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Deficits, Surpluses, and the Public Debt
CHAPTER 10
DEFICITS, SURPLUSES,
AND THE PUBLIC DEBT
CHAPTER OVERVIEW
Three interrelated topics of national concern—federal budget deficits, surpluses and the public debt—are
the focus of this chapter. It begins by considering several contrasting budget philosophies. Table 10-1
provides statistical evidence that is useful in tracing the growth of the debt and assessing its current
quantitative significance.
The material on the public debt is designed to explode two popular misconceptions as to the character
and problems associated with a large public debt: (1) the debt will force the Canada into bankruptcy;
and (2) the debt imposes a burden on future generations. The debt discussion, however, also entails a
look at substantive economic issues. Potential problems of a large public debt include greater income
inequality, reduced economic incentives, and crowding out of private investment. Now attention turns to
what to do about budget surpluses.
The chapter examines the federal deficits of the early 1990s and recent and projected surpluses.
WHAT’S NEW
The discussion of tax cuts as a cause of expanding public debt has been revised to reflect the fact that tax
cuts don’t necessarily result in deficits if they are matched with restraints on government spending.
A “Consider This” box has been added on the federal and provincial per capita net debt.
Data and end-of-chapter questions have been updated and revised.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to understand:
1.
2.
3.
4.
5.
The definitions of budget surplus, budget deficit, the public debt, and the diverse budget philosophies.
About the recent Canadian budget surpluses, deficits, and public debt.
The misconceptions about budget deficits and the national debt.
The substantive issues about budget deficits and the national debt.
About recent budget surpluses.
COMMENTS AND TEACHING SUGGESTIONS
1.
In the discussion of myths about the debt, remind students that the debt is not completely harmless.
Explode the myths, but also discuss the substantive impact of the debt. Also, note the Global
Perspectives on debt in other nations.
2.
Current data on the public debt and on the federal budget are reported by Statistics Canada at
http://www.statcan.ca/english/Pgdb/govern.htm#assets. These sources can be used to update
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chapter data. The federal deficit can be measured in several ways, and these differences can lead to
different conclusions about its impact.
STUDENT STUMBLING BLOCK
1.
The national debt is an issue of great concern to politicians and citizens. Students probably have
major misconceptions based on the publicity surrounding the deficit and debt. The concern is most
often centered around the “myths” that the government can go bankrupt or that debt necessarily is a
burden on future generations. These myths are perpetuated in the media by many convincing
spokespersons. Spend some time discussing why these particular concerns are not the major issues
about which we should worry. Emphasize this section of the chapter and try to have students read
opposing points of view on these issues so that they can make informed decisions.
2.
“Millions, billions, trillions,” most people have a difficult time maintaining perspective and
proportion when using really large numbers. For most of us $100 million dollars sounds like an
incredible fortune. Ask students to calculate the percentage $100 million dollars represents out of
one trillion dollars. Check your figures before you try this in class. (The answer is .01 percent.)
This demonstration may help students understand why cutting a government budget can be so
difficult. What sounds like a huge sum of money may represent an extremely small percentage of
the total amount.
LECTURE NOTES
I.
Definitions of deficit, surplus and debt
A. A budget deficit is the amount by which government’s expenditures exceed its revenues
during a particular year. In contrast, a surplus is the amount by which its revenues exceed
expenditures.
1. In 1997 there was a Federal deficit of $22 billion.
2. In 2002 there was a surplus of $8.4 billion.
B. The national or public debt is the total accumulation of the Federal government’s total
deficits and surpluses that have occurred through time. Provincial and local governments
historically have a collective budget surplus.
II.
Three Budget Philosophies
A. The annually balanced budget was the goal until the 1930s Depression, but this ruled out
using fiscal policy as a countercyclical, stabilizing force and even makes recession or
depression worse.
1. The balanced budget is not neutral, but is pro-cyclical, that is, it worsens the business
cycle.
