$ on the same paycheck. The two taxes have different structures and are associated with different parts of the federal budget. ### 9.1.2 Individual Income Taxes The **individual income tax** is a tax imposed by the federal government on taxable income received by individuals and households. ::: definitionbox **Definition** The **individual income tax** is a federal tax imposed on the taxable income of individuals and households. ::: Income can come from several sources, including: - wages and salaries, - business income, - interest, - dividends, - investment income, - other taxable sources. However, the federal government does not simply multiply all income by one tax rate. The tax code contains deductions, exemptions, credits, and other provisions that determine how much income is ultimately subject to tax and how much tax is owed. For our purposes, the most important concept is **taxable income**. Taxable income is not necessarily the same thing as total income. ::: definitionbox **Definition** **Taxable income** is the amount of income subject to income taxation after applying the deductions and other adjustments permitted by tax law. ::: ### 9.1.3 A Progressive Income Tax The federal individual income tax is **progressive**. A progressive tax system applies higher marginal tax rates to higher portions of taxable income. ::: definitionbox **Definition** A **progressive tax** is a tax for which higher portions of taxable income are subject to higher tax rates. The federal individual income tax is progressive. ::: The key phrase is: > *higher portions of income*. A person does not generally pay their highest marginal tax rate on every dollar earned. Instead, taxable income is divided into **tax brackets**. Each portion is taxed at the rate associated with that bracket. ### 9.1.4 Understanding Tax Brackets Consider a simplified tax system with the following brackets: ::: center Taxable Income Tax Rate ----------------------- ---------- First \$20,000 10% \$20,001–\$50,000 20% Income above \$50,000 30% ::: Suppose a person earns $$\$60{,}000$$ of taxable income. A common mistake is to calculate: $$0.30(\$60{,}000)=\$18{,}000.$$ That is incorrect. Only the income within the highest bracket is taxed at 30%. The first \$20,000 is taxed at 10%: $$0.10(\$20{,}000)=\$2{,}000.$$ The next \$30,000 is taxed at 20%: $$0.20(\$30{,}000)=\$6{,}000.$$ The final \$10,000 is taxed at 30%: $$0.30(\$10{,}000)=\$3{,}000.$$ Total tax liability is: $$\$2{,}000+\$6{,}000+\$3{,}000 = \$11{,}000.$$ ### 9.1.5 Marginal Tax Rates The tax rate applied to the next dollar of taxable income is called the **marginal tax rate**. ::: definitionbox **Definition** The **marginal tax rate** is the tax rate applied to an additional dollar of taxable income. ::: In our example, a person earning \$60,000 is in the 30% marginal tax bracket. If that person earns one additional taxable dollar, approximately $$\$0.30$$ of that dollar would be owed in additional income tax under our simplified system. Thus: $$Marginal\ Tax\ Rate=30\%.$$ Marginal tax rates matter economically because people make decisions at the margin. A worker deciding whether to work an additional hour cares partly about how much of the additional income can be kept after taxes. A business owner considering additional work or investment may make a similar calculation. ### 9.1.6 Average Tax Rates The **average tax rate** measures the share of total taxable income paid in taxes. $$Average\ Tax\ Rate = \frac{Total\ Taxes}{Taxable\ Income}\times100.$$ ::: definitionbox **Definition** The **average tax rate** is total taxes paid as a percentage of taxable income: $$Average\ Tax\ Rate = \frac{Total\ Taxes}{Taxable\ Income}\times100.$$ ::: Return to our taxpayer earning: $$\$60{,}000.$$ Total income tax was: $$\$11{,}000.$$ Therefore: $$Average\ Tax\ Rate = \frac{\$11{,}000}{\$60{,}000}\times100$$ $$Average\ Tax\ Rate \approx18.3\%.$$ Notice the difference: $$Marginal\ Tax\ Rate=30\%$$ while: $$Average\ Tax\ Rate\approx18.3\%.$$ These rates answer different questions. The marginal tax rate tells us how an additional dollar is taxed. The average tax rate tells us what percentage of total taxable income is paid in taxes. ::: modelbox **Key Economic Model** **Marginal Tax Rate** $$tax\ rate\ on\ the\ next\ dollar\ of\ taxable\ income$$ **Average Tax Rate** $$\frac{Total\ Taxes}{Taxable\ Income}\times100.$$ In a progressive tax system: $$Marginal\ Tax\ Rate$$ can be substantially higher than: $$Average\ Tax\ Rate.$$ ::: ### 9.1.7 Moving Into a Higher Tax Bracket One of the most persistent misconceptions about income taxes concerns what happens when a taxpayer moves into a higher tax bracket. Suppose someone earning $$\$50{,}000$$ receives a raise to $$\$51{,}000.$$ Using our simplified tax system, the additional \$1,000 enters the 30% bracket. The taxpayer owes $$0.30(\$1{,}000)=\$300$$ of additional income tax. The taxpayer still keeps $$\$700$$ of the additional income before considering any other taxes. Moving into the higher bracket did not cause all \$51,000 to become subject to the 30% tax rate. ::: misconception **Common Misconception** A common misconception is that earning enough money to enter a higher tax bracket can cause someone to take home less money than before. Under a marginal tax system, entering a higher bracket changes the tax rate applied only to income within that higher bracket. It does not cause all previous income to be taxed at the new rate. A higher marginal tax bracket can reduce how much of an additional dollar a taxpayer keeps, but earning additional taxable income does not normally reduce after-tax income simply because a bracket threshold was crossed. ::: ### 9.1.8 Payroll Taxes Workers also commonly pay **payroll taxes**. Payroll taxes are different from individual income taxes. They are taxes on earnings used primarily to finance Social Security and Medicare. ::: definitionbox **Definition** A **payroll tax** is a tax imposed on earnings from employment. Federal payroll taxes primarily finance Social Security and Medicare. ::: Employees generally see these taxes withheld directly from their paychecks. Employers also make payroll-tax payments associated with their employees. For this reason, discussions of the economic burden of payroll taxes should consider both the employee and employer portions. The fact that the employer formally sends part of the tax to the government does not necessarily mean the employer bears the entire economic cost. Compensation, wages, hiring, and other labor-market conditions can adjust in response to taxes. This distinction between who legally pays a tax and who ultimately bears its economic cost is called **tax incidence**. ::: definitionbox **Definition** **Tax incidence** refers to who ultimately bears the economic burden of a tax. The person or business legally responsible for sending a tax payment to the government does not necessarily bear the entire economic cost of the tax. ::: ### 9.1.9 Social Security and Medicare Payroll Taxes The two major federal payroll taxes finance: - Social Security, - Medicare. Social Security provides benefits primarily to retirees, disabled workers, and qualifying family members. Medicare provides federal health insurance primarily to older Americans and certain other eligible individuals. These programs will appear again in the next section because they also represent major categories of federal expenditure. This creates an important connection: $$Payroll\ Taxes \rightarrow Federal\ Revenue$$ while: $$Social\ Security\ and\ Medicare \rightarrow Federal\ Expenditures.$$ The revenue and expenditure sides of the federal budget are related, but they should not be confused. ### 9.1.10 Corporate Income Taxes The federal government also taxes corporate income. ::: definitionbox **Definition** The **corporate income tax** is a tax imposed on the taxable profits of corporations. ::: Corporate income taxes are an important source of federal revenue, although they generally raise less revenue than individual income taxes or payroll taxes. As with other taxes, the person or organization legally responsible for paying the tax does not necessarily bear its entire economic burden. Corporate taxes can potentially affect: - shareholders, - workers, - consumers, - investment decisions. Determining the exact incidence of a tax can therefore be more complicated than simply identifying who writes the check to the government. ### 9.1.11 Excise Taxes An **excise tax** is a tax imposed on the sale or use of a particular product or activity. ::: definitionbox **Definition** An **excise tax** is a tax imposed on a particular good, service, or activity. ::: Federal excise taxes apply to selected products and activities. Unlike a general income tax, an excise tax applies specifically to the taxed item. Excise taxes generally provide a much smaller share of federal revenue than individual income taxes or payroll taxes. ### 9.1.12 Customs Duties and Other Revenue The federal government also receives revenue from **customs duties**, commonly called tariffs. A tariff is a tax on imported goods. ::: definitionbox **Definition** A **tariff** is a tax imposed on imported goods. Tariff revenue is one source of federal revenue, although it is generally much smaller than revenue from individual income taxes and payroll taxes. ::: The government also receives revenue from various fees, charges, and other sources. The important lesson is that the federal government’s revenue system is diversified, but it relies heavily on taxes connected to household income and employment. ### 9.1.13 Who Pays Federal Taxes? Statements about who “pays taxes” require care. Different taxes apply to different activities. A household may pay: - individual income taxes, - payroll taxes, - excise taxes, - tariffs indirectly through the prices of imported goods. A household that owes little or no federal individual income tax may still pay substantial payroll taxes. Likewise, businesses may legally remit taxes whose economic burden is partly passed to workers, consumers, or shareholders. Economists therefore distinguish between: > *Who sends the tax payment to the government?* and: > *Who ultimately bears the economic cost?* These are not always the same question. ### 9.1.14 Taxes Change Incentives Taxes provide revenue for government programs, but they also change economic incentives. Suppose a worker earns an additional $$\$100.$$ If the worker keeps the entire \$100, the reward from earning additional income is \$100. If taxes reduce the amount kept to \$70, the reward from earning the additional income is smaller. This does not mean that every tax increase causes people to stop working or that every tax cut causes people to work substantially more. It means that taxes change the marginal benefits associated with economic decisions. Taxes can potentially affect decisions about: - work, - saving, - investment, - entrepreneurship, - consumption. The magnitude of these responses is an empirical question. ::: modelbox **Key Economic Model** Taxes perform two economic functions simultaneously. First: $$Taxes \rightarrow Federal\ Revenue.$$ Second: $$Taxes \rightarrow Changes\ in\ Incentives.$$ Evaluating a tax therefore requires considering both the revenue it raises and the behavioral responses it creates. ::: ### 9.1.15 Tax Revenue Is Not the Same as the Tax Rate Another important distinction is between a tax rate and the amount of revenue collected. Suppose the government increases a tax rate. Revenue may increase. But the exact increase depends partly on how people respond. If the tax substantially changes work, investment, consumption, or other taxable activity, the tax base may change as well. Thus: $$Tax\ Revenue \neq Tax\ Rate.$$ Tax revenue depends on both $$Tax\ Rate$$ and $$Taxable\ Economic\ Activity.$$ This does not imply that lower tax rates always increase revenue or that higher tax rates always decrease revenue. Instead, it means that economic behavior matters when predicting the revenue consequences of tax changes. The relationship between tax rates and tax revenue is sometimes illustrated using the **Laffer Curve**. At a tax rate of 0%, the government collects no tax revenue. At the theoretical extreme of a 100% tax rate, the incentive to earn taxable income may become extremely weak, so the government may also collect relatively little revenue. Between these extremes, there is some tax rate that maximizes government revenue. The important insight of the Laffer Curve is not that tax cuts always increase tax revenue. If tax rates are below the revenue-maximizing rate, reducing the tax rate will reduce revenue; only when tax rates are sufficiently high could a lower rate potentially increase revenue by increasing taxable economic activity. Determining where an actual tax system lies on the Laffer Curve is therefore an empirical question about how strongly individuals and businesses respond to changes in tax rates. ### 9.1.16 Federal Revenue Changes with the Economy Federal revenue also changes automatically as economic conditions change. During a strong expansion: $$Employment\uparrow$$ and: $$Income\uparrow.$$ Income-tax and payroll-tax revenue therefore tend to increase. During a recession: $$Employment\downarrow$$ and: $$Income\ Growth\downarrow.$$ Federal tax revenue tends to decrease. These changes can occur even if Congress does not change any tax law. This feature of the tax system will become important when we discuss **automatic stabilizers** later in the chapter. ::: realworld **Economics in the Real World** Consider a worker looking at a paycheck. The amount withheld for federal taxes may include both individual income-tax withholding and payroll taxes. These are separate taxes. Income-tax withholding is associated with the worker’s expected federal individual income-tax liability. Payroll taxes finance Social Security and Medicare. Understanding this distinction helps explain why someone who ultimately owes little federal individual income tax can still have federal taxes deducted from every paycheck. ::: ::: misconception **Common Misconception** A common misconception is that the federal government receives most of its revenue from corporations or tariffs. Although these sources contribute to federal revenue, individual income taxes and payroll taxes generally provide much larger shares. Another misconception is that a tax’s legal payer necessarily bears its entire economic burden. Economists distinguish legal responsibility for remitting a tax from tax incidence, which describes who ultimately bears the economic cost. ::: :::: thinkingeconomist **Thinking Like an Economist** Consider the following simplified income-tax system: ::: center Taxable Income Marginal Tax Rate ----------------------- ------------------- First \$25,000 10% \$25,001–\$75,000 20% Income above \$75,000 30% ::: Suppose a taxpayer earns: $$\$90{,}000$$ of taxable income. Answer: 1. How much tax is owed on the first \$25,000? 