Download Chapter 30: Fiscal Policy, Deficits, and Debt

Chapter 30: Fiscal Policy, Deficits, and Debt
Because of economic instability the Federal government sometimes uses
budgetary actions to try to “stimulate the economy” or “rein in inflation.”
Such countercyclical fiscal policy consists of deliberate changes in
government spending and tax collections designed to achieve full
employment, control inflation, and encourage economic growth. In this
case the adjective “fiscal” simply means a 12 month financial period
running from Oct. 1 to Sept. 30.
3 Budgetary Outcomes
1. Balanced Budget- When federal tax revenues equal government
spending. This never happens.
2. Budget Surplus- When federal tax revenues exceed government
spending. This happens occasionally, the last time was in 2001.
3. Budget Deficit- When federal tax revenues are less than government
spending. The federal budget has been in deficit approximately 85% since
WWII.
For example in 2009, Congress and the Obama Administration passed a
$787 billion stimulus program designed to help lift the U.S. economy out of
a deep recession.
Discretionary Fiscal Policy
Discretionary fiscal policy- involves changes in government spending and
taxes and is at the discretion or option of the Federal government. These
changes do not occur automatically.
1. Expansionary Fiscal Policy- consists of government spending
increases, tax reductions, or both, designed to increase (AD) and
therefore raise real GDP, employment and get the economy out of a
recession. (↑G, ↓T)
AD = C + Ig + G + Xn
A decrease in taxes will increase after tax income thereby increasing
(C) and the increase in government spending (G) will create new jobs
and people will spend that income which will ripple through the
economy.
Price level
AS
P2
P1
AD2
AD1
Q1
Qf
f
Real
GDP
EX. ↓taxes/↑government spending→ ↑C,G→ ↑AD→ ↑real GDP,
employment and ↑Pl.
If the Federal budget is balanced at the outset, expansionary fiscal policy
will create a government budget deficit where government spending is
greater than tax revenues. If (Q1) = $490 and (Qf) = $510, then how much
do we need to increase (G) spending to bring the economy back to full
employment assuming a (MPC) of .75?
Multiplier = ______
↑G by __________
How much of a tax cut would be necessary to achieve the same result?
Remember the tax multiplier is always 1 less than the spending multiplier
and negative.
Tax Multiplier = _____
↓T by _______
Key Point: The tax cut must be larger than the proposed increase in
government spending to achieve the same result.
Balanced Budget Multiplier- says we can stimulate the economy without
pushing the budget toward deficit by increasing government spending and
taxes by the same amount. The balanced budget multiplier is = 1.
EX. Let’s assume we ↑G and ↑T by $10. With a (MPC) = .80, how much will
real GDP increase?
Multiplier = _______
↑ GDP by ________
Crowding Out Effect- the main problem with using expansionary fiscal
policy is that when you cut taxes and/or increase government spending it
pushes the budget toward deficit. In essence the government is spending
money it doesn’t have so it borrows. Borrowing drives up interest rates and
crowds out some private investment (Ig) spending. With investment
demand (Id) weak during a recession, the crowding out effect is likely to be
small, but when the economy is operating near or at capacity, investment
demand (Id) is likely to be quite strong so that crowding out is a more
serious problem.
Price level
AS
P2
P3
P1
AD2
AD3
AD1
Q1
Q3 Q2
Real
GDP
2. Contractionary Fiscal Policy- When demand-pull inflation occurs, a
restrictive or contractionary fiscal policy may help control it. We
could cut government spending, raise taxes, or a combination of the
two. The combination of ↑T and ↓G will push the budget toward
surplus. (AD) will shift to the left lowering real GDP and employment
and decreasing the price level.
Price level
AS
P1
P2
AD1
AD2
Q2
Q1
Real GDP
Policy Options? (G or T)- Which is preferable as a means of eliminating
recession or inflation? The answer depends largely on one’s view as to
whether the government is too large or too small.
 If you believe that the size of government should be preserved or
expanded, you would choose spending increases during recession
and tax increases during inflationary periods. This is the Democratic
view.
 However, if you believe that government should be small and less
intrusive, you would favor tax cuts during recession and spending
cuts during times of inflation. This is the Republican view.
Non-discretionary Fiscal Policy
This is fiscal policy that does not require Congress to act. These programs
simply take effect when the economy moves toward recession or inflation.
This built-in stability results from 2 main sources.
