Economics 1022A/B Chapter Notes - Chapter 29: Real Wages, Tax Wedge, Potential Output
1 Sep 2018
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CHAPTER 29 – Fiscal Policy
The Federal Budget
Federal budget – annual statement of the outlays + revenues of the Government of Canada, together
with laws + regulations that approve and support those outlays + revenues
Provincial budget – same as Federal budget but instead of Gov of Canada it is the provincial government
Fiscal policy – the use of the federal budget to achieve macroeconomic objectives such as; full
employment, sustained long-term economic growth + price level stability
3 main items apart of the Federal budget:
1. Revenues – federal government’s receipts
• Come from 4 sources:
o Personal income taxes (largest source)
o Corporate income taxes (taxes paid by companies on their profits)
o Indirect + other taxes (2nd largest – include HST + taxes on sale of gas, alcohol, etc)
o Investment income (income from gov’t enterprises/investments)
2. Outlays – total federal government outlays
• Classified in 3 categories:
o Transfer payments (payments to individuals, businesses, others level of gov + rest of
world)
o Expenditure on g+s (gov’t expenditure on final g+s) – appears in circular flow
o Debt interest (interest on gov’t debt)
3. Budget balance – equal to its revenues minus its outlays
BUDGET BALANCE = REVENUES – OUTLAYS
• Budget surplus: revenues exceed outlays
• Budget deficit: outlays exceed revenues
Government debt – total amount of government borrowing, which equals the sum of past deficits minus
the sum of the past surpluses
Supply-Side Effects of Fiscal Policy
Full Employment + Potential GDP:
• At full employment: real wage rate adjusts to make the quantity of labour demanded equal the
quantity of labour supplied
• Potential GDP: real GDP that the full-employment quantity of labour produces
The Effects of the Income Tax
• Income tax: weakens the incentive to work + drives a wedge between take-home wage of
workers + cost of labour to firms
• Result: smaller Q of labour + lower potential GDP
• Does not effect demand for labour: Q of labour that firms plan to hire depends on how
productive labour it + what it costs (real wage rate)
• Decreases supply of labour: each dollar of before-tax earnings workers must pay gov’t so
workers look at the after-tax wage when seeing how much labour to supply
• Vertical distance between LS and LS+tax is the amount of income tax
Tax wedge – gap created between the before-tax + after-tax wage rates
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• Full-employment Q of labour decreases – so potential GDP decreases
o Potential GDP decrease – decreases aggregate supply
Taxes on Expenditure and the Tax Wedge
• Taxes on consumption expenditure add to the tax wedge
o Reason: tax on consumption raises the prices paid for consumption g+s and is equivalent
to a cut in the real wage rate
• Incentive to supply labour depends on the g+s that an hour of labour can buy
• Higher taxes on g+s + lower after-tax wage rate – less incentive to supply labour
Taxes and the Incentive to Save and Invest
• Tax on interest income weakens incentive to save + drives wedge between after-tax interst rate
earned by savers + interest rate paid by firms
o Effects are analogous to those of tax on labour income
o More serious for 2 reasons
1. Tax on labour income lowers Q of labour employed + lower potential GDP BUT tax
on capital income lowers Q of saving + investment + slows the growth rate of real
GDP
2. True tax rate on interest income is much higher than that on labour income b/c of
inflation + taxes on interest income interact
Effect of Tax rate on Real Interest Rate: **
• Real after-tax interest rate: influences investment and saving plans
o Real after-tax interest rate = (income tax rate paid on interest income – real interest
rate)
o Taxes depend on nominal interest rate (not real interest rate)
o Higher the inflation rate – higher the true tax rate on interest income
• No inflation: nominal interest rate = real interest rate
REAL AFTER-TAX RATE % = (Nominal Interest Rate %) * (1 – Tax Rate %) – Inflation %
Effect of Income Tax on Savng and Investment:
• Initially no taxes + gov’t has balanced budget
• DLF (demand for loanable funds) – also investment deamnd curve
• SLF (supply for loanable funds) – also saving supply curve
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ECON 1022A/B Full Course Notes
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Document Summary
Federal budget annual statement of the outlays + revenues of the government of canada, together with laws + regulations that approve and support those outlays + revenues. Provincial budget same as federal budget but instead of gov of canada it is the provincial government. Fiscal policy the use of the federal budget to achieve macroeconomic objectives such as; full employment, sustained long-term economic growth + price level stability. 3 main items apart of the federal budget: revenues fede(cid:396)al go(cid:448)e(cid:396)(cid:374)(cid:373)e(cid:374)t"s (cid:396)e(cid:272)eipts, come from 4 sources, personal income taxes (largest source, corporate income taxes (taxes paid by companies on their profits) Indirect + other taxes (2nd largest include hst + taxes on sale of gas, alcohol, etc) Budget balance = revenues outlays: budget surplus: revenues exceed outlays, budget deficit: outlays exceed revenues. Government debt total amount of government borrowing, which equals the sum of past deficits minus the sum of the past surpluses.