2. How much tax is owed on the next \$50,000? 3. How much tax is owed on the final \$15,000? 4. What is total income-tax liability? 5. What is the taxpayer’s marginal tax rate? 6. What is the taxpayer’s average tax rate? 7. If the taxpayer earns one additional \$1,000, approximately how much of that additional income is owed in income tax? Then explain why saying “this taxpayer pays a 30% income-tax rate” is potentially misleading. :::: ::: researchbox **From the Research** In the last 70 years, the United States has employed many different tax regimes. However, during that time, tax revenue has remained remarkably stable at about 18% of GDP. The lack of response from tax revenue based on the tax regime calls into question our ability to “choose” tax revenue. In fact, if the government typically brings in about 18% of GDP in tax revenue, the government may be better served to pursue policies which maximize GDP. ::: ::: keytakeaways **Key Takeaways** - Federal revenue comes primarily from individual income taxes, payroll taxes, and corporate income taxes, with smaller amounts from excise taxes, tariffs, and other sources. - Individual income taxes and payroll taxes are different taxes. - The federal individual income tax uses a progressive marginal tax structure. - Moving into a higher tax bracket does not cause all taxable income to be taxed at the higher rate. - The marginal tax rate is the tax rate applied to an additional dollar of taxable income. - The average tax rate is: $$\frac{Total\ Taxes}{Taxable\ Income}\times100.$$ - Payroll taxes primarily finance Social Security and Medicare. - Corporate income taxes are imposed on taxable corporate profits. - Excise taxes apply to particular goods, services, or activities. - Tariffs are taxes on imported goods. - Tax incidence describes who ultimately bears the economic burden of a tax. - The legal payer of a tax does not necessarily bear its entire economic cost. - Taxes raise government revenue but can also change incentives to work, save, invest, consume, and engage in entrepreneurship. - Tax revenue depends on both tax rates and the amount of taxable economic activity. - Federal tax revenue tends to increase during economic expansions and decrease during recessions even without changes in tax law. ::: ::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to strengthen your understanding of federal revenue. Develop your own answer before asking the AI for assistance. 1. **Tax Brackets:** Ask the AI to generate five hypothetical progressive income-tax systems and taxable incomes. Calculate total tax liability yourself before checking the AI’s answers. 2. **Marginal Versus Average:** Ask the AI to create five taxpayers with different incomes under the same progressive tax system. Calculate each taxpayer’s marginal and average tax rates. 3. **Catch the Fallacy:** Ask the AI whether receiving a raise that moves someone into a higher marginal tax bracket can cause all of their income to be taxed at the higher rate. Evaluate its explanation carefully. 4. **Classify Revenue:** Ask the AI to generate ten examples of federal taxes or government receipts. Classify each as an individual income tax, payroll tax, corporate tax, excise tax, tariff, or other revenue before checking its answers. 5. **Tax Incidence:** Ask the AI to create three taxes in which the person legally sending the payment to the government may not bear the entire economic cost. Identify the possible effects on workers, consumers, businesses, or shareholders. 6. **Incentives:** Ask the AI to explain how marginal tax rates could affect decisions about work, saving, and investment. Critique any claim that assumes the behavioral response must always be either zero or extremely large. 7. **Reflect:** Explain in your own words why understanding where federal revenue comes from requires looking beyond the individual income tax shown on an annual tax return. ::: ## 9.2 Federal Government Expenditures {#sec:federal_expenditures} Section [9.1](#sec:federal_revenue){reference-type="ref" reference="sec:federal_revenue"} examined where the federal government gets its money. We now turn to the other side of the federal budget: > *Where does the money go?* The federal government spends money on many different activities, including retirement benefits, health care, national defense, transportation, scientific research, income support, and interest on the national debt. To understand federal spending, however, simply memorizing a list of programs is not enough. Students should understand three fundamental distinctions: 1. mandatory versus discretionary spending, 2. government purchases versus transfer payments, 3. current program spending versus interest on previously accumulated debt. These distinctions make it much easier to understand debates over the federal budget and the role of fiscal policy. ::: definitionbox **Definition** **Federal expenditures** are payments made by the federal government for government programs, purchases, transfers, interest, and other authorized activities. ::: ### 9.2.1 Three Broad Categories of Federal Spending For our purposes, federal expenditures can be organized into three broad categories: 1. mandatory spending, 2. discretionary spending, 3. net interest. Mandatory spending accounts for many of the largest federal programs. Discretionary spending includes defense and many federal agencies funded through the annual appropriations process. Net interest represents the cost of servicing federal debt. ::: modelbox **Key Economic Model** A useful way to organize the federal budget is: $$Federal\ Expenditures$$ $$\Downarrow$$ $$\begin{array}{ccc} Mandatory & Discretionary & Net\ Interest \end{array}$$ These categories differ in how spending is determined and why the government makes the payments. ::: ### 9.2.2 Mandatory Spending **Mandatory spending** is spending determined primarily by laws establishing eligibility rules, benefit formulas, and other program requirements. ::: definitionbox **Definition** **Mandatory spending** is federal spending that occurs because existing laws establish eligibility requirements or payment formulas. Congress does not need to determine the exact amount of mandatory spending through the annual appropriations process each year. ::: The word “mandatory” can be misleading. It does not mean that the programs can never be changed. Congress can change the laws governing mandatory programs. Rather, it means that once the law establishes who qualifies and what benefits they receive, spending occurs according to those rules. Suppose a law states that everyone meeting particular age and earnings requirements qualifies for a Social Security benefit determined by a formula. If more people become eligible $$Number\ of\ Beneficiaries\uparrow,$$ then $$Government\ Spending\uparrow$$ even if Congress does not pass a new appropriations bill increasing spending that year. This makes mandatory spending different from discretionary spending. ### 9.2.3 Social Security **Social Security** is one of the largest federal programs. It provides benefits primarily to: - retired workers, - disabled workers, - qualifying spouses and dependents, - survivors of deceased workers. Workers generally become eligible for benefits based on their history of covered employment and payroll-tax contributions. As discussed in Section [9.1](#sec:federal_revenue){reference-type="ref" reference="sec:federal_revenue"}, Social Security is financed substantially through payroll taxes. This creates an important connection between the revenue and expenditure sides of the federal budget: $$Payroll\ Tax\ Revenue$$ helps finance: $$Social\ Security\ Benefits.$$ However, students should avoid imagining Social Security as simply an individual savings account in which the government stores each worker’s payroll taxes until retirement. Current payroll-tax revenue is used largely to finance current benefits, with trust-fund accounting helping track the program’s finances. ::: definitionbox **Definition** **Social Security** is a federal social-insurance program providing retirement, disability, survivor, and related benefits to eligible individuals and families. ::: Demographics therefore matter enormously for Social Security finances. If the number of beneficiaries grows relative to the number of workers paying payroll taxes, financing the program becomes more difficult. ### 9.2.4 Medicare **Medicare** is another major mandatory program. Medicare provides federal health-insurance coverage primarily to people age 65 and older, as well as certain younger people who meet specific eligibility requirements. ::: definitionbox **Definition** **Medicare** is a federal health-insurance program primarily serving older Americans and certain other eligible individuals. ::: Medicare is financed through several sources, including: - payroll taxes, - premiums paid by beneficiaries, - general federal revenue, - other program revenues. Medicare spending depends partly on: - the number of eligible beneficiaries, - the quantity of medical services used, - the prices of medical services, - the structure of federal benefits. As the population ages and health-care costs change, Medicare can become an increasingly important part of the federal budget. ### 9.2.5 Medicaid and Other Health Programs The federal government also spends substantial amounts on **Medicaid** and other health programs. Medicaid provides health coverage to qualifying low-income individuals and families and is jointly financed by the federal government and state governments. ::: definitionbox **Definition** **Medicaid** is a public health-insurance program for qualifying low-income individuals and families that is jointly financed by the federal and state governments. ::: Medicare and Medicaid are therefore different programs. A simple distinction is: - Medicare is primarily associated with age and certain qualifying conditions. - Medicaid is primarily associated with income and other eligibility requirements. Some individuals can qualify for both programs. ### 9.2.6 Income-Support Programs Mandatory spending also includes programs intended to provide income or other assistance to qualifying households. Examples can include: - unemployment benefits, - food assistance, - disability programs, - refundable tax credits, - other means-tested benefits. Eligibility and funding structures differ across programs. The important macroeconomic feature is that spending on some of these programs changes automatically when economic conditions change. During a recession: $$Unemployment\uparrow$$ may cause: $$Unemployment\ Benefits\uparrow.$$ Likewise, falling household income can increase eligibility for some assistance programs. This feature will become important when we study **automatic stabilizers**. ### 9.2.7 Discretionary Spending The second major category is **discretionary spending**. ::: definitionbox **Definition** **Discretionary spending** is federal spending determined through the regular congressional appropriations process. Congress decides how much funding to provide for these programs through legislation. ::: Discretionary spending includes many activities people commonly associate with the federal government. Examples include: - national defense, - transportation, - scientific research, - federal law enforcement, - environmental programs, - education programs, - foreign affairs, - many federal agencies. The term “discretionary” does not mean that the spending is unimportant or optional in an everyday sense. It refers to the budgeting process used to determine the spending. Essentially, Congress uses its discretion to set the level of spending on these items. ### 9.2.8 Defense Spending National defense represents a major component of discretionary spending. Defense expenditures include resources used for: - military personnel, - equipment, - weapons systems, - military facilities, - operations, - research and development, - other national-security activities. Much of this spending involves the federal government purchasing currently produced goods and services. For example, when the government purchases an aircraft produced this year, that expenditure contributes directly to current GDP. This will matter when we return to: $$Y=C+I+G+NX.$$ ### 9.2.9 Nondefense Discretionary Spending Discretionary spending also includes many nondefense activities. Examples include federal spending on: - transportation infrastructure, - scientific research, - federal courts, - environmental protection, - education programs, - space exploration, - public health agencies, - law enforcement. Individual programs can be economically important while still representing relatively small portions of total federal expenditures. This distinction matters when evaluating proposals to substantially reduce total federal spending. ### 9.2.10 Foreign Aid Foreign aid receives substantial public attention, and surveys have often found that people considerably overestimate its share of the federal budget. Foreign assistance can include: - humanitarian assistance, - economic-development programs, - security assistance, - disaster relief, - other international programs. These programs can be important for foreign-policy or humanitarian reasons. However, foreign aid represents a relatively small portion of total federal expenditures compared to major categories such as Social Security, health programs, defense, and interest. ::: misconception **Common Misconception** A common misconception is that foreign aid accounts for a very large share of federal spending. It does not. Eliminating foreign aid entirely would not come close to eliminating the federal government’s major long-run budget challenges. Understanding the scale of different spending categories is essential when evaluating proposals to reduce total federal expenditures. ::: ### 9.2.11 Mandatory Versus Discretionary Spending The distinction between mandatory and discretionary spending helps explain why reducing federal expenditures can be politically and economically difficult. Suppose someone proposes: > *“Cut government agency budgets and balance the federal budget.”