 To some degree, government tax revenues change automatically
over the course of the business cycle and in ways that stabilize the
economy. The actual U.S. tax system is such that net tax revenues
vary directly with GDP. Net taxes are tax revenues minus transfers
and subsidies. Personal income taxes have progressive rates and
thus generate more than proportionate increases in tax revenues as
GDP expands. Furthermore, as GDP rises and more goods and
services are purchased, revenues from corporate income taxes and
from sales taxes and excise taxes also increase. And similarly,
revenues from payroll taxes rise as economic expansion creates more
jobs. Conversely, when GDP falls, tax receipts from all these sources
also fall.
 Transfer payments behave in the opposite way from tax revenues.
Unemployment compensation payments and welfare payments
decrease during economic expansion and increase during economic
contraction.
Automatic or Built-in Stabilizers- are anything that increases the
government’s budget deficit or reduces its budget surplus during a
recession and increases its budget surplus or reduces its budget deficit
during an expansion without requiring explicit action by Congress.
Gov’t
spending &
Tax revenues
T
Surplus
G
Deficit
GDP1
GDP2
GDP3
Real GDP
As you can see tax revenues automatically increase as GDP rises during
prosperity, and since taxes reduce household and business spending, they
restrain the economic expansion. The graph above reveals that the size of
the automatic budget deficits or surpluses, and therefore the amount of
stability, depends on the responsiveness of tax revenues to changes in GDP.
If tax revenues change sharply as GDP changes, the slope of the T line will
be steep and the vertical distances between the T and G lines will be large.
If tax revenues change very little when GDP changes, the slope will be
gentle and built-in stability will be low. The steepness of the T line will
depend on the tax system itself.
In a progressive tax system, the average tax rate rises with GDP. This
simply means that as income rises so does the percentage you pay in taxes.
Our federal income tax is an example.
In a proportional tax system, the average tax rate remains constant as GDP
rises. This is sometimes called a flat tax or fair tax. The medicare tax is
proportional.
In a regressive tax system, the average tax rate falls as GDP rises. This tax
tends to hurt poor families more than wealthier families. An example is the
state sales tax.
Average tax rate = total tax paid ÷ total income
Key Point: Built-in stabilizers can only dampen, not counteract, swings in
real GDP. Discretionary fiscal policy therefore is needed to counter a
recession or inflation of any magnitude.
Budget deficits & Projections
Problems, Criticisms, & Complications
1. Problems of Timing
• Recognition Lag- is the time between the beginning of recession or
inflation and the certain awareness that it is actually happening. The
economy is often 4 to 6 months into a recession or inflation before
the situation is clearly discernible in the relevant statistics.
• Administrative Lag- is the time the need for fiscal policy is recognized
and the time action is taken. Political gridlock and partisan politics
often slow the wheels of government.
• Operational Lag- is the time between when action is taken and the
time that action affects output, employment, or the price level.
Although changes in tax rates can be put into effect relatively quickly
once new laws are passed, government spending on public works
requires long planning periods and even longer periods of
construction. Consequently, discretionary fiscal policy has
increasingly relied on tax changes rather than on changes in spending
as its main tool.
2. Political Considerations- fiscal policy is conducted in the political arena.
In short, elected officials may cause so-called political business cycles
resulting from election motivated fiscal policy, rather than from inherent
instability in the private sector.
3. Future Policy Reversals- fiscal policy may fail to achieve its intended
objectives if households expect future reversals of policy. A tax
reduction thought to be temporary may not increase present
consumption spending and (AD) by as much as our simple model
suggests. Ex. Payroll tax holiday.
4. Offsetting State & Local Finance- The fiscal policies of state and local
governments are frequently pro-cyclical, meaning that they worsen
rather than correct recession or inflation. Unlike the Federal
government, most state and local governments face constitutional or
other legal requirements to balance their budgets.
5. Crowding-Out Effect- An expansionary fiscal policy may increase the
interest rate and reduce investment spending, thereby weakening or
canceling the stimulus of the expansionary policy.
U.S. Public Debt
The U.S. national debt or public debt, is essentially the accumulation of all
past Federal deficits and surpluses. The deficits have greatly exceeded the
surpluses and have emerged mainly from war financing, recessions, and
fiscal policy. Let’s put the size of the debt into perspective.
Who Owns the Debt?
 Ownership- The total public debt of $11.9 trillion represents the total
amount of money owed by the Federal government to the holders of
U.S. securities: financial instruments issued by the Federal
government to borrow money to finance expenditures that exceed
tax revenues.
These U.S. securities are of 4 types. Treasury bills, which are short
term securities, Treasury notes, which are medium term securities,
Treasury bonds, which are long term securities, and U.S. savings
bonds, which are long term, nonmarketable bonds.