2. In a recession, the government would have to raise taxes and lower spending to balance
the budget as tax revenues fell with recessionary income levels. This policy would
worsen recession.
3. In an inflationary boom period, a balanced budget would intensify the inflation. As tax
revenues increased, the government would need to cut taxes or raise spending to avoid a
budget surplus. This strategy would make the inflation worse.
4. Those who argue for the annually balanced budget want to limit the growth of
government.
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B. The cyclically balanced budget is a spending philosophy which allows for some government
stabilization policy over the length of the business cycle. Deficit spending is allowed during
a recession, and surpluses during an inflationary period. Over the business cycle, deficits
would be offset by surpluses. But in reality, surpluses and deficits do not equally offset each
other.
C. Functional finance is the third budget philosophy. Advocates argue that the budget is
secondary, but the primary purpose of Federal finance is to achieve non-inflationary full
employment. Government should do what is necessary to achieve this goal regardless of the
deficit or surplus in the budget. Proponents offer several responses to critics.
III.
The Public Debt: Facts and Figures
A. The public debt in 2002 was $640 billion.
B. Causes of the expansion in debt:
1. National defence and military spending have soared during wartime. During World Wars
I and II debt grew rapidly. See Table 10-1 for facts that show World War II debt
exceeded GDP.
2. Recessions cause a decline in revenues and growth in government spending on programs
for income maintenance. Such periods included 1974-75, 1980-82, 1990-91.
B. Quantitative aspects of the debt are found in Table 10-1. Note that the absolute level in
column 2 is not meaningful without comparison of the relative size of debt and interest
payments to the nation’s ability to pay, as estimated by GDP and shown in column 5.
1. Comparing the debt to GDP is more meaningful than the absolute level of debt by itself.
Use the example of a family or corporate borrowing. For a prosperous family or firm,
$100,000 worth of debt may be a small fraction of their income; for others, $100,000
worth of debt may mean they’re unable to make payments on the debt. The amount is not
as important as the amount relative to the ability to pay. Also, most borrowing is made to
purchase physical assets such as buildings, equipment, etc. Another way to judge
government debt is to compare it to an estimate of public assets.
2. International comparisons show that other nations have relative public debts as great or
greater than that of Canada when compared to their GDPs. See Global Perspective 10-1.
3. Interest charges as a percentage of GDP represent the primary burden of the debt today.
4. Who owns the debt is also an important question. About one-quarter of the Canadian
debt is held by government agencies and the Bank of Canada; the rest is held by
individuals, banks, investment and insurance companies, and about 17 percent was held
by foreign investors in 2002. See Figure 10-1.
C. False concerns about the federal debt include several popular misconceptions:
1. Can the federal government cannot go bankrupt? There are reasons why it cannot.
a. The government does not need to raise taxes to pay back the debt, but it can refinance
bonds when they mature by more borrowing, that is, selling new bonds.
Corporations use similar methods—they almost always have outstanding debt.
b. The government has the power to tax, which businesses and individuals do not have
when they are in debt.
2. Does the debt impose a burden on future generations? In 2002 the per person gross
federal debt in Canada was $20,232. But the public debt is a public credit—your
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grandmother may own the bonds on which taxpayers are paying interest. Some day you
may inherit those bonds, which are assets to those who have them. The true burden is
borne by those who pay taxes or loan government money today to finance government
spending. If the spending is for productive purposes, it will enhance future earning
power and the size of the debt relative to future GDP and population could actually
decline. Borrowing allows growth to occur when it is invested in productive capital.
D. Substantive issues do exist.
1. Repayment of the debt affects income distribution. If working taxpayers will be paying
interest to the mainly wealthier groups who hold the bonds, this probably increases
income inequality.
2. Since interest must be paid out of government revenues, a large debt and high interest can
increase tax burden and may decrease incentives to work, save, and invest for taxpayers.