* The proposal may reduce some spending. But many of the largest federal programs are mandatory programs rather than ordinary agency appropriations. Large reductions in total federal spending therefore eventually require confronting questions involving major categories such as: - Social Security, - Medicare, - other health programs, - defense, - interest. Small programs can matter, but arithmetic matters too. ::: modelbox **Key Economic Model** When evaluating a proposal to reduce federal spending, ask: 1. How large is the program relative to total federal expenditures? 2. Is the program mandatory or discretionary? 3. Would reducing it require changing eligibility or benefits? 4. What economic or social services would no longer be provided? A large percentage cut to a small program can still produce only a small reduction in total federal spending. ::: ### 9.2.12 Government Purchases Versus Transfer Payments One of the most important distinctions in macroeconomics is between **government purchases** and **transfer payments**. A government purchase occurs when the government buys a currently produced good or service. Examples include: - purchasing military equipment, - paying a federal employee for current work, - purchasing construction services, - buying office equipment. These expenditures involve current production. They therefore enter GDP through: $$G.$$ ::: definitionbox **Definition** A **government purchase** is government spending on a currently produced good or service. Government purchases are included in: $$G$$ in the expenditure approach to GDP. ::: A **transfer payment** is different. A transfer payment transfers purchasing power from the government to an individual without purchasing a currently produced good or service in return. Examples include many: - Social Security benefits, - unemployment benefits, - income-support payments. ::: definitionbox **Definition** A **transfer payment** is a government payment to an individual for which the government does not receive a currently produced good or service in exchange. Transfer payments are not directly included in $G$ when calculating GDP. ::: This distinction is crucial. Suppose the federal government sends a retiree \$2,000 in Social Security benefits. That payment itself does not represent current production. Therefore, it is not directly counted in GDP. If the retiree subsequently spends \$1,500 on currently produced goods and services, that spending may enter GDP through C. Thus, transfers can affect Aggregate Demand without directly entering G. ::: modelbox **Key Economic Model** **Government Purchase** $$Government \rightarrow Purchases\ Current\ Good\ or\ Service \rightarrow G.$$ **Transfer Payment** $$Government \rightarrow Transfers\ Purchasing\ Power \rightarrow Household \rightarrow Possible\ Consumption.$$ Transfers can influence Aggregate Demand, but they are not themselves government purchases in GDP. ::: ### 9.2.13 Net Interest The third broad category of federal expenditure is **net interest**. When the federal government borrows money, it issues Treasury securities. Investors who hold these securities receive interest. ::: definitionbox **Definition** **Net interest** is the federal government’s interest payments on outstanding federal debt, net of certain interest income received by the government. ::: Interest spending differs from many other federal expenditures. The government is not primarily purchasing a new public service with the payment. Instead, it is paying the financing cost associated with previous borrowing. Suppose federal debt increases. Holding interest rates constant: $$Federal\ Debt\uparrow$$ tends eventually to cause: $$Interest\ Payments\uparrow.$$ Likewise, if market interest rates rise: $$Interest\ Rates\uparrow,$$ the cost of financing federal debt can increase as existing debt matures and is replaced with newly issued debt carrying higher interest rates. ::: modelbox **Key Economic Model** Federal interest costs depend importantly on: $$Amount\ of\ Debt$$ and: $$Interest\ Rates.$$ Therefore: $$Debt\uparrow$$ or: $$Interest\ Rates\uparrow$$ can cause: $$Federal\ Interest\ Expenditures\uparrow.$$ ::: Interest costs will become especially important in the next section when we distinguish annual budget deficits from the accumulated national debt. ### 9.2.14 Federal Spending Changes Over Time The composition of federal spending is not fixed. Demographics can change mandatory spending. Wars and national-security conditions can change defense spending. Recessions can increase unemployment benefits and other income-support expenditures. Interest rates and accumulated debt can change net interest costs. New legislation can create, expand, reduce, or eliminate programs. Thus, federal expenditures reflect both: - deliberate policy choices, - automatic responses to changing economic and demographic conditions. This distinction becomes particularly important during recessions. An increase in federal spending does not necessarily mean Congress passed a new stimulus bill. Some spending can increase automatically because more people qualify for existing programs. ### 9.2.15 Spending Requires Resources Federal expenditures are often discussed only in dollar terms. But economics asks a deeper question: > *What real resources are being used?* Suppose the government spends \$10 billion building highways. The true economic cost is not simply the \$10 billion. The government uses: - construction workers, - concrete, - steel, - machinery, - land, - engineering services. Those resources could have been used elsewhere. Government spending therefore has an **opportunity cost**, just like private spending. This does not mean government spending is necessarily undesirable. A highway, scientific discovery, national defense, or other public service may create benefits greater than its cost. The economic question is whether the resources create more value in the government use than they would have created in their best alternative use. ::: modelbox **Key Economic Model** The economic cost of government spending is ultimately: $$Resources\ Used$$ rather than simply: $$Dollars\ Spent.$$ Every government expenditure therefore has an opportunity cost. The relevant economic question is whether the benefits of the expenditure exceed the value of the resources in their best alternative use. ::: ::: realworld **Economics in the Real World** Suppose federal expenditures increase during a recession. There are several possible explanations. Congress may have passed a new infrastructure bill. That would represent a deliberate increase in government purchases. Alternatively, unemployment may have increased, automatically raising unemployment-benefit payments. That would increase transfer spending even without new legislation. Both changes increase federal expenditures, but they occur for different reasons and affect the economy through different mechanisms. Understanding the composition of spending is therefore more informative than simply observing the total dollar amount. ::: ::: misconception **Common Misconception** A common misconception is that every dollar the federal government spends is included in $G$ when GDP is calculated. It is not. Government purchases of currently produced goods and services enter $G$. Transfer payments such as many Social Security and unemployment benefits do not directly represent current production and therefore are not directly included in $G$. Transfers can still affect GDP indirectly when recipients use the income for consumption. ::: ::: thinkingeconomist **Thinking Like an Economist** Classify each federal expenditure according to whether it is primarily: - mandatory or discretionary, - a government purchase or transfer payment. 1. A Social Security retirement benefit. 2. The federal government purchases a new military aircraft. 3. A federal agency pays an engineer for current work. 4. An unemployed worker receives unemployment benefits. 5. The federal government pays a construction company to repair a highway. 6. A qualifying household receives income-support benefits. Then answer: a. Which expenditures enter $G$ directly? b. Which could affect $C$ indirectly? c. Why does the distinction matter for understanding fiscal policy? ::: ::: researchbox **From the Research** Read the paper *Federal Debts and Deficits: Past, Present and Future* by Baier and Posmanick available here: . The paper shows how the government budget has changed over time. In the past 50 years, the share of GDP spent on discretionary programs has remained relatively constant. However, the amount of GDP spent on mandatory programs has exploded to more than half of the federal budget. The change has caused some economists to remark that the federal government is the world’s largest insurance company with an army. ::: ::: keytakeaways **Key Takeaways** - Federal expenditures can be organized broadly into mandatory spending, discretionary spending, and net interest. - Mandatory spending occurs according to eligibility rules and formulas established in existing law. - Social Security, Medicare, Medicaid, and many income-support programs are major examples of mandatory spending. - Discretionary spending is determined through the congressional appropriations process. - Defense and many federal agencies are funded through discretionary spending. - Foreign aid represents a relatively small share of total federal expenditures. - Large reductions in total federal spending generally cannot be achieved solely by cutting small discretionary programs. - Government purchases and transfer payments are economically different. - Government purchases of currently produced goods and services are included in $G$. - Transfer payments are not directly included in $G$ because they do not represent purchases of current production. - Transfer payments can affect Aggregate Demand indirectly through household consumption. - Net interest represents the financing cost associated with outstanding federal debt. - Larger federal debt and higher interest rates can increase federal interest expenditures. - Some federal expenditures change automatically with economic conditions. - Government spending uses scarce real resources and therefore has an opportunity cost. - The amount spent on a program is not itself a measure of the value or effectiveness of the program. ::: ::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to strengthen your understanding of federal expenditures. Develop your own answer before asking the AI for assistance. 1. **Classify Spending:** Ask the AI to generate fifteen examples of federal expenditures. Classify each as mandatory, discretionary, or net interest before checking its answers. 2. **Purchases Versus Transfers:** Ask the AI to generate ten government payments. Determine whether each is a government purchase or transfer payment and whether it enters $G$ directly. 3. **Social Security:** Ask the AI whether Social Security benefits are included directly in GDP. Evaluate whether it correctly distinguishes the transfer itself from subsequent consumption by the recipient. 4. **Budget Scale:** Ask the AI to rank several broad federal spending categories by approximate size. Verify its claims using a reliable federal budget source rather than accepting the rankings automatically. 5. **Foreign Aid:** Ask the AI what percentage of federal expenditures goes to foreign aid. Compare its estimate with a reliable government source and explain why public perceptions might differ from the actual budget share. 6. **Opportunity Cost:** Ask the AI to choose a hypothetical \$10 billion government expenditure and identify the real resources required. Then identify at least two alternative uses of those resources. 7. **Reflect:** Explain in your own words why knowing that “federal spending increased” is not enough information to determine either why spending increased or how it affects the economy. ::: ## 9.3 Deficits, Surpluses, and the National Debt {#sec:deficits_debt} Sections 9.1 and 9.2 examined federal revenue and expenditures. We can now combine them to understand the federal government’s budget balance and the national debt. The most important distinction in this section is simple: > *The deficit is a flow. The debt is a stock.* A deficit measures how much the government borrows during a particular period. Debt measures how much the government has accumulated over time. ### 9.3.1 The Federal Budget Balance The government’s budget balance is: $$Budget\ Balance = Revenue-Expenditures.$$ If: $$Revenue>Expenditures,$$ the government runs a **budget surplus**. If: $$Revenue. In the video, Antony Davies from Duquesne University presents a variety of interesting facts about the federal debt. While the video is from 2017 and the numbers are a bit outdated, the main themes remain interesting and relevant today. ::: ::: keytakeaways **Key Takeaways** - The budget balance is: $$Revenue-Expenditures.$$ - A deficit occurs when expenditures exceed revenue. - A surplus occurs when revenue exceeds expenditures. - Deficits are flows; debt is a stock. - Deficits are financed primarily through government borrowing. - Repeated deficits generally increase federal debt. - A falling deficit does not necessarily mean falling debt. - Debt-to-GDP provides important context for evaluating federal debt. - Federal debt creates interest costs. - Government borrowing can potentially crowd out private investment. - Deficits can increase automatically during recessions as tax revenue falls and transfer spending rises. - Fiscal sustainability depends on debt, GDP, interest rates, revenue, and future expenditures rather than simply on whether debt exists. ::: ::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to practice the basic fiscal accounting relationships in this section. 1. **Deficit or Surplus:** Ask the AI to generate ten combinations of federal revenue and expenditures. Classify each as a deficit or surplus before checking the answers. 2. **Deficit Versus Debt:** Ask the AI to create a five-year sequence of deficits and surpluses. Calculate the resulting debt yourself. 3. **Debt-to-GDP:** Ask the AI to generate five hypothetical debt and GDP combinations. Calculate the debt-to-GDP ratio before checking its answers. 4. **Catch the Fallacy:** Ask the AI whether a falling deficit necessarily means falling debt. Explain the answer yourself before evaluating its response. 5. **Automatic Changes:** Ask the AI to explain how a recession can increase the federal deficit even if Congress passes no new tax or spending legislation. 6. **Reflect:** Explain in your own words why the deficit and national debt are different economic concepts and why both matter for understanding fiscal policy. ::: ## 9.4 Fiscal Policy and Aggregate Demand {#sec:fiscal_policy_ad} Sections 9.1 through 9.3 examined the federal government’s revenue, expenditures, deficits, and debt. We can now return to the AD–AS model from Chapter 7 and ask: > *How can changes in federal taxes and government spending affect the economy?