Download Chapter 26. Fiscal Policy: A Summing Up

CHAPTER 26. FISCAL POLICY: A SUMMING UP
I.
MOTIVATING QUESTION
What Do Macroeconomists Know about Fiscal Policy?
Fiscal policy affects output in the short run—through its effect on aggregate demand—and in the long
run—through its effect on investment. Fiscal policy is limited by the government budget constraint,
which links the deficit to the increase in debt. Given the budget constraint, prudence suggests that
governments should run fiscal surpluses during booms to balance deficits during recessions. This is
called a cyclically balanced budget policy. It may or may not work depending on the length and severity
of the downturn compared to the upswing. Such a policy may allow the government to stimulate the
economy during recession, but avoid the dangers inherent in accumulating a large debt.
II.
WHY THE ANSWER MATTERS
The major long-term policy issue facing U.S. economic policymakers is how to finance expenditures
associated with the retirement of the baby boomers and the continued aging of the population. This
chapter alerts students to what lies ahead for them personally. (There’s not much of the text left ahead.)
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
The inflation-adjusted deficit is the deficit measured in real terms.
payments plus the (real) primary deficit, defined below.
ii.
It equals real interest
The primary deficit is government spending minus taxes.
iii. The cyclically-adjusted deficit measures what the deficit would be if output were at its natural
level.
iv. Ricardian equivalence is the (incorrect) proposition that neither deficits nor debts have any effect
on economic activity.
IV. SUMMARY OF THE MATERIAL
In the short run, an increase in the deficit increases aggregate demand and real output, with the strength
of the initial impact depending on expectations. In the medium run, output returns to its natural level, but
with a higher real interest rate and a lower rate of investment. In the long run, a output may be lower
(than it would be otherwise) because a higher deficit may lead to less investment and therefore less
capital accumulation.
1.
The Government Budget Constraint
The inflation-adjusted deficit is defined as
Deficit=rBt-1+Gt-Tt,
(26.1)
where all variables are expressed in real terms, B is real debt, and r is the real interest rate. The text notes
that official deficit measures typically substitute nominal interest payments (iBt-1) for real interest
payments (rBt-1) in equation 26.1. The deficit is linked to the increase in debt by the government budget
constraint:
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Bt-Bt-1= rBt-1+Gt-Tt.
(26.2)
Defining the primary deficit as Gt-Tt, government debt can be expressed as
Bt=(1+r)Bt-1+Primary Deficit.
(26.3)
This relationship implies that, starting from zero debt and a zero primary deficit, a one-unit increase in
the primary deficit for one period will generate a debt of Bt=(1+r)t after t periods. To repay this debt
after t periods, the government must run a primary surplus of (1+r)t. If spending is unchanged, this means
that a reduction in taxes today implies an increase in future taxes of equal present value. If instead of
repaying the debt, the government merely seeks to stabilize it, it must run a primary surplus equal to the
real interest payment on the debt in every future period. This implies a zero inflation-adjusted deficit.
To examine the evolution of the debt-to-GDP ratio, rewrite the government budget constraint as
Bt/Yt=(1+r)(Yt-1/Yt)(Bt-1/Yt-1) + (Gt-Tt)/Yt,
which can be approximated as
(Bt/Yt)-(Bt-1/Yt-1)=(r-g)(Bt-1/Yt-1) + (Gt-Tt)/Yt,
(26.4)
where g is the growth rate of output. Given some initial debt, equation (26.4) implies that the debt-toGDP ratio will grow when there is a primary deficit and when the real interest rate exceeds the growth
rate of output. To understand the latter effect, suppose the primary deficit is zero. Then, debt (the
numerator) will grow at rate r and output (the denominator) will grow at rate g. The difference in growth
rates is approximately the change in the debt-to-GDP ratio.
2.
Four Issues in Fiscal Policy
i.
Ricardian equivalence. Ricardian equivalence is the proposition that neither deficits nor debt
affect economic activity. For example, given unchanged government spending, a tax cut today implies a
tax increase of equal present value in the future. Therefore, consumer wealth is unchanged, and
(according to the benchmark consumption theory presented in Chapter 16) private consumption is
unaffected. An increase in today's government deficit will be matched with an equal increase in private
saving. In practice, however, tax increases that are distant and uncertain are likely to be ignored by
consumers, because they may not live to see them or because they do not think that far into the future.
As a result, although expectations certainly affect economic behavior, it is unlikely that Ricardian
equivalence holds in strict form.
ii.
Deficits, output stabilization, and the cyclically-adjusted deficit.
The fact that deficits
reduce investment does not mean that they should be avoided at all times, but rather that deficits during
recessions should be offset by surpluses during booms. In this way, fiscal policy will not lead to a steady
increase in debt. The cyclically-adjusted deficit removes the effect of the business cycle from the deficit.
Thus, it can be used to assess whether fiscal policy is consistent with no systematic increase in debt over
time. Estimating the cyclically-adjusted deficit requires knowledge of two facts: the reduction in the
deficit that would occur if output were to increase by 1% and the difference between current output and
its natural level. The first fact is relatively easy to determine; as a rule of thumb, a 1 percent decrease in
output increases the deficit by 0.5% of GDP. The deficit increases because most taxes are proportional
to output, but most spending does not depend on output. The second fact is more difficult to ascertain,
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because the natural level of output depends on the natural rate of unemployment, which changes over
time.
iii.
