Long Run Effects of Fiscal Policy: Study with Video Lessons, Practice Problems & Examples

Persistent government budget deficits occur when tax revenues are less than expenditures, leading to borrowing and the crowding out effect. This competition for loanable funds raises interest rates, reducing investment spending and stunting long-run economic growth. Lower taxes can increase disposable income and consumption, while also enhancing corporate investment. However, maintaining a balanced budget is crucial, as lower taxes necessitate reduced spending to avoid deficits. Understanding these dynamics is essential for grasping fiscal policy's long-term implications on GDP and economic stability.

Persistent Budget Deficit

Alright. Now let's see some of the long-run effects of fiscal policy. So let's start with the first situation which is one that we kind of see happening in the US right now, is a persistent government budget deficit. That means that the tax revenues, the money they're bringing in, is less than they're spending. Okay? So they're spending more than they are bringing in in revenue. They have a budget deficit. So how are they going to pay for this deficit? By borrowing funds, right? Just like anyone, when you need money, you're going to borrow it to make up your debts. So, when the government needs to borrow money, we have what's called the crowding-out effect. Okay? This is one of those buzzwords that they love to use is the crowding-out effect. And this is where the government is competing with firms for loanable funds and that's going to drive up the interest rate. So let's kind of follow. Let's see how this leads to higher interest rates. When the budget, when there's a budget deficit, well, the government is going to be borrowing money, right? The government's going to be borrowing money, meaning there's more demand for money driving up the price of money, which is interest, right? So when the government is borrowing, there are more people trying to borrow, there's not just firms trying to borrow money right now, now there's also a government trying to borrow money and they're going to fight for those loanable dollars driving the price up. So with that interest rate higher, well now at a higher interest rate, there's going to be less investment spending, right? Because investors want to have a low interest rate when they're going to invest in long-term things like factories and equipment. Whatever they're going to build, they want to have a lower interest rate to have higher profit. So the higher the interest rate goes, the lower the investment spending is going to go, which leads to lower long-run growth, right? Because if there's no investment spending, no factories being built, no equipment, no buildings being built, well, those are the things that we need, those investments, those capital investments for long-term growth. So, this budget deficit has long-term implications on our GDP, right? Our long-term growth, our long-run growth of our economy is stunted by having a budget deficit. So the debt leads to interest payments and that's going to put pressure on future budgets, right? The more money you borrow now, well, that's the more interest you're going to have to pay off later. So in further years, we're going to have to be even more conservative with our spending because of all of these interest payments. So, in future years, the government's going to have to increase taxes or cut spending to pay off the debt. Right? They're gonna have to be more conservative in the future. Now, the government should try to balance extra spending during recessions with surpluses during expansions, right? So when they're in a recession, maybe they should increase their spending and then in an expansion, maybe they should pull it back. Does this actually happen? Not really, right? Even though they boost up their spending during a recession, a lot of times, it's hard to take back that spending, okay? Sometimes, once those wheels are in motion, it's hard to kind of stop the train of government spending from going. So it doesn't really happen that they balance out when they spend a lot with times where the economy is good and spend less, okay? So that's really what happens with a persistent government deficit. A budget deficit has this crowding-out effect leads to stunted long-run growth, okay? Let's pause here and let's talk about long-run tax policy in the next video.

Long Run Tax Policy

So another effect of government policy, or our fiscal policy, is the long-run tax policy. We use this idea of a tax wedge, which is the difference between pretax and post-tax income. Let's say you earn $20 an hour, but are taxed 25%. So, 25% of that is going to taxes. That means you're paying $5 of that wage in taxes, right? So, you're going to have $15 of income post-tax, and there's this $5 tax wedge. That's what we call the tax wedge: the difference between what you earned gross, at $20 an hour, and what you actually have left after taxes, $15.