3. A higher proportion of the debt is owed to foreigners (about 23 percent) than in the past,
and this can increase the burden since payments leave the country. But Canadians also
own foreign bonds and this offsets the concern.
4. Some economists believe that public borrowing crowds out private investment, but the
extent of this effect is not clear (see Figure 10-2).
5. There are some positive aspects of borrowing even with crowding out.
a. If borrowing is for public investment that causes the economy to grow more in the
future, the burden on future generations will be less than if the government had not
borrowed for this purpose.
b. Public investment makes private investment more attractive. For example, new
federal buildings generate private business; good highways help private shipping, etc.
ANSWERS TO END-OF-CHAPTER QUESTIONS
10-1
(Key Question) Assess the leeway for using fiscal policy as a stabilization device under (a) an
annually balanced budget, (b) a cyclically balanced budget, and (c) functional finance.
(a) There is practically no potential for using fiscal policy as a stabilization tool under an
annually balanced budget. In an economic downturn, tax revenues fall. To keep the budget in
balance, fiscal policy would require the government to reduce its spending or increase its tax
rates, adding to the deficiency in spending and accelerating the downturn. If the economy
were booming and tax revenues were mounting, to keep the budget balanced fiscal policy
would have to increase government spending or reduce taxes, thus adding to the already
excessive demand and accelerating the inflationary pressures. An annually balanced budget
would intensify cyclical ups and downs.
(b) A cyclically balanced budget would be countercyclical, as it should be, since it would bolster
demand by lowering taxes and increasing government spending during a recession and
restrain demand by raising taxes and reducing government spending during an inflationary
boom. However, because boom and bust are not always of equal intensity and duration,
budget surpluses during the upswing need not automatically match budget deficits during the
downswing. Requiring the budget to be balanced over the cycle may necessitate inappropriate
changes in tax rates or levels of government expenditures.
(c) Functional finance pays no attention to the balance of deficits and surpluses annually or over
the cycle. What counts is the maintenance of a non-inflationary full-employment level of
spending. Balancing the economy is what counts, not the budget.
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10-2
What have been the major sources of the public debt historically? Why were deficits so large in
the 1980s? Why did the deficit rise in 1991 and 1992? What explains the budget surpluses of the
late 1990s and early 2000s?
Historically, wars and recessions have caused the public debt to increase. It would have been
possible to finance World War II entirely through taxes, but this would have greatly decreased the
work incentives deemed essential to get the job done. It would have been possible to finance the
war effort by printing new money but, in the conditions of the already excessive demand then
existing, this would have been highly inflationary. So, the government borrowed from the public.
This reduced purchasing power without greatly impairing the growing wealth and work
incentives of the civilian labour force. Recessions have also been responsible for the growing
debt. Government deficits to bolster the economy during recessions have not been equalled by
surpluses during booms.
Recent large surpluses result from several years of economic prosperity coupled with the results
of the deficit reduction by the federal government.
10-3
(Key Question) What are the two main ways the size of the public debt is measured? Distinguish
between refinancing the debt and retiring the debt. How does an internally held public debt differ
from an externally held public debt? Contrast the effects of retiring an internally held debt and
retiring an externally held debt.
Two ways of measuring the public debt: (1) measure its absolute dollar size; or (2) measure its
size as a percentage of GDP.
Refinancing the public debt simply means rolling over outstanding debt—selling “new” bonds to
retire maturing bonds. Retiring the debt means purchasing bonds back from those who hold them
or paying the bonds off at maturity.
An internally held debt is one in which the bondholders live in the nation having the debt; an
externally held debt is one in which the bondholders are citizens of other nations. Paying off an
internally held debt would involve buying back government bonds. This could present a problem
of income distribution because holders of the government bonds generally have higher incomes
than the average taxpayer. But paying off an internally held debt would not burden the economy
as a whole—the money used to pay off the debt would stay within the domestic economy. In
paying off an externally held debt, people abroad could use the proceeds of the bonds sales to buy
products or other assets from Canada. However, the dollars gained could be simply exchanged
for foreign currency and brought back to their home country. This reduces Canadian foreign
reserves holdings and may lower the dollar exchange rate.
