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Lecture

EC140 Lecture Notes - Real Wages, Tax Wedge, Laffer Curve


Department
Economics
Course Code
EC140
Professor
Rizwan Tahir

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Chapter 29: Fiscal Policy
Wednesday, March 13, 2013
2:37 PM
Government Budgets
Federal budget: annual statement of federal government's outlays
(spending) and tax revenues
Federal budge has two purposes:
Finance activities of federal government (mostly income
redistribution)
Achieve macroeconomic objectives (stabilization of economy)
Fiscal policy: use of federal budget to achieve macroeconomic
objectives
Maintain full employment, economic growth, price level stability
Budget making:
Federal government and Parliament make fiscal policy
Minister of Finance presents budget plan to Parliament
Parliament debates plan and enacts laws necessary to
implement it
Budgets usually very politically driven
May not always be in interests of economy
Revenues come from:
Personal income taxes (largest component), corporate income
taxes, indirect taxes (GST/HST), investment income
Outlays:
Transfer payments largest component)- achieves income
redistribution, expenditure on goods/services, debt interest
Budget Balance
Budget balance = revenue - outlays
Budget surplus: revenues > outlays
Budget deficit: outlays > revenues
Balanced budget: revenues = outlays
Budget balance usually presented as percentage of GDP -> shows
spending relative all income earned in Canada
Adds perspective to numbers
Government Debt: accumulation of government borrowing
Sum of past deficits minus past surpluses
Fiscal Policy
Government collects most of its money through taxes, then spends
that money
Supply Side Effects
Operates through labour market
Effect of fiscal policy on employment, potential GDP, aggregate
supply
Income tax changes full employment, potential GDP, aggregate
supply
Taking part of peoples' income through taxes reduces income
Introduces "wedge" between income earned and received
Can have strong effects on incentives to work

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Supply of labour decreases because tax decreases after-
tax wage rate
Before-tax real wage rate rises but after-tax real wage
rate falls
Tax wedge: gap created between before-tax and after-
tax wage rates
Quantity of labour employed decreases
Potential GDP decreases
Supply-side effect of rise in income tax decreases
potential GDP, decreases aggregate supply
Taxes on expenditure and tax wedge
Taxes on consumption (GST/HST) add to tax wedge
Tax on consumption raises prices paid for consumption goods
and services
Has effects similar to cut in real wage rate
Decreases goods you can buy with each dollar
Ex. income tax rate - 25%, tax rate on consumption
expenditure- 10%, dollar earned buys only 65 cents worth of
goods and services, tax wedge is 35%
Taxes and Incentive to Save
Tax on interest income lowers quantity of saving and
investment, slows growth rate of real GDP
Reduces real after-tax interest rate
Real interest rate = nominal rate - inflation rate
Real after-tax rate = nominal rate - inflation rate - (tax
rate x nominal rate)
Subtracts income tax paid on interest income from
real interest, lowers return you get on savings
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Tax Revenues and Laffer Curve
Laffer curve: relationship between tax rate and amount of tax
revenue collected
At T*, tax revenue is maximized
Below T*, rise in tax rate increases revenue
People work less, but not enough to reduce total revenues
Above T*, rise in tax rate decreases tax revenue
People work a lot less, decreasing total revenues
Macroeconomic Effects
Taxing and spending by government has consequences on
business cycle
Can affect GDP through multiplier process
Fiscal Stimulus
Fiscal policy actions that seek to stabilize business cycle work by
changing aggregate demand
Discretionary fiscal policy: policy action that is initiated by
act of Parliament
Automatic fiscal policy: fiscal policy action triggered by state
of economy with no explicit action by government
Occurs automatically given structure of government
programs
Some items in government budget change automatically
with state of economy
Automatic changes in revenues:
Government legislates tax rates, not dollars
Given tax rate, when income goes up we pay more
tax in dollars
Given tax rate, when income goes down we pay
less dollars
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