When Bill Clinton became president in January 1993, his administration’s primary challenge was to contain the budget def
Posted: Wed Apr 27, 2022 11:39 am
When Bill Clinton became president in January 1993, his
administration’s primary
challenge was to contain the budget deficit and support the U.S.
economy that was recovering
from the 1991 recession. President Clinton proposed a fiscal
strategy comprising a deficit-reduction
package by means of a tax increase together with a stimulus package
to ease the short-run effects
of the fiscal contraction. Assume that consumers were not Ricardian
and that the U.S. is a closed
economy that was at full employment before implementing Clinton’s
fiscal mix.
a) How does the tax increase (this policy only) affect the economy
in the short run? What is the
effect on the aggregate demand? Illustrate your answer on the
AD-SRAS-LRAS diagram.
It turned out that 80 percent of the personal tax increase fell on
the most affluent 1% of Americans
(those with annual incomes above $200,000) who would pay 17 percent
more taxes. For income
groups between $30,000 and $200,000, total taxes rose approximately
by 1 percent. For taxpayers
whose income was below $30,000, there was no change in taxes.
b) Given that wealthier people have a lower marginal propensity to
consume, did the distribution
of the tax burden selected by the Clinton administration alleviate
or worsen the contractionary
effect of the tax increase? Explain by comparing the Clinton tax
increase with a tax increase
that is evenly divided across income groups.
The stimulus package provided $4 billion in additional unemployment
benefits (a transfer).
c) Does the provision of unemployment benefits alleviate or worsen
the contractionary effects of
the tax increase? Explain and illustrate your answer on the graph
of part a).
In what follows, assume that the fiscal policy caused a
contraction in the AD. You don’t need to
have answered the previous questions.
d) Was the Clinton fiscal policy mix inflationary or deflationary
in the long run? What was the
effect on unemployment in the short run? Explain.
Consider now the effects on labor supply. A Republican
economist argued that Clinton’s policy
would have caused taxpayers to work shorter hours and take
longer vacations, thereby producing
less taxable income. In contrast, a Democrat economist claimed
that people would have worked
more rather than less, in order to keep their after-tax incomes
at the same level.
e) Which economist focuses on the effects of marginal taxes (i.e.
on the substitution effect)?
Who focuses on the effects of average taxes (i.e. the income
effect)?
f) If the Democrats were right, how would the increase in taxes
shift the LRAS? What would be
the long-run effect on employment and on the average productivity?
Illustrate your answer
on an LRAS-AD diagram. Would the shift in LRAS make the fiscal
policy more or less
deflationary? What monetary policy would the U.S. economy need to
offset the deflationary
pressures?
administration’s primary
challenge was to contain the budget deficit and support the U.S.
economy that was recovering
from the 1991 recession. President Clinton proposed a fiscal
strategy comprising a deficit-reduction
package by means of a tax increase together with a stimulus package
to ease the short-run effects
of the fiscal contraction. Assume that consumers were not Ricardian
and that the U.S. is a closed
economy that was at full employment before implementing Clinton’s
fiscal mix.
a) How does the tax increase (this policy only) affect the economy
in the short run? What is the
effect on the aggregate demand? Illustrate your answer on the
AD-SRAS-LRAS diagram.
It turned out that 80 percent of the personal tax increase fell on
the most affluent 1% of Americans
(those with annual incomes above $200,000) who would pay 17 percent
more taxes. For income
groups between $30,000 and $200,000, total taxes rose approximately
by 1 percent. For taxpayers
whose income was below $30,000, there was no change in taxes.
b) Given that wealthier people have a lower marginal propensity to
consume, did the distribution
of the tax burden selected by the Clinton administration alleviate
or worsen the contractionary
effect of the tax increase? Explain by comparing the Clinton tax
increase with a tax increase
that is evenly divided across income groups.
The stimulus package provided $4 billion in additional unemployment
benefits (a transfer).
c) Does the provision of unemployment benefits alleviate or worsen
the contractionary effects of
the tax increase? Explain and illustrate your answer on the graph
of part a).
In what follows, assume that the fiscal policy caused a
contraction in the AD. You don’t need to
have answered the previous questions.
d) Was the Clinton fiscal policy mix inflationary or deflationary
in the long run? What was the
effect on unemployment in the short run? Explain.
Consider now the effects on labor supply. A Republican
economist argued that Clinton’s policy
would have caused taxpayers to work shorter hours and take
longer vacations, thereby producing
less taxable income. In contrast, a Democrat economist claimed
that people would have worked
more rather than less, in order to keep their after-tax incomes
at the same level.
e) Which economist focuses on the effects of marginal taxes (i.e.
on the substitution effect)?
Who focuses on the effects of average taxes (i.e. the income
effect)?
f) If the Democrats were right, how would the increase in taxes
shift the LRAS? What would be
the long-run effect on employment and on the average productivity?
Illustrate your answer
on an LRAS-AD diagram. Would the shift in LRAS make the fiscal
policy more or less
deflationary? What monetary policy would the U.S. economy need to
offset the deflationary
pressures?