* The answer is the subject of **fiscal policy**. ::: definitionbox **Definition** **Fiscal policy** refers to deliberate changes in government spending and taxation intended to influence economic activity. ::: The key to understanding fiscal policy is to remember the expenditure identity from Chapter 2: $$Y=C+I+G+NX.$$ Government purchases are part of: $$G.$$ Taxes are not a separate term in the expenditure identity. Instead, taxes influence the spending decisions of households and businesses, especially consumption and investment. This distinction is the foundation of fiscal policy. ### 9.4.1 Expansionary Fiscal Policy Suppose the economy is experiencing a recessionary growth gap: $$\%\Delta Yg^*.$$ The economy is growing faster than its sustainable long-run rate and experiencing inflationary pressure. The government can adopt **contractionary fiscal policy** by: - reducing government purchases, - increasing taxes. ::: definitionbox **Definition** **Contractionary fiscal policy** consists of deliberate reductions in government spending or increases in taxes intended to reduce Aggregate Demand. ::: A reduction in government purchases directly reduces G. Therefore, the economy experiences a reduction in aggregate spending and AD shifts left. Higher taxes reduce disposable income and can reduce consumption and investment. Therefore, C and I may be lower as taxes become higher. This reduces aggregate spending and shifts AD left. ::: modelbox **Key Economic Model** **Contractionary Fiscal Policy** $$G\downarrow \quad\ and/or \quad T\uparrow$$ $$\Downarrow$$ $$Aggregate\ Spending\ Growth\downarrow$$ $$\Downarrow$$ $$AD\leftarrow$$ In the short run: $$Real\ GDP\ Growth\downarrow$$ and: $$Inflation\downarrow.$$ ::: ### 9.4.3 Fiscal Policy in the AD–AS Model The mechanics are nearly identical to the monetary-policy analysis in Chapter 8. The difference is the source of the Aggregate Demand shift. With monetary policy: $$Federal\ Reserve \rightarrow Monetary\ Conditions \rightarrow AD.$$ With fiscal policy: $$Government\ Spending\ and\ Taxes \rightarrow Aggregate\ Spending \rightarrow AD.$$ ::: center Monetary Policy Fiscal Policy ------------------------------------------------------- -------------------------------------------------------------- Federal Reserve changes monetary conditions Government changes spending or taxes Works through interest rates and financial conditions Works directly through $G$ or indirectly through $C$ and $I$ Changes Aggregate Demand Changes Aggregate Demand Short-run effects on inflation and real GDP growth Short-run effects on inflation and real GDP growth ::: This is why fiscal and monetary policy can produce similar short-run effects even though they operate through different institutions and mechanisms. ### 9.4.4 The Fiscal Multiplier Government spending can have effects larger than the initial expenditure because one person’s spending becomes another person’s income. Suppose the government purchases: \$100 billion of goods and services. The firms receiving that revenue may pay workers and suppliers. Those workers and suppliers now have additional income. They may spend part of that income. The recipients of that spending receive additional income and may spend part of it as well. The process can continue through several rounds. This is the intuition behind the **fiscal multiplier**. ::: definitionbox **Definition** The **fiscal multiplier** describes the change in aggregate economic activity associated with an initial change in government spending or taxation. The multiplier can make the total change in Aggregate Demand larger than the initial fiscal change. ::: The simplest spending-multiplier model assumes a constant marginal propensity to consume. If households spend a fraction: $$MPC$$ of each additional dollar of income, the simplified government-spending multiplier is: $$\frac{1}{1-MPC}.$$ For example, if: $$MPC=0.75,$$ then: $$Multiplier = \frac{1}{1-0.75} = 4.$$ A \$100 billion increase in government purchases would therefore produce a theoretical \$400 billion increase in aggregate spending under the simplified model. ::: modelbox **Key Economic Model** The simplified spending multiplier is: $$\frac{1}{1-MPC}.$$ A larger $MPC$ produces a larger multiplier because households spend a larger portion of each additional dollar of income. The multiplier is a simplified model. In reality, taxes, saving, imports, interest rates, expectations, and changes in investment can reduce or otherwise alter the total effect. ::: ### 9.4.5 Tax Changes Have a Different Multiplier Tax changes generally have a smaller immediate effect on Aggregate Demand than an equal-sized change in government purchases. Why? Because households do not necessarily spend all of a tax cut. Suppose the government reduces taxes by: \$100 billion If households spend only: $$75\%$$ of the additional disposable income, initial consumption increases by approximately: $$\$75\text{ billion}.$$ The remaining: $$\$25\text{ billion}$$ is saved or used for other purposes. Thus, the initial effect on aggregate spending is smaller than it would be from a \$100 billion increase in government purchases. This does not mean tax cuts can never have large effects. It means the mechanism differs. ::: modelbox **Key Economic Model** Government purchases: $$G\uparrow$$ enter Aggregate Demand directly. Tax reductions: $$T\downarrow$$ first increase disposable income and then affect: $$C$$ and potentially: $$I.$$ Therefore, an equal-sized change in $G$ and $T$ does not necessarily produce equal changes in Aggregate Demand. ::: ### 9.4.6 Fiscal Policy Has Limits The AD–AS model makes fiscal policy look simple. If growth is too low: $$AD\rightarrow.$$ If growth is too high: $$AD\leftarrow.$$ But the government faces many practical limitations. First, fiscal policy requires political decisions. Congress and the President must agree on tax and spending legislation. Second, legislation can take time. Third, the economy can change between the time a policy is proposed and the time its effects occur. Fourth, households and businesses may respond differently than policymakers expect. Finally, expansionary fiscal policy can increase the federal deficit and therefore increase government borrowing. These limitations are one reason fiscal policy cannot be treated as a perfectly precise economic instrument. ### 9.4.7 Fiscal Policy Versus Long-Run Growth Fiscal policy can influence short-run Aggregate Demand. But some fiscal policies can also affect the economy’s long-run productive capacity. Consider two hypothetical government expenditures. One finances productive infrastructure that reduces transportation costs for businesses. Another finances spending that produces no lasting increase in productive capacity. Both increase G in the short run. But their long-run effects could be very different. Similarly, taxes can affect incentives to: - work, - save, - invest, - start businesses. Therefore, unlike a purely short-run AD analysis, fiscal policy can potentially influence both: $$AD$$ and: $$LRAS.$$ Which effect occurs depends on the specific policy. ::: misconception **Common Misconception** A common misconception is that fiscal policy is simply “government spending.” Fiscal policy includes both: $$Government\ Spending$$ and: $$Taxation.$$ Furthermore, not every government expenditure has the same economic effect. Government purchases directly enter $G$, while transfer payments affect Aggregate Demand through the spending decisions of recipients. The economic effect therefore depends on exactly what the government changes. ::: ::: realworld **Economics in the Real World** Imagine that the economy enters a recession without Congress passing a new stimulus bill. Household incomes fall. Because federal income taxes are linked to income, tax revenue falls automatically. At the same time, more people may become eligible for unemployment insurance and other income-support programs. Federal spending therefore increases while revenue falls. The budget deficit becomes larger. The resulting fiscal impulse can cushion the decline in Aggregate Demand even though policymakers did not deliberately change tax rates or spending programs. This is one reason the federal budget can act as a partial stabilizer of the business cycle. ::: ::: thinkingeconomist **Thinking Like an Economist** Suppose an economy has: $$g^*=3\%.$$ Consider two situations. **Economy A** is growing at: $$0\%.$$ **Economy B** is growing at: $$6\%.$$ For each economy: 1. Would expansionary or contractionary fiscal policy be more appropriate if policymakers wanted to move growth toward $g^*$? 2. Should government purchases increase or decrease? 3. Should taxes increase or decrease? 4. What happens to Aggregate Demand? 5. What happens to inflation and real GDP growth in the short run? 6. What happens to the budget deficit, holding other factors constant? Then explain why an automatic increase in the deficit during a recession is not necessarily evidence of a deliberate fiscal-policy decision. ::: ::: researchbox **From the Research** One key limitation to fiscal policy is the political process. First, the necessary amount of spending or tax breaks necessary to move the AD curve may not be politically feasible. For instance, if Congress presented a plan to spend \$10 trillion this year in stimulus, it would probably be sufficiently unpopular with the American people that the plan would not pass. Second, Congress generally has a very difficult time passing budgets during the regular allocation process and frequently the US government is financed through continuing resolutions or with budget allocations passed after their “deadline.” While the gridlock in Washington, D.C. is an intentional design feature of the US Constitution, it constrains the ability of Congress to use fiscal policy. ::: ::: keytakeaways **Key Takeaways** - Fiscal policy consists of deliberate changes in government spending and taxation intended to influence economic activity. - Expansionary fiscal policy increases $G$ and/or reduces $T$, shifting AD right. - Contractionary fiscal policy reduces $G$ and/or increases $T$, shifting AD left. - Government purchases affect Aggregate Demand directly through: $$G.$$ - Taxes affect Aggregate Demand indirectly through household and business spending. - Transfer payments are not included directly in $G$, but they can affect Aggregate Demand through consumption and saving decisions. - The fiscal multiplier describes how an initial fiscal change can produce a larger total change in aggregate spending. - The simplified government-spending multiplier is: $$\frac{1}{1-MPC}.$$ - The effect of a tax change depends on how recipients change their spending and saving. - Expansionary fiscal policy can help close a recessionary growth gap. - Contractionary fiscal policy can help close an inflationary growth gap. - Expansionary fiscal policy typically increases the budget deficit, while contractionary fiscal policy typically reduces it. - Fiscal policy is limited by political decision-making, policy lags, uncertainty, and behavioral responses. - Some fiscal policies can affect long-run productive capacity in addition to short-run Aggregate Demand. - Automatic stabilizers change government revenue and expenditures as economic conditions change without requiring new legislation. ::: ::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to practice applying fiscal policy to the AD–AS model. 1. **Classify:** Ask the AI to generate ten fiscal-policy actions. Identify whether each is expansionary, contractionary, or neither before checking the AI’s answers. 2. **Government Purchases Versus Transfers:** Ask the AI to generate examples of government purchases and transfer payments. Determine which directly enter $G$ and which affect Aggregate Demand indirectly. 3. **Multiplier:** Ask the AI to create five problems involving different marginal propensities to consume. Calculate the simplified spending multiplier yourself before checking the answers. 4. **Diagnose the Gap:** Give the AI several values for $g^*$ and actual real GDP growth. Determine whether expansionary or contractionary fiscal policy would move the economy toward long-run equilibrium. 5. **Compare Policies:** Ask the AI to compare a \$100 billion increase in government purchases with a \$100 billion tax cut. Explain why the two policies may have different effects on Aggregate Demand. 6. **Automatic Stabilizers:** Ask the AI to explain why the federal deficit can increase during a recession without a new fiscal-policy law. Check whether it correctly discusses declining tax revenue and increasing transfer payments. 7. **Challenge:** Ask the AI whether a larger federal deficit always means that policymakers adopted expansionary fiscal policy. Critique the answer using the distinction between discretionary policy and automatic stabilizers. 8. **Reflect:** Explain in your own words why fiscal policy is more than simply “government spending” and why the exact type of spending or tax change matters. ::: ## 9.5 Automatic Stabilizers {#sec:automatic_stabilizers} In Section 9.4, we examined **discretionary fiscal policy**: deliberate changes in taxes or government spending made by policymakers to influence economic activity. But the federal budget can also respond to the business cycle automatically. When the economy weakens, some taxes automatically fall while some government transfers automatically rise. When the economy strengthens, the process reverses. These features of the tax and transfer system are called **automatic stabilizers**. ::: definitionbox **Definition** **Automatic stabilizers** are features of the federal tax and transfer system that automatically change government revenue or expenditures as economic conditions change, without requiring new legislation. They tend to support Aggregate Demand during recessions and restrain Aggregate Demand during expansions. ::: ### 9.5.1 Automatic Stabilizers During a Recession Suppose the economy enters a recession. Household incomes and employment decline: $$Income\downarrow$$ and: $$Employment\downarrow.$$ Because federal income-tax revenue is tied to income: $$Tax\ Revenue\downarrow.$$ At the same time, more households may qualify for unemployment insurance and other income-support programs: $$Transfer\ Payments\uparrow.