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Chapter 29 Notes.docx

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Economics 1022A/B
Jeannie Gillmore

Chapter 29 Notes The Federal Budget  the annual statement of the outlays and revenues of the GoC, together with the laws and regulations that approve and support those outlays and revenues make up the federal budget o since the late 1940s, the federal budget has assumed the purpose to pursue the government’s fiscal policy o fiscal policy is the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained long-term economic growth, and price level stability Budget Making  the process of budget making begins with consultations between the Minister of Finance and department of finance officials with their counterparts in provincial governments o discussions deal with programs that are funded and operated jointly by the two levels of government o after the consultations, the Minister develops a set of proposals, which are discussed in Cabinet and which become government policy  then presents a budget plan to Parliament Highlights of the Budget: Revenues, Outlays, Budget Balance  revenues are the federal government’s receipts, which come from four main sources: o personal income taxes (largest source) o indirect and other taxes o investment income o corporate income taxes (smallest source)  outlays are classified in three categories: o transfer payments  largest outlay  payments made by the government to individuals, businesses, other levels of government, and the rest of the world  includes unemployment cheques, welfare, farm subsidies, aid to developing nations, dues to international organizations, etc. o expenditures on goods and services  include those on national defence, computers for the CRA, government cars, and highways  this is the component that appears on the circular flow of expenditure and income o debt interest  interest on the government debt  large debts can arise if the federal government has large and persistent budget deficits  the budget balance is equal to revenues minus outlays o if revenues exceed outlays, there is a budget surplus o if outlays exceed revenues, there is a budget deficit o if revenues equal outlays, the government has a balanced budget o in 2011, it was projected that the government would have a deficit of $32 billion Historical Perspective on the Budget  during the 1960s, government expanded but tax revenues and outlays kept pace with each other  from the mid-1970s to 1996, the federal budget was in deficit, and the average deficit over these years was 4.2% of the GDP o reached a peak in 1985 (6.6%)  in 1997, the government finally eradicated its deficit by cutting outlays, especially transfer payments to provincial governments  to see what exactly the budget fluctuated, we need to examine the sources of revenues and outlays  revenues o total revenues have no strong trends  increased through the 1960s and again through the 1980s  decreased during the 1970s and the first half of the 2000s o the main source of fluctuations was personal income taxes  the increase in personal income taxes during the 1980s resulted from increases in tax rates in successive budgets o indirect taxes decreased during the 1990s with the introduction of GST  this initially maintained revenues at a constant level, but gradually, the revenue from indirect taxes fell  outlays o total outlays increased from 1971 through 1985 o relatively high through 1993, before decreasing afterward  main source of the change was transfers to the provincial governments, which were cut drastically during the 1990s Deficit and Debt  government debt is the total amount of government borrowing o the sum of past deficits minus the sum of past surpluses  when the government budget is in deficit, government debt increases (when in surplus, debt decreases) o a persistent budget deficit emerged during the mid-1970s, which led to the deficit feeding on itself  led to increased borrowing  larger debt  larger interest payments  larger deficit o a persistent budget surplus creates a cycle of falling interest payments, larger surpluses, and falling debt  Alberta, Saskatchewan, Ontario, and BC receive the least amount of outlays  Yukon, NWT, and Nunavut receive the most amount of outlays  the Canadian government budget is in the middle of the pack relative to other countries o US, UK have larger deficits o Germany has a smaller deficit o newly industrialized Asian economies have small surpluses Debt and Capital  when individuals and businesses incur debts, they usually do so to buy capital (assets that yield a return) o the government incurs debt to build highways, irrigation schemes, public schools and universities, libraries, and stock of national defence  all of these yield a social rate of return that exceeds the interest rate the government pays on its debt  but Canadian government debt ($500 billion) is much larger than the value of the public capital stock  some government debt has been incurred to