10-4
True or false? If false, explain why.
a. “An internally held debt is like a debt of the left hand to the right hand.”
b. The Canadian public debt was smaller in percentage terms in 2002 than it was in 1990.
c. The basic cause of the federal debt is a lack of political courage.
(a) The statement is true about a national debt held internally, but this does not mean a large debt
is entirely problem free.
(b) True.
(c) True, for the most part.
10-5
Why might economists be quite concerned if the annual interest payments on the debt sharply
increased as a percentage of the GDP?
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The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the
debt and refinancing were automatic, there would be no debt-load at all. But interest does have to
be paid. Lenders expect that. And to pay the interest the government must either use tax
revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be
assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP
is a measure of total national income or how much the government can raise in taxes to pay the
interest.
10-6
Do you think that paying off the public debt would increase or decrease inequality? Explain.
Probably those who hold bonds are in the upper-income, higher wealth proportion of taxpayers
and since middle-income groups pay a sizable portion of taxes, interest payments on the debt
increase income inequality since recipients are primarily wealthy. In the long run, therefore,
paying down the debt should reduce inequality since interest payments would be diminished
10-7
(Key Question) Trace the cause-and-effect chain through which large deficits might affect
domestic real interest rates, domestic investment, the international value of the dollar, and our
international trade. Comment: “There is too little recognition that the deterioration of Canada’s
position in world trade is more the result of our own policies than the harm wrought by
foreigners.”
Cause and effect chain: Government borrowing to finance the debt competes with private
borrowing and drives up the interest rate; the higher interest rate induces an inflow of foreign
money to buy the now higher-return Canadian bonds; to buy the bonds the foreign financiers
must first buy Canadian dollars; the demand for dollars rises and the dollar appreciates; Canada’s
exports fall and imports rise; a Canadian trade deficit results.
The Canadian public often blames the large trade deficits on the trade policies of other
countries—particularly the United States. But, as noted in the scenario just described, a
substantial portion of the large Canadian trade deficits may have resulted from Canada running
large budget deficits for the past decade or more.
10-8
Why did the budget deficits rise sharply in 1991 and 1992? What explains the large budget
surpluses of the late 1990s and early 2000s?
In 1991 and 1992 the economy was in recession. The recession was followed by a slow recovery.
Surpluses from 1998-2002 resulted from several years of economic prosperity and the avoidance
of a recession in the period following the expansion of the late 1990s.
10-9
(The Last Word) What are the pros and cons of raising government revenues through lotteries?
The argument in favour of lotteries is that the purchase of lottery tickets is voluntary and involves
free consumer choice. It is not appropriate for governments to decide how people should spend
their money, so they should have this option. Lotteries compete with illegal gambling and may be
beneficial to the extent that they limit this criminal activity.
The argument against lotteries is that the approximately 40% of ticket revenue that goes to
governments is a steep 40% tax on the purchase of tickets. It is regressive in that about 10% of
the people account for one-half of sales. Presumably these are primarily low- and/or middleincome people. Also, it is ethically wrong for governments to support gambling that may generate
compulsive gambling and encourage gambling of other kinds in any case.
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Consider This
The absolute level of gross debt in Ontario, with a population of 12 million, was $120.7 billion
and that of Nova Scotia, with a population of 945,000, was $11.5 billion in 2002. Why is the per
capita debt more meaningful than the absolute debt level?
We must look not only at the debt level, but also a province’s ability to sustain and pay it. It is
completely misleading to look at absolute level of debt. Clearly, Ontario’s total gross debt is more
that 10 times larger that that of Nova Scotia, but it population is more than 12 times that of Nova
Scotia. Thus, Nova Scotians, with a much lower absolute debt, are on a per capita basis actually
more in debt than residents of Ontario.
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