$$ The federal budget therefore becomes more expansionary automatically. Households have less income taken away through taxes, while some households receive additional transfer income. These changes support consumption and therefore help prevent Aggregate Demand from falling as much as it otherwise would. ::: modelbox **Key Economic Model** During a recession: $$Income\downarrow \rightarrow Tax\ Revenue\downarrow$$ and: $$Unemployment\uparrow \rightarrow Transfer\ Payments\uparrow.$$ Therefore: $$Disposable\ Income\ is\ supported$$ and: $$AD\downarrow\ is\ partially\ cushioned.$$ ::: The important feature is that no new fiscal-policy law is required for these changes to occur. ### 9.5.2 Automatic Stabilizers During an Expansion During an economic expansion, the process reverses. As: $$Income\uparrow,$$ tax revenue increases: $$Tax\ Revenue\uparrow.$$ As: $$Unemployment\downarrow,$$ fewer people qualify for unemployment benefits and some other transfers: $$Transfer\ Payments\downarrow.$$ Households therefore receive less support from the fiscal system while paying more in taxes. This tends to restrain the growth of Aggregate Demand. ::: modelbox **Key Economic Model** During an expansion: $$Income\uparrow \rightarrow Tax\ Revenue\uparrow$$ and: $$Unemployment\downarrow \rightarrow Transfer\ Payments\downarrow.$$ Therefore: $$AD\uparrow\ is\ partially\ restrained.$$ ::: Automatic stabilizers therefore work in both directions. They provide some support when the economy is weak and some restraint when the economy is strong. ### 9.5.3 The Limits of Automatic Stabilizers Automatic stabilizers do not eliminate recessions or expansions. They simply reduce the size of the change in Aggregate Demand. Their effect also depends on the structure of the tax and transfer system. A more progressive tax system generally provides stronger automatic stabilization because tax revenue changes more substantially as incomes change. Likewise, transfer programs with eligibility tied closely to economic conditions can provide greater support during downturns. The important lesson is that the federal budget is not passive. Even without a new fiscal-policy decision, changes in economic activity automatically change both federal revenue and federal expenditures. ::: realworld **Economics in the Real World** Suppose unemployment suddenly rises. Congress does not need to pass a new law before eligible workers can begin receiving unemployment benefits under an existing program. At the same time, the incomes of employed workers and businesses may fall, reducing tax payments. The result is an automatic increase in the federal deficit that helps support household income and Aggregate Demand. When the economy recovers, these effects reverse automatically. ::: ::: misconception **Common Misconception** A common misconception is that every increase in the federal budget deficit is evidence of a new stimulus program. A recession can increase the deficit automatically because tax revenue falls and some transfer payments rise. Economists therefore distinguish between changes in the budget caused by the business cycle and deliberate changes in fiscal policy. ::: ::: thinkingeconomist **Thinking Like an Economist** Suppose the economy enters a recession. Without any change in tax law or spending legislation: $$Income\downarrow$$ and: $$Unemployment\uparrow.$$ Explain the two automatic changes to the federal budget and how each one helps cushion the decline in Aggregate Demand. Then explain why the same mechanisms work in reverse during an economic expansion. ::: ::: keytakeaways **Key Takeaways** - Automatic stabilizers change federal revenue and expenditures automatically as economic conditions change. - During recessions, tax revenue falls and some transfer payments rise. - These changes partially cushion declines in Aggregate Demand. - During expansions, tax revenue rises and some transfer payments fall. - These changes partially restrain Aggregate Demand. - Automatic stabilizers do not require new fiscal-policy legislation. - Automatic stabilizers are different from discretionary fiscal policy. - A larger federal deficit can result from automatic stabilization rather than deliberate fiscal stimulus. ::: ::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to practice identifying automatic stabilizers. 1. **Classify:** Ask the AI to generate ten changes in the federal budget. Determine whether each is an automatic stabilizer or discretionary fiscal policy before checking its answers. 2. **Trace:** Ask the AI to explain what happens to taxes, transfers, the budget deficit, and Aggregate Demand during a recession. Check the causal chain yourself. 3. **Reverse:** Ask the AI to explain how the same mechanisms operate during an expansion. 4. **Catch the Fallacy:** Ask the AI whether a larger federal deficit proves that Congress enacted expansionary fiscal policy. Evaluate its answer. 5. **Reflect:** Explain in your own words why automatic stabilizers make the federal budget respond to the business cycle even when policymakers do nothing. ::: ## 9.6 Fiscal Policy in the Long Run {#sec:fiscal_policy_long_run} Fiscal policy can influence Aggregate Demand in the short run, but its long-run effects depend on the particular taxes and expenditures involved. Recall from Chapters 5 and 6: $$Y=AF(K,L).$$ Long-run economic growth depends on capital, labor, and productivity. Fiscal policy can affect these variables, but simply increasing government spending does not automatically increase the economy’s sustainable growth rate. ### 9.6.1 Fiscal Policy and Productive Capacity Suppose the government increases spending by \$100 billion. In the short run, additional government purchases can increase Aggregate Demand. But the long-run effect depends on what the government purchases. Spending on productive infrastructure, basic scientific research, or other activities that increase private-sector productivity could potentially increase: $$A$$ or facilitate greater capital accumulation. If so: $$g^*\uparrow.$$ By contrast, spending that does not increase productive capacity may increase Aggregate Demand today without increasing long-run growth. ::: modelbox **Key Economic Model** Fiscal policy can affect two different parts of the AD–AS model: $$Taxes\ and\ Spending \rightarrow AD$$ in the short run. But some policies can also affect: $$K,\quad L,\quad A$$ and therefore: $$LRAS$$ in the long run. The long-run effect depends on the specific policy, not simply on the number of dollars spent. ::: ### 9.6.2 Taxes and Long-Run Growth Taxes can also affect long-run productive capacity because they change incentives. Tax policy can influence decisions to: - work, - save, - invest, - start businesses, - develop new technologies. A tax change that encourages productive investment could contribute to greater long-run output. A tax system that substantially discourages productive activity could reduce it. However, taxes also finance government services, some of which can themselves contribute to productivity. The relevant economic question is therefore not simply whether taxes are “high” or “low.” It is how the combination of taxes and government expenditures affects incentives and productive capacity. ### 9.6.3 Deficits and Future Tradeoffs Fiscal policy also affects the federal government’s long-run financial position. Persistent deficits produce: $$Debt\uparrow,$$ which can produce: $$Interest\ Costs\uparrow.$$ Higher interest costs require future resources. Those resources must ultimately come from some combination of: - higher future taxes, - lower future spending on other programs, - additional borrowing. Government borrowing can also potentially crowd out private investment. Thus, fiscal policy that provides benefits today can create costs or constraints in the future. ### 9.6.4 There Is No Free Fiscal Lunch Fiscal policy ultimately involves tradeoffs. Government spending uses real resources. Taxes affect incentives. Borrowing creates future obligations. None of this means that government spending, taxation, or borrowing is inherently undesirable. It means that every fiscal choice has an opportunity cost. ::: modelbox **Key Economic Model** Good fiscal analysis asks two separate questions: **Short Run:** $$How\ does\ the\ policy\ affect\ Aggregate\ Demand?$$ **Long Run:** $$How\ does\ the\ policy\ affect\ K,\ L,\ A,\ and\ fiscal\ sustainability?$$ A policy can have beneficial short-run effects while creating long-run costs, or impose short-run costs while producing long-run benefits. ::: This distinction is the central lesson of fiscal policy. Government can influence Aggregate Demand, but lasting improvements in living standards ultimately require increases in the economy’s ability to produce real goods and services. ::: misconception **Common Misconception** A common misconception is that government spending that increases GDP in the short run must also increase long-run economic growth. It does not. Short-run Aggregate Demand and long-run productive capacity are different concepts. Whether fiscal policy increases long-run growth depends on how it affects: $$K,\quad L,\quad A.$$ ::: ::: thinkingeconomist **Thinking Like an Economist** Suppose two governments each borrow \$100 billion. Government A uses the money for a project that substantially increases future productivity. Government B uses the money for spending that provides current benefits but does not increase future productive capacity. Both policies may increase Aggregate Demand today. Explain why their long-run effects on: $$g^*$$ could nevertheless be very different. ::: ::: keytakeaways **Key Takeaways** - Fiscal policy can influence Aggregate Demand in the short run. - Fiscal policy can also affect long-run productive capacity through its effects on capital, labor, and productivity. - Government spending does not automatically increase long-run economic growth. - Taxes can affect incentives to work, save, invest, and engage in entrepreneurship. - Persistent deficits increase debt and can increase future interest costs. - Government borrowing can potentially crowd out private investment. - Every fiscal choice has an opportunity cost. - Long-run fiscal analysis should focus on productive capacity and fiscal sustainability rather than simply the amount of money spent. ::: ::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to distinguish short-run fiscal effects from long-run effects. 1. Ask the AI to generate five examples of government spending. Determine which could plausibly increase $K$, $L$, or $A$ before checking its analysis. 2. Ask the AI why a government expenditure can increase Aggregate Demand without increasing $g^*$. 3. Ask the AI to identify possible long-run costs of persistent government deficits. 4. Explain in your own words why evaluating fiscal policy requires considering both its immediate effects on Aggregate Demand and its long-run effects on productive capacity. ::: ## Chapter Summary {#chapter-summary .unnumbered} Chapter 9 examined **fiscal policy**: the federal government’s decisions involving taxation, spending, borrowing, and their effects on the economy. While monetary policy is conducted by the Federal Reserve, fiscal policy operates through the federal government’s budget. The chapter therefore began not with the AD–AS model, but with a more fundamental question: > *Where does the federal government get its money, and where does that money go?* Section 9.1 examined **federal government revenue**. The federal government receives revenue from several sources, but the largest generally include: - individual income taxes, - payroll taxes, - corporate income taxes. The government also collects revenue from excise taxes, tariffs, fees, and other sources. The federal individual income tax uses a progressive marginal tax structure. Under this system, higher portions of taxable income face higher tax rates. The **marginal tax rate** is the tax rate applied to an additional dollar of taxable income. The **average tax rate** is: $$Average\ Tax\ Rate = \frac{Total\ Taxes}{Taxable\ Income}\times100.$$ Moving into a higher tax bracket does not cause all of a taxpayer’s income to become subject to the higher rate. Only income within the higher bracket receives that marginal rate. The chapter also distinguished individual income taxes from **payroll taxes**, which primarily finance Social Security and Medicare. The person or business legally responsible for sending a tax payment to the government does not necessarily bear the entire economic cost of the tax. Economists call the ultimate distribution of that burden **tax incidence**. Taxes also affect economic incentives. Marginal tax rates can influence decisions involving: - work, - saving, - investment, - entrepreneurship. The relationship between tax rates and tax revenue is sometimes illustrated using the **Laffer Curve**. The important insight is not that tax cuts always increase revenue. Rather, changes in tax rates can change taxable economic activity, so the revenue effect of a tax change depends partly on behavioral responses. Section 9.2 examined **federal government expenditures**. Federal expenditures can be divided broadly into: - mandatory spending, - discretionary spending, - net interest. **Mandatory spending** occurs according to eligibility requirements and benefit formulas established in existing law. Major examples include Social Security, Medicare, Medicaid, and various income-support programs. **Discretionary spending** is determined through the congressional appropriations process. It includes defense and many federal agencies and programs. The chapter emphasized that relatively small programs cannot produce enormous reductions in total federal spending even if they are eliminated entirely. Understanding the relative size of different expenditure categories is therefore important when evaluating budget proposals. The chapter also distinguished **government purchases** from **transfer payments**. Government purchases of currently produced goods and services enter GDP directly through: $$G.$$ Transfer payments do not represent purchases of current production and therefore do not directly enter $G$. However, transfers can affect Aggregate Demand when recipients use the transferred income for consumption. Federal expenditures also include **net interest** on previously accumulated federal debt. Section 9.3 combined revenue and expenditures to explain **deficits, surpluses, and federal debt**. The federal budget balance is: $$Budget\ Balance = Revenue-Expenditures.$$ If: $$Revenue>Expenditures,$$ the federal government has a budget surplus. If: $$Revenue *The deficit is a flow. The debt is a stock.