Chapter 14 Deficit Spending and The Public Debt. Copyright © 2008 Pearson Addison Wesley. All...

Chapter 14

Deficit Spending and The Public Debt

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 14-2

Introduction

In adopting the euro, European nations agreed to abide by the Stability and Growth Pact.

The pact called for limitations on government spending over tax collections to be no more than 3% of GDP—yet many European governments have since changed their tune.


Learning Objectives

• Explain how federal government budget deficits occur

• Define the public debt and understand alternative measures of the public debt

• Evaluate circumstances under which the public debt could be a burden to future generations


Learning Objectives (cont'd)

• Discuss why the federal budget deficit might be measured incorrectly

• Analyze the macroeconomic effects of government budget deficits

• Describe possible ways to reduce the government budget deficit


Chapter Outline

• Public Deficits and Debts: Flows versus Stocks

• Government Finance: Spending More than Tax Collections

• Evaluating the Rising Public Debt

• Federal Budget Deficits in an Open Economy

• Growing U.S. Government Deficits: Implications for U.S. Economic Performance


Did You Know That...

• Throughout the rest of this decade, the U.S. federal government expects to run annual budget deficits?

• The relationship between budget deficits and macroeconomic performance is somewhat elusive?


Public Deficits and Debts: Flows versus Stocks

• Government Budget Deficit

Exists if the government spends more than it receives in taxes during a given period of time

Is financed by the selling of government securities (bonds)


Public Deficits and Debts: Flows versus Stocks (cont'd)

• The federal deficit is a flow variable, one defined for a specific period of time, usually one year.



• If spending equals receipts, the budget is balanced.

• If receipts exceed spending, the government is running a budget surplus.



• Balanced Budget

A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time



• Government Budget Surplus An excess of government revenues over

government spending during a given period of time



• Public Debt

A stock variable

The total value of all outstanding government securities


Government Finance: Spending More than Tax Collections

• Since 1940, the U.S. federal government has operated with a budget surplus in 13 years.

• In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.


Figure 14-1 Federal Budget Deficits and Surpluses Since 1940


Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP


Government Finance: Spending More than Tax Collections (cont'd)

• The resurgence of federal government deficits

• Question Why has the government’s budget recently

slipped from a surplus of 2.5% of GDP into a deficit?


Policy Example: Explaining a $109 Billion Deficit Projection Turnaround

• Why was the government’s 2005 deficit projection off by $109 billion?

• Federal tax revenues turned out to be more than 15% higher in 2005.

• Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.


Evaluating the Rising Public Debt

• Gross Public Debt All federal government debt irrespective of

who owns it

• Net Public Debt Gross public debt minus all government

interagency borrowing


Evaluating the Rising Public Debt (cont'd)

• Some government bonds are held by government agencies.

In this case, the funds are owed from one branch of the federal government to another.

To arrive at the net public debt, we subtract interagency borrowings from the gross public debt.



• Tax revenues tend to be stagnant during times of slow economic growth.

• Tax revenues grow more quickly when overall growth enhances incomes.

• As long as spending exceeds revenues, the budget deficit will persist.


Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It


Figure 14-3 Net U.S. Public Debt as a Percentage of GDP


Net U.S. Public Debt as a Percentage of GDP

• During World War II, the net public debt grew dramatically.

• After the war It fell until the 1970s

Started rising in the 1980s

Declined once more in the 1990s

And recently has been increasing again



• The government must pay interest on the public debt outstanding.

• The level of these payments depends on the market interest rate.

• Interest payments as a percentage of GDP are likely to rise in the future.



• As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases.

• Foreign residents, businesses and governments hold nearly 50% of the net public debt.

• Thus, we do not owe the debt just to ourselves.



• If the economy is already at full employment, then further provision of government goods will crowd out some private goods.

• Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.



• Crowding-out may place a burden on future generations.

Increased present consumption may crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth.

Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt.



• Paying off the public debt in the future

If the debt becomes larger, each person’s share would increase.

Taxes would be levied, and may not be assessed equally.

A special tax could be levied based on a person’s ability to pay.



• Our debt to foreign residents

We do not owe all the debt to ourselves.

Future U.S. residents will be taxed to repay principal and interest.

Portions of U.S. incomes will be transferred abroad.



• If deficits lead to slower growth rates future generations will be poorer.

• Both present and future generations will be economically better off if… Government expenditures are really investments

The rate of return on such public investments exceeds the interest rate paid on the bonds


International Example: Where Are Most Treasury Securities Held Abroad?

• More than $2 trillion in U.S. Treasury securities of the $5 trillion in net outstanding debt is held outside the United States.

• Japan accounts for more than one-third of all foreign holdings of the U.S. net public debt.


Figure 14-4 The Distribution of Foreign Holdings of U.S. Treasury Securities


International Example: Where Are Most Treasury Securities Held Abroad? (cont'd)

• For critical analysis:

Why might the fact that market interest rates in Japan have hovered very close to 0% during the 2000s help explain relatively large holdings of U.S. Treasury securities by residents of that country?


Federal Budget Deficits in an Open Economy

• Question

Is there a connection between the U.S. trade deficit and the federal government budget deficit?