You can imagine that the long-run effects of tax policy are going to have effects on the economy as well. The first one, we'll talk about how lowering taxes affects the economy. The lower the individual taxes, the more disposable income leading to more consumption, right? Just like we've talked about pretty consistently throughout this course. The lower the taxes, the more income you have, the more you can consume. And it's the same for corporate taxes because for firms, when there's lower corporate taxes, they are going to have higher returns leading to more investment, right? So when there's lower taxes, it leads to higher investment as well. Lower taxes also help on capital gains and dividends, so they increase the supply of loanable funds. When there's lower taxes, there's an increase in the supply of loanable funds because this is savings from households. Households are more likely to save when there's lower taxes, right? If there's lower taxes on their earnings from savings, because remember, if you earn any money from a savings, you're going to be taxed on that. So, the lower those taxes go, the more incentive you have to save.

When there's an increase in that supply of loanable funds, it's going to lower the interest rate as well. So there are benefits here to a long-run sustained lower tax policy. However, that needs to be balanced in a balanced budget. Remember, a budget deficit means the lower the taxes go, the spending has to come down too, right? To keep that balanced budget. So these are the effects that we'll see from long-run tax policy here. Alright? Let's go ahead and pause and we'll move on to the next video.

Here’s what students ask on this topic:

What are the long-run effects of a persistent government budget deficit?

A persistent government budget deficit occurs when government spending exceeds tax revenues, leading to borrowing. This borrowing creates a crowding out effect, where the government competes with private firms for loanable funds, driving up interest rates. Higher interest rates reduce investment spending, as firms find it more expensive to finance new projects. This reduction in investment stunts long-run economic growth, as fewer factories, equipment, and buildings are constructed. Additionally, the debt incurred leads to future interest payments, putting pressure on future budgets and potentially necessitating higher taxes or reduced spending. Overall, persistent deficits can hinder GDP growth and economic stability in the long run.

How does the crowding out effect influence long-term economic growth?

The crowding out effect occurs when government borrowing increases the demand for loanable funds, leading to higher interest rates. Higher interest rates make it more expensive for private firms to borrow money for investment purposes. As a result, investment spending decreases, which negatively impacts long-term economic growth. Investments in capital goods like factories, machinery, and infrastructure are crucial for enhancing productivity and expanding the economy. When these investments decline, the economy's growth potential is stunted, leading to lower GDP growth over time. Thus, the crowding out effect can significantly hinder long-term economic development.

What is the tax wedge, and how does it affect the economy in the long run?

The tax wedge is the difference between pretax and post-tax income. For example, if you earn $20 per hour and are taxed at 25%, you pay $5 in taxes, leaving you with $15 post-tax income. The tax wedge affects the economy by influencing disposable income and consumption. Lower taxes reduce the tax wedge, increasing disposable income and boosting consumption. For firms, lower corporate taxes mean higher returns, leading to more investment. Additionally, lower taxes on savings increase the supply of loanable funds, reducing interest rates and encouraging further investment. However, these benefits must be balanced with maintaining a budget to avoid deficits.

How do lower taxes impact long-term investment and economic growth?

Lower taxes increase disposable income for individuals and higher returns for firms, leading to more consumption and investment. For individuals, more disposable income means higher consumption, which can stimulate economic activity. For firms, lower corporate taxes result in higher after-tax profits, encouraging more investment in capital goods like machinery and infrastructure. Additionally, lower taxes on savings increase the supply of loanable funds, reducing interest rates and further promoting investment. These factors collectively enhance long-term economic growth by increasing productivity and expanding the economy's capacity. However, it is crucial to balance lower taxes with government spending to avoid budget deficits.

Why is maintaining a balanced budget important for long-term economic stability?

Maintaining a balanced budget is crucial for long-term economic stability because it prevents the accumulation of excessive government debt. When a government runs a budget deficit, it must borrow funds, leading to higher interest rates due to the crowding out effect. Higher interest rates can reduce private investment, stunting long-term economic growth. Additionally, accumulated debt requires future interest payments, putting pressure on future budgets and potentially necessitating higher taxes or reduced spending. By maintaining a balanced budget, the government can avoid these negative consequences, ensuring sustainable economic growth and stability over the long term.