* A smaller deficit does not necessarily mean the national debt is declining. As long as the government continues running a deficit, additional borrowing generally continues to increase the debt. The chapter also distinguished **gross federal debt** from **debt held by the public**. Because a raw dollar value provides limited information about the burden of debt relative to the economy, economists frequently examine the **debt-to-GDP ratio**: $$Debt\text{-}to\text{-}GDP = \frac{Federal\ Debt}{GDP}\times100.$$ Debt can increase in dollar terms while declining relative to GDP if the economy grows faster than the debt. Government borrowing also creates interest costs. Approximately: $$Interest\ Cost \approx Interest\ Rate\times Debt.$$ Higher debt or higher interest rates can therefore increase federal interest expenditures. Government borrowing can also potentially **crowd out** private investment by competing for available saving and placing upward pressure on interest rates. The existence of government debt is not by itself sufficient to determine whether borrowing is desirable or sustainable. Economists consider the purpose of the borrowing, the growth of the economy, interest rates, future revenue, and future expenditures. Section 9.4 applied these fiscal concepts to the AD–AS model. **Expansionary fiscal policy** consists of deliberate increases in government spending or reductions in taxes intended to increase Aggregate Demand: $$G\uparrow \quad\text{and/or}\quad T\downarrow$$ which tends to produce: $$AD\rightarrow.$$ **Contractionary fiscal policy** consists of reductions in government spending or increases in taxes intended to reduce Aggregate Demand: $$G\downarrow \quad\text{and/or}\quad T\uparrow$$ which tends to produce: $$AD\leftarrow.$$ Government purchases affect Aggregate Demand directly through $G$. Taxes affect Aggregate Demand primarily by changing disposable income and private spending. The chapter also introduced the simplified government-spending multiplier: $$Multiplier = \frac{1}{1-MPC},$$ where $MPC$ is the marginal propensity to consume. The multiplier illustrates how one person’s spending can become another person’s income, generating additional rounds of spending. However, the actual size of a fiscal multiplier depends on saving, taxes, imports, interest rates, expectations, monetary conditions, and the state of the economy. Section 9.5 introduced **automatic stabilizers**. Automatic stabilizers are features of the tax and transfer system that change automatically as economic conditions change without requiring new legislation. During a recession: $$Income\downarrow \rightarrow Tax\ Revenue\downarrow$$ while: $$Unemployment\uparrow \rightarrow Transfer\ Payments\uparrow.$$ These changes partially cushion the decline in Aggregate Demand. During an expansion, the process reverses: $$Income\uparrow \rightarrow Tax\ Revenue\uparrow$$ while: $$Unemployment\downarrow \rightarrow Transfer\ Payments\downarrow.$$ Automatic stabilizers therefore help moderate changes in Aggregate Demand. They also explain why an increasing federal deficit does not necessarily mean policymakers deliberately adopted expansionary fiscal policy. Section 9.6 concluded by distinguishing the **short-run** and **long-run** effects of fiscal policy. Fiscal policy can shift Aggregate Demand in the short run. But long-run economic growth depends on: $$Y=AF(K,L).$$ Therefore, the long-run effect of fiscal policy depends on how taxes and expenditures affect: $$K,\quad L,\quad A.$$ Government spending that increases productive capacity may contribute to long-run growth. Government spending that merely increases current demand may not. Taxes can also influence incentives to work, save, invest, and innovate. Persistent deficits can increase debt and future interest costs and may crowd out private investment. The central lesson is therefore that fiscal policy must be evaluated along two dimensions: $$\boxed{\text{Short Run: How does the policy affect Aggregate Demand?}}$$ and: $$\boxed{\text{Long Run: How does the policy affect productive capacity and fiscal sustainability?}}$$ Fiscal policy has no free lunch. Taxes, spending, and borrowing all involve tradeoffs and opportunity costs. ## Key Terms {#key-terms .unnumbered} Automatic stabilizers : Features of the federal tax and transfer system that automatically change government revenue or expenditures as economic conditions change without requiring new legislation. Average tax rate : Total taxes paid as a percentage of taxable income: $$Average\ Tax\ Rate = \frac{Total\ Taxes}{Taxable\ Income}\times100.$$ Budget balance : The difference between federal revenue and federal expenditures: $$Budget\ Balance = Revenue-Expenditures.$$ Budget deficit : A situation in which federal expenditures exceed federal revenue during a particular period. Budget surplus : A situation in which federal revenue exceeds federal expenditures during a particular period. Corporate income tax : A tax imposed on the taxable profits of corporations. Crowding out : A reduction in private investment or other private spending that can occur when increased government borrowing places upward pressure on interest rates or otherwise competes with private borrowing. Debt held by the public : Federal debt held outside federal government accounts, including debt held by households, businesses, financial institutions, foreign investors, and the Federal Reserve. Debt-to-GDP ratio : Federal debt relative to the size of the economy: $$Debt\text{-}to\text{-}GDP = \frac{Federal\ Debt}{GDP}\times100.$$ Discretionary fiscal policy : Deliberate changes in taxes or government spending enacted by policymakers to influence economic activity. Discretionary spending : Federal spending determined through the congressional appropriations process. Excise tax : A tax imposed on a particular good, service, or activity. Expansionary fiscal policy : Deliberate increases in government spending or reductions in taxes intended to increase Aggregate Demand. Federal expenditures : Payments made by the federal government for programs, purchases, transfers, interest, and other authorized activities. Federal revenue : Money received by the federal government from taxes and other sources. Fiscal multiplier : The change in aggregate economic activity associated with an initial change in government spending or taxation. Fiscal policy : Deliberate changes in government spending and taxation intended to influence economic activity. Fiscal sustainability : The government’s ability to maintain its tax, spending, and borrowing policies over time without requiring increasingly large or disruptive future adjustments. Flow : An economic variable measured over a period of time. Government purchase : Government spending on a currently produced good or service. Government purchases are included in $G$ when GDP is calculated. Gross federal debt : Federal debt held by the public plus certain debt the federal government owes to its own government accounts. Individual income tax : A federal tax imposed on the taxable income of individuals and households. Laffer Curve : A conceptual relationship between tax rates and tax revenue emphasizing that tax rates can affect the amount of taxable economic activity and therefore the revenue collected. Mandatory spending : Federal spending determined primarily by eligibility rules and payment formulas established in existing law. Marginal propensity to consume ($MPC$) : The fraction of an additional dollar of income that is spent on consumption. Marginal tax rate : The tax rate applied to an additional dollar of taxable income. Medicaid : A public health-insurance program for qualifying low-income individuals and families jointly financed by the federal and state governments. Medicare : A federal health-insurance program primarily serving older Americans and certain other eligible individuals. National debt : The accumulated outstanding borrowing of the federal government. Net interest : The federal government’s interest payments on outstanding federal debt, net of certain interest income received by the government. Payroll tax : A tax imposed on earnings from employment, used primarily at the federal level to finance Social Security and Medicare. Progressive tax : A tax structure in which higher portions of taxable income are subject to higher marginal tax rates. Social Security : A federal social-insurance program providing retirement, disability, survivor, and related benefits to eligible individuals and families. Stock : An economic variable measured at a particular point in time. Tariff : A tax imposed on imported goods. Tax incidence : The distribution of the actual economic burden of a tax. Taxable income : The amount of income subject to income taxation after applying deductions and other adjustments permitted by tax law. Transfer payment : A government payment for which the government does not receive a currently produced good or service in exchange. Treasury security : A debt obligation issued by the U.S. Department of the Treasury to borrow money. ## Concept Check {#concept-check .unnumbered} Answer the following questions in your own words. ::: {.bold-list-markers source-label-style="[label=\\textbf{\\arabic*.}]"} 1. What are the major sources of federal government revenue? 2. What is the individual income tax? 3. What is taxable income? 4. What does it mean for the federal individual income tax to be progressive? 5. What is a marginal tax rate? 6. What is an average tax rate? 7. Why can a taxpayer’s marginal tax rate be higher than the taxpayer’s average tax rate? 8. If a taxpayer moves into a higher marginal tax bracket, does all of the taxpayer’s income become subject to the higher rate? Explain. 9. What is a payroll tax? 10. What major federal programs are financed substantially through payroll taxes? 11. How is a payroll tax different from an individual income tax? 12. What is a corporate income tax? 13. What is an excise tax? 14. What is a tariff? 15. What is tax incidence? 16. Why might the person legally responsible for paying a tax not bear its entire economic burden? 17. How can taxes affect economic incentives? 18. Why is tax revenue not determined by the tax rate alone? 19. What is the basic insight of the Laffer Curve? 20. Does the Laffer Curve imply that every tax cut increases government revenue? Explain. 21. What are the three broad categories of federal expenditures discussed in this chapter? 22. What is mandatory spending? 23. What is discretionary spending? 24. Explain the basic difference between Social Security and Medicare. 25. Explain the basic difference between Medicare and Medicaid. 26. Why is foreign aid unlikely by itself to explain most federal spending? 27. What is the difference between a government purchase and a transfer payment? 28. Which type of government expenditure enters $G$ directly? 29. Why are Social Security benefits not directly counted in $G$? 30. How can a transfer payment nevertheless affect Aggregate Demand? 31. What is net interest? 32. Why can higher federal debt increase net interest expenditures? 33. Why can higher interest rates increase net interest expenditures even if the amount of debt does not immediately change? 34. Why does government spending have an opportunity cost? 35. Why is the amount of money spent on a government program not necessarily a measure of its success? 36. Write the federal budget-balance equation. 37. What is a budget deficit? 38. What is a budget surplus? 39. How does the federal government generally finance a deficit? 40. What is a Treasury security? 41. Explain the difference between the federal deficit and the national debt. 42. Why is the deficit a flow? 43. Why is the debt a stock? 44. Can the federal deficit decrease while the national debt continues increasing? Explain. 45. What is the difference between gross federal debt and debt held by the public? 46. Why do economists examine debt relative to GDP? 47. Write the formula for the debt-to-GDP ratio. 48. Can federal debt increase in dollars while the debt-to-GDP ratio decreases? Explain. 49. How do debt and interest rates affect federal interest costs? 50. What is crowding out? 51. Why might government borrowing reduce private investment? 52. What is fiscal sustainability? 53. Does fiscal sustainability require the federal government to have zero debt? Explain. 54. Define fiscal policy. 55. What is expansionary fiscal policy? 56. What happens to Aggregate Demand when government purchases increase, holding other factors constant? 57. How can a tax cut increase Aggregate Demand? 58. What is contractionary fiscal policy? 59. How can higher taxes reduce Aggregate Demand? 60. Why does an increase in government purchases affect Aggregate Demand differently from an equal-sized increase in transfer payments? 61. What is the fiscal multiplier? 62. Write the simplified government-spending multiplier. 63. What does the marginal propensity to consume measure? 64. Why is the actual fiscal multiplier unlikely to equal the simplified multiplier in every situation? 65. Why might policymakers use expansionary fiscal policy during a recessionary growth gap? 66. Why might policymakers use contractionary fiscal policy during an inflationary growth gap? 67. How does expansionary fiscal policy generally affect the federal budget deficit? 68. How does contractionary fiscal policy generally affect the deficit? 69. What is an automatic stabilizer? 70. Why does federal tax revenue tend to fall automatically during a recession? 71. Why do some transfer payments tend to rise automatically during a recession? 72. How do automatic stabilizers cushion a decline in Aggregate Demand? 73. What happens to automatic stabilizers during an economic expansion? 74. Why does a larger federal deficit not necessarily prove that Congress enacted expansionary fiscal policy? 75. What is the difference between an automatic stabilizer and discretionary fiscal policy? 76. Why can fiscal policy affect both Aggregate Demand and long-run productive capacity? 77. How could government spending potentially increase $A$ or $K$? 78. How can taxes affect long-run economic growth? 79. Why can persistent deficits create future fiscal tradeoffs? 80. Why should economists evaluate both the short-run and long-run consequences of fiscal policy? ::: ## Problems and Applications {#problems-and-applications .unnumbered} ::: {.bold-list-markers source-label-style="[label=\\textbf{\\arabic*.