finance public consumption expenditure Supply-Side Effects of Fiscal Policy: Effects of Income Tax  at full employment, the real wage rate adjusts to make the quantity of labour demanded equal to that supplied  a tax on labour income influences potential GDP and aggregate supply by changing the full-employment quantity of labour o the income tax weakens the incentive to work and drives a wedge between the take-home wage of workers and the cost of labour to firms  results in a smaller quantity of labour and a lower potential GDP o the reason for this is that for each dollar of before-tax earnings, workers must pay the government an amount determined by the income tax code o workers look at the after-tax wage rate when they decide how much labour to supply  an income tax shits the supply curve leftwards to LS + tax  the vertical distance between the LS curve and the LS + tax curve measures the amount of income tax o with a smaller supply of labour, the before- tax wage rate rises to $35, but the after tax wage rate falls to $20  the gap created between the before- tax and after-tax wage rates is called the tax wedge Taxes on Expenditure and the Tax Wedge  taxes on consumption add to the tax wedge o this is because a tax on consumption raises the prices paid for consumption goods and services and is equivalent to a cut in the real wage rate  the incentive to supply labour depends on the goods and services that an hour of labour can buy o the higher the taxes on goods and services and the lower the after-tax wage rate, thee less is the incentive to supply labour o e/x if the income tax rate is 25% and the tax rate on consumption expenditure is 10%, a dollar earned only buys 65¢ worth of goods and services (tax wedge is 35%) Taxes and the Incentive to Save and Invest  a tax on interest income weakens the incentive to save and drives a wedge between the after-tax interest rate earned by saves and the interest rate paid by firms o these effects are analogous to those of a tax on labour income, but are more serious for two reasons:  a tax on labour income lowers the quantity of labour employed and lowers potential GDP, while a tax on capital income lowers the quantity of saving and investment and slows the growth rate of real GDP  a true tax rate on interest income is much higher than that on labour income because of the way in which inflation and taxes on interest income interact (see next section) Effect of Tax Rate on Real Interest Rate  the interest rate that influences investment and saving plans is the real after-tax interest rate o this subtracts the income tax rate paid on interest income from the real interest rate o however, taxes depend on the nominal interest rate  the higher the inflation rate, the higher is the true tax rate on interest income  example: o suppose the real interest rate is 4% and the tax rate is 40% o with no inflation, the nominal interest rate is the real interest rate  the tax on 4% interest is 1.6% (40% of 4%), so the real after-tax interest rate is 4 minus 1.6 percent, which equals 2.4% o suppose inflation is 10%  the tax on 10% interest is 4%, so the real after-tax interest rate is 4 minus 4 percent, which is 0  the true tax rate is 100 percent! Effect of Income Tax on Saving and Investment  a tax on interest income has no effect on the demand for loanable funds o the quantity of investment and borrowing that firms plan to undertake depends only on how productive capital is and what it costs (its real interest rate) o however, a tax on interest income weakens the incentive to save and lend and decreases the supply of loanable funds  for each dollar of before-tax interest, savers must pay the government an amount determined by the tax code  savers thus look at the after-tax interest rate when they decide how much to save  when a tax is imposed, saving decreases and the supply of loanable funds curve shifts leftward to SLF + tax o the amount of tax payable is measured by the vertical distance between the SLF curve and the SLF + tax curve o with a smaller supply of loanable funds, the interest rate rises, but the after-tax interest rate falls  a tax wedge is driven between the interest rate and the after-tax interest rate, and the equilibrium quantity of loanable funds decreases  saving and investment also decrease Tax Revenues and the Laffer Curve  an interesting consequence of the effect of taxes on employment and saving is that a higher tax rate does not always bring greater tax revenue o a higher tax rate brings in more revenue per dollar earned, but because a higher tax rate decreases the number of dollars earned, two forces operate in opposite directions  the relationship between the tax rate and the amount of tax revenue collected is called the Laffer Curve  on the curve: o T* is the revenue maximizing tax rate o if below T*, increasing the tax rate increases tax revenue o above T*, decreasing the tax rate decreases tax revenue The Supply-Side Debate  b
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