Wars and deficits. There are two good reasons to run deficits during wars. First, deficits shift
part of the burden of paying for a war to future generations (because they inherit a smaller capital stock).
Second, by using debt instead of tax financing, the government avoids imposing very large and
distortionary tax rates. Borrowing permits tax increases to be smoothed over time.
iv.
The dangers of very high debt. High debt can lead to vicious cycles. If financial investors
begin to demand a higher risk premium to hold domestic bonds, the higher interest rate on government
debt implies that the debt-to-GDP will increase unless the government increases the primary surplus. If
the government does nothing, the increase in the debt ratio may lead investors to demand an even higher
risk premium, making the problem worse. On the other hand, if the government takes steps to increase
the primary surplus, it may create a recession, which will lead to a lower growth rate and (by equation
(26.4)) faster growth of the debt-to-GDP ratio. In addition, the required fiscal measures may create
political costs for the government and increase uncertainty about the political situation, which could
increase the risk premium, thereby increasing the interest rate on government debt and compounding the
problem. In short, the presence of a large debt leaves the government in a vulnerable position.
Moreover, a vicious cycle can be self-fulfilling. Even initially unfounded fears that the government will
repay its debt can lead to an increase in the risk premium, which will start the process in motion.
The problems associated with high debt lead some governments to consider debt repudiation. Although
this can eliminate the problems of high debt in the short run, governments who repudiate debt will find it
difficult to borrow in the future.
3.
The U.S. Budget Deficit
The chapter concludes with an examination of the U.S. budget deficit. There are three sets of issues:
NIPA vs. government deficit measures, Congressional Budget Office (CBO) forecasts, and the case for
surpluses instead of deficits.
On the first issue, the text argues in favor of the NIPA measure because it does not distinguish between
on-budget and off budget programs, does not treat government asset sales as revenues, and does not
include government investment (but does include depreciation) in its measure of government spending.
Using NIPA numbers, the inflation-adjusted deficit was 2.3% of GDP in fiscal year 2003. The deficit
was a sharp change from the surpluses a few years earlier.
On the second issue, the CBO baseline shows the deficit declining to less than 1% of GDP by 2014, but
this projection is based on two unrealistic assumptions. The first is that that discretionary spending will
grow at the rate of inflation, instead of the rate of growth of GDP, which is historically a more accurate
assumption. The second is that the Bush tax cuts will actually expire in 2010. It is widely believed that
the cuts were given an expiration date to lessen their total projected cost. Moreover, it is the stated
policy of the Bush administration to extend the tax cuts, which most people believe will happen, absent a
change in policy. Under these two more realistic assumptions, CBO projections show a deficit above 4%
of GDP in 2014.
Finally, on the third issue, many economists believe that the government should be running surpluses
instead of deficits, because the U.S. saving rate is low, entitlement programs are projected to grow
rapidly, and the population is aging rapidly. A low saving rate leads either to lower investment or an
increase in foreign indebtedness to finance investment. The United States has taken the latter route, and
is now the largest debtor in the world. Entitlements and aging are closely related. As the U.S. population
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ages, the retirement of the baby boomers and the rising cost of health care will combine to set off large
increases in Social Security, Medicare, and Medicaid spending, which will create huge deficits in the
absence of policy changes. The projections suggest that waiting to address policy changes until the funds
are required will imply large and distortionary tax increases in the future. Thus, the analysis suggests
that the U.S. should start running higher surpluses—through reductions in benefits and increases in
taxes—to accumulate assets that can be used to finance future expenditures.
V. PEDAGOGY
1.
Points of Clarification
It is worthwhile to emphasize that Ricardian equivalence implies that the size of the deficit has no effect
on economic activity, not that fiscal policy has no effect on economic activity. For example, starting
from a position of budget balance, the balanced budget multiplier implies that an increase in government
spending fully financed by taxes would increase aggregate demand and thus output. Ricardian
equivalence implies that the effect will be the same regardless of whether the increase in government
spending is financed by tax increases or debt.
2.
Alternative Sequencing
It is easy for instructors to pick and choose from this chapter. Any of the theoretical topics – for
example, Ricardian equivalence – can be lifted out and examined independently (or, more appropriately,
ignored). Alternatively, instructors could limit attention to the U.S. budget deficit and ignore the
theoretical sections.
VI. EXTENSIONS
The concept of the inflation-adjusted deficit provides instructors an opportunity to review the Fisher
effect. For a given nominal interest rate, the inflation-adjusted deficit will be less than the official deficit
when unanticipated inflation is positive. Thus, it seems that the government can reduce its real deficit
and its real debt burden through inflation. In fact, historically inflation has been an important means for
governments to reduce their real debt burdens. Although governments can use inflation in this way for
some period of time, they cannot do so indefinitely. In the long run, the Fisher effect implies that the
nominal interest rate will increase one-for-one with the inflation rate. Thus, in the long run, an increase
in inflation will simply increase the nominal deficit and have no effect on the inflation-adjusted deficit.
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