}]"} 1. **Calculating Income Taxes** Suppose a simplified federal income-tax system has the following brackets: ::: center Taxable Income Marginal Tax Rate ----------------------- ------------------- First \$25,000 10% \$25,001–\$75,000 20% Income above \$75,000 30% ::: A taxpayer has: $$\$100{,}000$$ of taxable income. a. Calculate the tax owed on the first \$25,000. b. Calculate the tax owed on the next \$50,000. c. Calculate the tax owed on the final \$25,000. d. Calculate total income-tax liability. e. What is the taxpayer’s marginal tax rate? f. Calculate the taxpayer’s average tax rate. 2. **Moving Into a Higher Tax Bracket** Using the tax brackets from Problem 1, suppose a taxpayer’s taxable income increases from: $$\$74{,}000$$ to: $$\$76{,}000.$$ a. Calculate total tax liability at \$74,000. b. Calculate total tax liability at \$76,000. c. How much additional tax results from the \$2,000 increase in income? d. Does entering the 30% bracket cause all \$76,000 to be taxed at 30%? e. Explain why earning the additional income still increases after-tax income. 3. **Marginal Versus Average Tax Rates** Suppose a taxpayer has: $$\$80{,}000$$ of taxable income and owes: $$\$14{,}000$$ in federal income tax. The taxpayer’s marginal tax rate is: $$25\%.$$ a. Calculate the average tax rate. b. Explain why the average and marginal tax rates differ. c. Which rate is more relevant when deciding whether to earn one additional dollar of taxable income? 4. **The Laffer Curve** Consider two hypothetical tax systems. In Economy A, the tax rate increases from 20% to 25%, and taxable income remains nearly unchanged. In Economy B, the tax rate increases from 80% to 90%, but taxable economic activity declines substantially. a. In which economy is the tax increase more likely to increase revenue? b. In which economy could the higher tax rate potentially reduce revenue? c. Why does the Laffer Curve not imply that every tax cut increases tax revenue? d. What information would economists need to determine the actual revenue effect? 5. **Classifying Federal Revenue** Classify each item as primarily an individual income tax, payroll tax, corporate income tax, excise tax, or tariff. a. A tax on a worker’s taxable household income. b. A tax on corporate profits. c. A tax on imported automobiles. d. A tax on earnings used to finance Social Security. e. A federal tax imposed on a particular product. 6. **Tax Incidence** Suppose the government imposes a new payroll tax that employers are legally responsible for sending to the government. a. Does this prove that employers bear the entire economic burden of the tax? b. How might wages adjust? c. How might hiring adjust? d. Explain the difference between the legal payer and tax incidence. 7. **Mandatory or Discretionary?** Classify each expenditure as primarily mandatory spending, discretionary spending, or net interest. a. Social Security retirement benefits. b. Purchases of military equipment through an appropriated defense budget. c. Medicare benefits. d. Interest payments on Treasury securities. e. Funding for a federal scientific-research agency. f. Medicaid expenditures. 8. **Government Purchases or Transfers?** Classify each payment as a government purchase or transfer payment. Then determine whether it enters $G$ directly. a. The federal government purchases a new aircraft. b. A retired worker receives Social Security benefits. c. The federal government pays an engineer for current work. d. An unemployed worker receives unemployment benefits. e. The government pays a construction company to repair a highway. 9. **Transfers and GDP** Suppose the federal government sends households: $$\$20\text{ billion}$$ in additional transfer payments. Households spend: $$\$15\text{ billion}$$ of the additional income on currently produced consumption goods. a. Does the original \$20 billion transfer directly enter $G$? b. How much additional consumption occurs? c. Through which component of $$Y=C+I+G+NX$$ does that spending enter GDP? d. What happens to the remaining \$5 billion if households save it? 10. **Calculating the Budget Balance** Suppose federal revenue is: $$\$5.2\text{ trillion}$$ and federal expenditures are: $$\$6.8\text{ trillion}.$$ a. Calculate the budget balance. b. Is this a deficit or surplus? c. How much must the government approximately finance through borrowing? 11. **Deficit Versus Debt** Suppose federal debt begins at: $$\$28\text{ trillion}.$$ The government then runs deficits of: $$\$1.5\text{ trillion},$$ $$\$1.0\text{ trillion},$$ and: $$\$0.5\text{ trillion}$$ over the next three years. Ignoring other accounting changes: a. Calculate debt after Year 1. b. Calculate debt after Year 2. c. Calculate debt after Year 3. d. Is the deficit rising or falling? e. Is the debt rising or falling? f. Explain why these answers are not contradictory. 12. **A Budget Surplus** Suppose federal debt is: $$\$32\text{ trillion}.$$ The government receives: $$\$6.2\text{ trillion}$$ in revenue and spends: $$\$5.7\text{ trillion}.$$ a. Calculate the budget balance. b. Is the government running a deficit or surplus? c. Ignoring other accounting adjustments, what happens to federal debt? 13. **Debt-to-GDP** Consider two economies. **Economy A** $$Debt=\$5\text{ trillion}$$ $$GDP=\$4\text{ trillion}.$$ **Economy B** $$Debt=\$15\text{ trillion}$$ $$GDP=\$30\text{ trillion}.$$ a. Calculate Economy A’s debt-to-GDP ratio. b. Calculate Economy B’s debt-to-GDP ratio. c. Which economy has more debt in dollars? d. Which economy has more debt relative to its economic output? e. Why does this demonstrate the usefulness of debt-to-GDP? 14. **Debt Can Rise While Debt-to-GDP Falls** Suppose federal debt increases from: $$\$20\text{ trillion}$$ to: $$\$22\text{ trillion}.$$ Over the same period, GDP increases from: $$\$20\text{ trillion}$$ to: $$\$25\text{ trillion}.$$ a. Calculate the initial debt-to-GDP ratio. b. Calculate the new debt-to-GDP ratio. c. Did the dollar value of debt rise or fall? d. Did debt relative to GDP rise or fall? 15. **Interest Costs** Suppose the federal government has: $$\$25\text{ trillion}$$ of interest-bearing debt. a. Estimate annual interest costs if the average interest rate is 2%. b. Estimate annual interest costs if the average interest rate is 4%. c. Estimate annual interest costs if the average interest rate is 6%. d. Why can rising interest rates create fiscal pressure even if the amount of debt does not immediately increase? 16. **The Debt-Interest Feedback Loop** Explain the following chain: $$Debt\uparrow$$ $$\Downarrow$$ $$Interest\ Payments\uparrow$$ $$\Downarrow$$ $$Federal\ Expenditures\uparrow$$ $$\Downarrow$$ $$Deficit\uparrow$$ $$\Downarrow$$ $$Debt\uparrow.$$ Does this process necessarily continue forever? Explain what could interrupt it. 17. **The Spending Multiplier** Suppose: $$MPC=0.80.$$ a. Calculate the simplified government-spending multiplier: $$\frac{1}{1-MPC}.$$ b. If government purchases increase by \$50 billion, what is the theoretical total increase in spending under the simplified model? c. Why might the actual effect be smaller? 18. **Comparing MPCs** Calculate the simplified government-spending multiplier for each value: a. $MPC=0.50$ b. $MPC=0.60$ c. $MPC=0.75$ d. $MPC=0.90$ What relationship do you observe between the MPC and the multiplier? 19. **Government Spending Versus a Tax Cut** Suppose the government is considering either: $$\$100\text{ billion}$$ of additional government purchases or a: $$\$100\text{ billion}$$ tax cut. Households spend 75% of additional disposable income. a. What is the initial increase in aggregate spending from the government-purchase option? b. What is the initial increase in consumption from the tax-cut option? c. Why are the initial effects different? d. Why might the eventual effects also depend on saving, investment, imports, and interest rates? 20. **Expansionary Fiscal Policy** Suppose: $$g^*=3\%$$ and: $$\%\Delta Y=0\%.$$ a. Is the economy growing above or below its sustainable rate? b. Identify two possible expansionary fiscal policies. c. What happens to AD? d. What happens to short-run real GDP growth? e. What happens to inflation? f. What generally happens to the federal deficit, holding other factors constant? 21. **Contractionary Fiscal Policy** Suppose: $$g^*=3\%$$ and: $$\%\Delta Y=6\%.$$ a. Is the economy growing above or below its sustainable rate? b. Identify two possible contractionary fiscal policies. c. What happens to AD? d. What happens to short-run real GDP growth? e. What happens to inflation? 22. **Automatic Stabilizers in a Recession** Suppose the economy enters a recession without Congress passing any new legislation. a. What happens to household income? b. What happens to federal income-tax revenue? c. What happens to unemployment benefits? d. What happens to the federal deficit? e. How do these changes cushion the decline in Aggregate Demand? 23. **Automatic Stabilizers in an Expansion** Suppose the economy enters a strong expansion. a. What happens to income-tax revenue? b. What happens to unemployment-related transfer payments? c. What happens to the budget balance, holding other factors constant? d. How do these changes restrain Aggregate Demand? 24. **Was It Fiscal Stimulus?** The federal deficit increases from: $$\$500\text{ billion}$$ to: $$\$1.5\text{ trillion}$$ during a recession. A commentator concludes: > “Congress must have passed a \$1 trillion fiscal stimulus.” Explain why this conclusion does not necessarily follow. What additional information would you need? 25. **Short Run Versus Long Run** Suppose the government borrows \$100 billion under each of the following scenarios: a. Building infrastructure that permanently increases private-sector productivity. b. Financing a temporary increase in purchases that has no effect on productive capacity. c. Funding basic scientific research that leads to new productive technologies. d. Financing transfers that increase current consumption but do not affect capital, labor, or productivity. For each scenario, identify whether the policy primarily affects: - Aggregate Demand, - long-run productive capacity, - or potentially both. 26. **Crowding Out** Suppose the federal government sharply increases borrowing while the economy is already operating near its productive capacity. a. What could happen to the demand for credit? b. What could happen to interest rates? c. What could happen to private investment? d. Why might crowding out reduce the long-run benefits of expansionary fiscal policy? ::: ## Thinking Like an Economist {#thinking-like-an-economist .unnumbered} :::: thinkingeconomist **Thinking Like an Economist** Use the concepts developed in Chapter 11 to evaluate the following claims. Focus on the economic reasoning rather than whether you agree with the policy being discussed. ::: {.bold-list-markers source-label-style="[label=\\textbf{\\arabic*.}]"} 1. **“I Don’t Pay Federal Taxes”** A worker owes no federal individual income tax at the end of the year and therefore claims: > “I pay no federal taxes.” Why might this statement be incorrect? What additional taxes should be considered? 2. **“Don’t Give Me the Raise”** A worker says: > “I don’t want a raise because it will put me into the next tax bracket and I’ll take home less money.” Evaluate this claim using marginal tax rates. 3. **“Corporations Pay the Tax”** Congress increases the corporate income tax. A commentator says: > “This tax cannot affect workers or consumers because corporations pay it.” Use tax incidence to evaluate the claim. 4. **“Cut Foreign Aid and Balance the Budget”** A politician proposes balancing the federal budget entirely by eliminating foreign aid. What information would you need to determine whether this is mathematically possible? Why is understanding the relative size of federal expenditure categories important? 5. **“Government Spending Is Government Spending”** Explain why these two expenditures are economically different: a. The government purchases \$1 billion of newly produced equipment. b. The government distributes \$1 billion in transfer payments. How does each enter the GDP identity? 6. **“The Deficit Fell, So the Debt Fell”** Evaluate the statement. Construct a numerical example in which the deficit falls substantially while the national debt continues increasing. 7. **“The Debt Has Never Been Higher”** Suppose someone observes that the dollar value of federal debt has reached a record high. Why is that fact alone insufficient to evaluate the government’s fiscal position? What other variables would an economist examine? 8. **“Debt Is Always Bad”** Compare government borrowing used to finance: a. a highly productive infrastructure project, b. spending that produces little future benefit. Why might identical amounts of borrowing have different long-run consequences? 9. **“The Government Should Never Run a Deficit”** Why might a balanced budget every single year interfere with automatic stabilizers during a recession? What would happen if the government attempted to offset every recession-induced decline in tax revenue immediately with tax increases or spending cuts? 10. **“The Multiplier Is Five”** Suppose: $$MPC=0.80.$$ A student calculates: $$\frac{1}{1-0.80}=5$$ and concludes: > “Every \$1 of government spending always creates exactly \$5 of GDP.” Why is this conclusion too strong? 11. **“Fiscal Policy Can Make Us Permanently Richer”** Under what circumstances could fiscal policy increase: $$g^*?$$ Under what circumstances might fiscal policy increase Aggregate Demand without increasing long-run productive capacity? 12. **Fiscal Versus Monetary Policy** Both expansionary fiscal policy and expansionary monetary policy can shift: $$AD\rightarrow.$$ Explain how the mechanisms differ. Which institutions make the decisions? What economic variables do they change first? 13. **The Opportunity Cost of Government** Suppose a government project produces real benefits. Does that fact alone prove that the project should be undertaken? Explain why an economist must compare those benefits with the opportunity cost of the resources used. 14. **Automatic or Deliberate?** During a recession: - tax revenue falls by \$300 billion, - unemployment-benefit spending increases by \$50 billion, - Congress passes a new \$200 billion infrastructure program. Which changes are automatic stabilizers? Which represent discretionary fiscal policy? Why does the distinction matter? 15. **Thinking About Fiscal Sustainability** Suppose: $$Debt\text{-}to\text{-}GDP$$ is rising year after year. What additional information would you want before determining whether the fiscal position is sustainable? Consider: - interest rates, - economic growth, - future taxes, - future spending commitments, - the uses of borrowed funds. ::: :::: ## Economics in the Real World {#economics-in-the-real-world .unnumbered} ::: realworld **Economics in the Real World** **Case Study: Why Federal Deficits Increase During Recessions** Federal budget deficits often become substantially larger during economic downturns. It is tempting to assume that this happens entirely because Congress deliberately increases government spending. That is only part of the story. Consider what happens when an economy enters a recession. Employment falls. Household incomes decline. Business profits weaken. Because federal tax revenue depends on income, wages, profits, and other forms of economic activity: $$Economic\ Activity\downarrow$$ causes: $$Federal\ Revenue\downarrow.