Fiscal Policy

The Government Budget Constraint

The Arithmetic of Deficits and Debt– The budget deficit in year t equals:

defic it rB G Tt t t t 1

is the government debt at the end of year is the government debt at the end of year tt-1.-1.rB t 1

is government spending during year is government spending during year tt..G t

is taxes minus transfers during year is taxes minus transfers during year tt..Tt

The Government Budget Constraint

The change in government debt during year t is equal to the deficit during year t:

B B B Tt t t t t 1 1 r G

change in the debt interest payments primary deficit

Debt at the end of year Debt at the end of year tt equals: equals:B r B G Tt t t t ( )1 1

U.S. Fiscal Deficits

Financing the Deficit

Full Repayment in Year 2

Tax Cuts, Debt Repayment, and Debt Stabilization

T G r r2 2 1 1 1 ( ) ( )

Debt Stabilization in Year 2

Tax Cuts, Debt Repayment, and Debt Stabilization

B r B G T2 1 2 21 ( ) ( )1 1 2 2 ( ) ( )r G TT G r r2 2 1 1 ( )

B B2 1 1

Conclusions

An increase in the deficit today must eventually be offset by a decrease in the deficit in the future (by increasing T or decreasing G).The longer the government waits or the higher the real interest rate, the higher the eventual increase in taxes.The legacy of deficits is higher government debt.To stabilize the debt, the government must run a surplus equal to the interest payments on the existing debt. To eliminate the debt, the government must run a surplus equal to the interest payments on the existing debt plus repayment of the stock of debt.

The Evolution of the Debt to GDP Ratio

If GDP grows (g increases), the ratio of debt to GDP will grow more slowly (at a rate equal to rg).

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U.S. National Debt as % of GDP

The Evolution of the Debt-to-GDP Ratioin OECD Countries

In the 1960s, GDP growth was strong. As a result, rg was negative. OECD Countries were able to decrease their debt ratios.In the 1970s, rg was again negative due to very low interest rates, leading to a further decrease in the debt ratio.

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The Evolution of the Debt-to-GDP Ratioin OECD Countries

In the 1980s, real interest rates increased and growth rates decreased, thus, debt ratios increased rapidly.Throughout the 1990s, interest rates remained high and growth rates low. However, most countries ran primary surpluses sufficient to imply a steady decline in their debt ratios.

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Public Debt (% of GDP)

Taxes

Sources of Tax Revenue in the United States(2004)

Government Spending in the United States(2004)

Foreign Aid from the Rich Countries

Issues in Fiscal Policy

Tax distortionsThe danger of high debts

Reducing Tax Distortions

Very high tax rates can lead to high economic distortions. People might work less, and engage in illegal, untaxed activities.Inflation (seigniorage) also distorts prices and therefore incentives.Tax smoothing is the idea that it is better to maintain a relatively constant tax rate.

The Dangers of Very High Debt

The higher the ratio of debt to GDP, the larger the potential for catastrophic debt dynamics.Expectations of higher and higher debt give a hint that a problem may arise, which will lead to the emergence of the problem, thereby validating the initial expectations.

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Public Debt

Surpluses and Aging

Entitlement programs are programs that require the payments of benefits to all who meet the eligibility requirements established by the law.

Surpluses and Aging

Entitlement spending to GDP is projected to increase for these reasons:– Aging – The steadily increasing cost of health care.

Projected entitlement spending would eventually exceed revenues.

Surpluses and Aging

Since 1983, Social Security contributions have exceeded benefits. The Social Security Trust Fund is an account where the surpluses have been accumulating, and now equal 12% of GDP.The Social Security Trust Fund is expected to reach 20% of GDP in 2020, then to decline and be equal to zero by 2030.

Aging in a Comparative Perspective

Possible Solutions to the Medicare Problem

Cut benefitsIncrease taxes on workersImmigrationDramatic health care reformRetirement Accounts– Fully-funded vs. pay-as-you-go schemes

PrivatizationAll of these are controversial!

Fiscal Policy in the short-, medium- and long-run

In the short run: fiscal policy and the IS-LM model (open or closed) – moving the IS curve.In the medium run: how will different fiscal policies affect employment and the price level.In the long run: how will fiscal policy affect the investment rate (capital accumulation) and the rate of technological progress:– private and public savings– incentives for R & D.