Federal Budget Deficits in an Open Economy (cont'd)

• We know what a budget deficit is, but a trade deficit exists when the value of imports exceeds the value of exports.

• Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.


Figure 14-5 The Related U.S. Deficits



• As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners.

• The interest rate paid on bonds will need to be high enough to attract foreign investors.



• If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports.

• This shows that a U.S. budget deficit can contribute to a trade deficit.


Growing U.S. Government Deficits: Implications for U.S. Economic Performance

• Which government deficit is the true deficit?

The government may report distorted measures of its own budget.Government has not adopted a

business-like approach to tracking its expenditures and receipts.

Official government “measures” yield lowest possible deficits and highest reported surpluses.


Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)

• An operating budget includes current outlays for on-going expenses, such as salaries and interest payments.

• A capital budget, includes expenditures on investment items, such as machines, buildings, roads, and dams.



• Capital budgeting theory

For years, many economists have recommended Congress create a capital budget and remove investment outlays from the operating budget.

Opponents point out this would allow the government to grow even faster than at present.



• Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure.



• Pick a deficit, any deficit: deficit estimates are produced both by The Office of Management and Budget

The Congressional Budget Office

• They have different names “Baseline deficit”

“Policy deficit”

“On-budget deficit”



• There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers.

• So keep in mind that any one specific deficit measure you hear is based on a definition and a set of assumptions with which others may disagree.



• Question How do higher deficits affect the economy in the

short run?

• Answers If the economy is below full-employment, the

deficit can close the recessionary gap.

If the economy is already at full-employment, the deficit can create an inflationary gap.



• In the long run, higher government budget deficits have no effect on equilibrium real GDP.

• Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.



• Thus, if the government operates with higher deficits over an extended period

The ultimate result is a shrinkage in the share of privately produced goods and services

By continually spending more than it collects, the government takes up a larger portion of economic activity.



• How could the government reduce all its red ink?

Increasing taxes for everyone

Taxing only the rich

Reducing expenditures

Whittling away at entitlements


Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase

• Many have proposed raising taxes on the highest-income earners.

• Just like everyone else high-income individuals respond to incentives.

• The richest tax payers could use deferred compensation plans.

• These individuals would shift income earned in current years to future years.


Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase (cont'd)

• Government estimates show increasing the top bracket from 35% to 39.6% would reduce total taxable income by at least 4%.

• Projections show the increase would give the highest income taxpayers a greater incentive to incorporate and pay lower corporate-profit tax rates.


Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase (cont'd)

• Thus, raising the income tax rate by 4.6 percentage points would result in less than a 4.6% increase in government tax collections.



• In considering how expenditures might be reduced, it is important to look at entitlements.

• These are federal government payments that are legislated obligations and cannot be reduced or eliminated.



• Entitlements Guaranteed benefits under a government

program such as Social Security, Medicare, or Medicaid

• Noncontrollable Expenditures Government spending that changes

automatically without action by Congress


Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending



• Entitlements are the largest component of the U.S. federal budget.

• To make a significant cut in expenditures, entitlement programs would have to be revised.



• Question

What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid?


Issues and Applications: Budget Deficit Rules Made to Be Broken?

• Under the Stability and Growth Pact each EU member nation agreed on net public debt and annual budget deficit percentages.

• Net public debt as a percentage of GDP should be no higher than 60%, with the annual budget deficit no higher than 3% of GDP.


Issues and Applications: Budget Deficit Rules Made to Be Broken? (cont'd)

• All EU nations satisfied the 60% constraint on net public debt as a proportion of GDP.

• Several EU countries failed to satisfy the 3% limitation on the ratio of the budget deficit to GDP.


Issues and Applications: Budget Deficit Rules Made to Be Broken? (cont'd)

• During the 2000s, many nations were experiencing deficits in excess of 3% of GDP as economies slowed, entitlements grew, and tax revenues were stagnant.

• Several governments that violated the 3% limit did so hoping expansionary fiscal policies would boost aggregate demand and prevent recessions.


Summary Discussion of Learning Objectives

• Federal government budget deficits Whenever the flow of government expenditures

exceeds the flow of government revenues a budget deficit occurs.

• The public debt Total value of all government bonds outstanding

The federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt.


Summary Discussion of Learning Objectives (cont'd)

• How the public debt might prove a burden to future generations Higher taxes will reduce private consumption.

Crowding out might reduce economic growth.

• Why the federal budget deficit might be incorrectly measured No distinction between capital expenses and

operating expenses

Each estimate is based on a set of assumptions.



• The macroeconomic effects of government budget deficits

Because higher government deficits are caused by increased government spending or tax cuts, they contribute to a short-run rise in total planned expenditures and aggregate demand.

In the long run, increased deficits only redistribute resources from the private sector to the public sector.



• Possible ways to reduce the government budget deficit

Increase taxes

Reduce expenditures by revising the terms of entitlement programs

End of Chapter 14

Deficit Spending and The Public Debt

Chapter 14 Deficit Spending and The Public Debt. Copyright © 2008 Pearson Addison Wesley. All...

Documents

Transcript of Chapter 14 Deficit Spending and The Public Debt. Copyright © 2008 Pearson Addison Wesley. All...