$$ At the same time, unemployment increases. More workers may qualify for unemployment benefits and some households may become eligible for other income-support programs. Therefore: $$Transfer\ Spending\uparrow.$$ These two changes occur even if Congress passes no new fiscal-policy legislation. The result is: $$Revenue\downarrow$$ and: $$Expenditures\uparrow,$$ which causes: $$Budget\ Deficit\uparrow.$$ This automatic increase in the deficit is not merely an accounting curiosity. It also cushions the downturn. If a worker loses a job but receives unemployment benefits, household income does not fall by as much as it otherwise would. If a household’s income falls and its tax payments decline, disposable income also falls by less than it otherwise would. Automatic stabilizers therefore reduce the decline in household spending and Aggregate Demand. Now consider what would happen if the government were required to maintain exactly the same budget balance during the recession. As tax revenue declined, the government would need to: - increase tax rates, - reduce expenditures, - or do some combination of both. Those actions would reduce Aggregate Demand further. A rule requiring the government to balance its budget every year could therefore make economic downturns more severe. When the economy eventually recovers, automatic stabilizers work in reverse. Employment and income increase. Tax revenue rises. Unemployment-related transfer payments fall. The deficit can therefore shrink automatically even without a deliberate change in fiscal policy. This example illustrates why economists distinguish between: > *the observed federal budget balance* and: > *deliberate fiscal-policy decisions.* A large deficit can reflect deliberate policy, automatic stabilizers, or both. **Questions for Discussion** a. Why does federal tax revenue tend to decline during a recession? b. Why do some federal expenditures automatically increase? c. How do these changes affect the budget deficit? d. Why do automatic stabilizers reduce the decline in Aggregate Demand? e. Why might requiring a perfectly balanced federal budget every year make recessions more severe? f. Why can a shrinking deficit during an expansion occur without contractionary fiscal-policy legislation? g. What information would you need to determine how much of a particular deficit resulted from deliberate fiscal policy rather than automatic stabilizers? ::: ## Data Exploration {#data-exploration .unnumbered} ::: dataexploration **Data Exploration** **Exploring the Federal Budget** Chapter 11 emphasized that understanding fiscal policy requires understanding the federal budget itself. In this activity, use actual U.S. budget data to examine where federal revenue comes from, where federal expenditures go, and how the budget balance changes over time. Use a reliable source such as the Congressional Budget Office (CBO), Office of Management and Budget (OMB), U.S. Treasury, or another government source. ### Part A: Federal Revenue {#part-a-federal-revenue .unnumbered} Collect data for a recent fiscal year showing federal revenue by major category. Identify: - individual income taxes, - payroll taxes, - corporate income taxes, - other major revenue sources. Calculate the percentage of total federal revenue provided by each category. Then answer: a. Which source provides the most federal revenue? b. Which provides the second most? c. How important are individual income taxes and payroll taxes relative to all other sources combined? d. How does the actual composition compare with your expectations before examining the data? ### Part B: Federal Expenditures {#part-b-federal-expenditures .unnumbered} Collect federal expenditure data for the same fiscal year. Identify the major spending categories and classify them as: - mandatory, - discretionary, - net interest. Calculate the approximate share of total federal expenditures represented by each broad category. Then answer: a. Which broad category is largest? b. Which specific programs account for the largest shares of spending? c. How large is defense spending relative to total federal expenditures? d. How large is foreign aid relative to total federal expenditures? e. Which findings most differ from your prior expectations? ### Part C: Deficit and Debt {#part-c-deficit-and-debt .unnumbered} Collect annual data for at least the past 15 years on: - federal revenue, - federal expenditures, - the budget deficit or surplus, - federal debt, - GDP. Calculate or report: $$Debt\text{-}to\text{-}GDP = \frac{Federal\ Debt}{GDP}\times100.$$ Create a table showing the data over time. Identify: a. years with unusually large deficits, b. years with unusually small deficits or surpluses, c. periods when the debt-to-GDP ratio increased substantially, d. periods when the debt-to-GDP ratio decreased. Then research the major economic events associated with the largest changes. ### Part D: Automatic Stabilizers {#part-d-automatic-stabilizers .unnumbered} Choose one recessionary period in your data. Examine what happened to: - federal revenue, - unemployment, - transfer payments, - the federal deficit. Determine whether the data are consistent with the operation of automatic stabilizers. Explain the causal chain: $$Recession \rightarrow Income\downarrow \rightarrow Tax\ Revenue\downarrow$$ and: $$Recession \rightarrow Unemployment\uparrow \rightarrow Transfer\ Payments\uparrow.$$ Then answer: > *How much of the increase in the deficit appears to have resulted automatically from the recession, and how much appears to have resulted from deliberate policy changes?* Do not assume that the entire change was caused by one factor. ### Part E: Presenting the Evidence {#part-e-presenting-the-evidence .unnumbered} Create two charts. The first should show: $$Federal\ Revenue \quad\text{and}\quad Federal\ Expenditures$$ over time. The second should show: $$Debt\text{-}to\text{-}GDP$$ over time. Write a short paragraph explaining the most important pattern in each chart. ### Part F: AI-Assisted Analysis {#part-f-ai-assisted-analysis .unnumbered} Provide your data and charts to a generative AI tool and ask: > “Analyze this federal budget data. Identify the major sources of revenue, the major categories of spending, the behavior of the deficit and debt, and evidence of automatic stabilizers. Use the concepts from my macroeconomics textbook.” Critically evaluate the response. Check whether the AI: - confuses deficits with debt, - confuses mandatory and discretionary spending, - treats transfer payments as government purchases, - mistakes a larger deficit for deliberate fiscal stimulus, - uses the debt-to-GDP ratio appropriately, - recognizes automatic stabilizers. Write a brief conclusion identifying one thing the data clearly demonstrate and one important question the data cannot answer by themselves. ::: ## Fiscal Policy Debate {#fiscal-policy-debate .unnumbered} :::: policydebate **Policy Debate** **Debate Question** ::: center *Should the federal government generally run smaller deficits, even when doing so requires higher taxes or lower spending?* ::: This question cannot be answered simply by saying that deficits are “good” or “bad.” The appropriate evaluation depends on: - economic conditions, - the size and composition of spending, - tax policy, - interest rates, - economic growth, - the purpose of government borrowing, - the resulting debt burden. ### Position A: Reduce Deficits {#position-a-reduce-deficits .unnumbered} Supporters of deficit reduction may emphasize: - lower future interest costs, - reduced government borrowing, - less potential crowding out, - greater fiscal flexibility in future crises, - reduced burden on future taxpayers. They may argue that persistent deficits can become increasingly difficult to manage when debt and interest costs grow faster than the economy. ### Position B: Deficits Can Be Valuable {#position-b-deficits-can-be-valuable .unnumbered} Others may argue that deficits can be economically useful when: - the economy is in a severe recession, - automatic stabilizers are cushioning a downturn, - borrowed funds finance productive investments, - immediate spending provides benefits that exceed the financing costs. From this perspective, forcing the budget into balance at all times could make downturns more severe or prevent valuable long-term investments. ### Questions for Analysis {#questions-for-analysis .unnumbered} a. Why might deficit reduction be valuable during a strong economic expansion? b. Why might running a deficit be useful during a severe recession? c. Why does the purpose of borrowing matter? d. Why is debt-to-GDP more informative than the dollar value of debt alone? e. How do interest rates affect the cost of government debt? f. Why might crowding out be more likely when the economy is operating near capacity? g. Why should automatic stabilizers be distinguished from discretionary fiscal policy? h. Why might a government reasonably choose to borrow for a productive investment? **Your Task** Write a short position paper addressing: > *Under what economic conditions should the federal government be most concerned about reducing its budget deficit?* Your argument should distinguish between: - recessions and expansions, - productive and unproductive spending, - temporary and persistent deficits, - debt measured in dollars and debt relative to GDP. Avoid the claim that deficits are always beneficial or always harmful. Identify the circumstances that make deficit reduction more or less important. :::: ## Chapter 9 AI Economics Lab {#chapter-9-ai-economics-lab .unnumbered} :::: ailab **AI Economics Lab** Use a generative AI tool as your virtual teaching assistant to review the major fiscal concepts from Chapter 9. The goal is to become comfortable reading and discussing the federal budget and evaluating fiscal policy without relying on slogans. ::: {.bold-list-markers source-label-style="[label=\\textbf{\\arabic*.}]"} 1. **Federal Revenue** Ask the AI to generate a hypothetical federal revenue table. Identify: - individual income taxes, - payroll taxes, - corporate income taxes, - excise taxes, - tariffs, - other revenues. Calculate each source as a percentage of total revenue before checking the AI. 2. **Tax Brackets** Ask the AI to create five progressive tax systems. For each: a. calculate total tax liability, b. calculate the marginal tax rate, c. calculate the average tax rate. Check whether the AI correctly distinguishes the three concepts. 3. **Tax Fallacies** Ask the AI to evaluate the following claims: > “Moving into a higher tax bracket makes you poorer.” > > “A corporate tax is paid entirely by corporations.” > > “Every tax cut increases tax revenue.” Evaluate each response using marginal tax rates, tax incidence, and the Laffer Curve. 4. **Federal Expenditures** Ask the AI to generate fifteen hypothetical federal expenditures. Classify each as: - mandatory, - discretionary, - net interest. Then classify each as: - government purchase, - transfer payment, - interest payment. 5. **Government Purchases Versus Transfers** Ask the AI: > “Why does a \$10 billion government purchase affect GDP differently from a \$10 billion transfer payment?” Evaluate whether the response correctly uses: $$Y=C+I+G+NX.$$ 6. **Deficit Versus Debt** Give the AI the following hypothetical information: $$Debt_{t-1}=\$30\text{ trillion}$$ $$Revenue=\$5\text{ trillion}$$ $$Expenditures=\$6\text{ trillion}.$$ Ask it to calculate the deficit and year-end debt. Then ask: > “If next year’s deficit falls to \$500 billion, does debt necessarily fall?” Evaluate the answer. 7. **Debt-to-GDP** Ask the AI to generate five countries with different levels of debt and GDP. Calculate: $$Debt\text{-}to\text{-}GDP.$$ Rank the countries by debt burden before checking the AI’s ranking. 8. **Interest Costs** Ask the AI to generate five scenarios involving different debt levels and average interest rates. Calculate: $$Interest\ Cost \approx Interest\ Rate\times Debt.$$ Explain which changes come from debt and which come from interest rates. 9. **Crowding Out** Ask the AI to explain crowding out. Then ask it: > “Under what conditions would crowding out likely be relatively small?” Evaluate whether its answer considers unemployment, unused resources, and the state of private investment. 10. **Automatic Stabilizers** Ask the AI to generate five recession scenarios. For each, identify what happens automatically to: - tax revenue, - transfer payments, - the budget deficit, - Aggregate Demand. 11. **Discretionary or Automatic?** Ask the AI to generate ten changes in federal revenue or spending. Classify each as: - automatic stabilizer, - discretionary fiscal policy, - neither. Then explain your reasoning. 12. **Fiscal Policy and AD** Give the AI several hypothetical economies with: $$g^*$$ and: $$\%\Delta Y.$$ Determine whether expansionary or contractionary fiscal policy would move each economy toward its sustainable growth rate. Then compare your answers with the AI. 13. **Short Run Versus Long Run** Ask the AI to generate examples of fiscal policy that: - increase Aggregate Demand without substantially changing productive capacity, - potentially increase both Aggregate Demand and productive capacity. Explain which examples affect: $$K,\quad L,\quad A.$$ 14. **Challenge the AI** Ask: > “Is a federal budget deficit always bad?” Then ask: > “Is a federal budget deficit always good during a recession?” Compare the responses. Identify what additional information is necessary before reaching a conclusion. 15. **Final Reflection** Without using AI, explain: > *How does the federal government raise revenue, how does it spend that revenue, and how can the resulting budget position affect the economy?* Your answer should distinguish among: - individual income taxes, - payroll taxes, - mandatory spending, - discretionary spending, - government purchases, - transfer payments, - deficits, - debt, - automatic stabilizers, - fiscal policy. Then ask the AI to critique your reasoning without rewriting it. 16. **Practice** Ask the AI to create multiple choice questions for you based on this chapter to use as a practice tool when you study. ::: ::::