The figure above shows that the public held 57% of the Federal debt
in 2009 and that federal government agencies and the Federal
Reserve held the remaining 43%. Public ownership consists of
individuals here and abroad, state and local governments, and U.S.
financial institutions.
Foreigners held about 29% of the total U.S. public debt in 2009. Of
the $3.7 trillion of debt held by foreigners, China held 24%, Japan
held 21%, and oil-exporting nations held 6%.
 Debt and GDP- A wealthy, highly productive nation can incur and
carry a large public debt much more easily than a poor nation can. A
more meaningful measure of the public debt relates it to an
economy’s GDP. See figure 30.7 for an illustration.
 Interest Charges- Many economists conclude that the primary
burden of the debt is the annual interest charge accruing on the
bonds sold to finance the debt. In 2009 interest on the total public
debt was $187 billion.
False Concerns About the Debt
 Bankruptcy- The large U.S. public debt does not threaten to bankrupt
the Federal government. There are 2 main reasons for this. First, as
long as the U.S. public debt is viewed by lenders as manageable and
sustainable, the public debt is easily refinanced. Of course,
refinancing could become an issue with a high enough debt-to-GDP
ratio. Some nations such as Greece have run into this problem.
Secondly, the federal government has the constitutional authority to
levy and collect taxes. A tax increase is a government option for
gaining sufficient revenue to pay interest and principal on the public
debt.
 Burdening Future Generations- In 2009 public debt per capita was
$37,437. The United States owes a substantial portion of the public
debt to itself. Although that part of the public debt is a liability to
Americans, as taxpayers, it is simultaneously an asset to Americans as
holders of government securities. To eliminate the American-owned
part of the public debt would require a gigantic transfer payment
from some Americans to other Americans.
Real Issues Concerning the Debt
o Income Distribution- The distribution of ownership of government
securities is highly uneven. In general, the ownership of the public
debt is concentrated among wealthier groups, who own a large
percentage of all stocks and bonds. Income is transferred from
people who, on average, have lower incomes to the higher income
bondholders. If greater income equality is one of society’s goals, then
this redistribution is undesirable.
o Incentives- As stated earlier the current public debt requires annual
interest payments of $187 billion per year. With no increase in the
size of the debt, that interest charge must be paid out of tax
revenues. Higher taxes may dampen incentives to bear risk, to
innovate, to invest, and to work. In this way, a large public debt may
impair economic growth and therefore impose a burden of reduced
output on future generations.
o Foreign-Owned Public Debt- The 29% of the U.S. debt held by citizens
and institutions of foreign countries is an economic burden to
Americans. The payment of interest and principal to foreigners
enables them to buy some of our output, which would otherwise go
to Americans.
o Crowding-Out Effect Revisited- A potentially more serious problem is
the financing, and refinancing, of the large public debt, which can
transfer a real economic burden to future generations by passing on
to them a smaller stock of capital goods. If the amount of current
investment crowded out is extensive, future generations will inherit
an economy with a smaller production capacity and, other things
equal, a lower standard of living.
EX. If government borrowing increases the interest rate from 6% to
10%, investment spending will fall from $25 billion to $15 billion. As a
result, $10 billion of private investment has been crowded out. With
less new capital being produced, the economy’s economic growth
rate slows down.
Expected
rate of
return &
real
interest
rate
10%
6%
Id
15
25
Investment
Social Security & Medicare
The American population, on average, is getting decidedly older. In the
future, more people will be receiving Social Security benefits and Medicare
for longer periods. Each person’s benefits will be paid for by fewer workers.
The number of workers per Social Security and Medicare beneficiary was
roughly 5:1 in 1960. Today it is 3:1, and by 2040 it will be only 2:1
The combined cost of the Social Security and Medicare programs was 7.6%
of GDP in 2008, and that percentage is projected to grow to 12% of GDP in
2030 and 17.2% of GDP in 2083.
Social Security is the major public retirement program in the U.S. The
program costs $615 billion annually and is financed by a 12.4% tax on
earnings up to $106,800 in 2009. Half the tax, 6.2%, is paid by the worker
and the other half by the employer. Social Security is largely an annual
“pay-as-you-go” plan, meaning that most of the current revenues from the
Social Security tax are paid to current Social Security retirees.
The Medicare program is the U.S. health care program for people age 65
and older in the U.S. It is also a pay-as-you-go plan, meaning that current
medical benefits are being funded by current tax revenues from the 2.9%
Medicare tax on earnings. 1.45% of the tax is paid by the worker and the
other 1.45% is paid by the employer. The financial status of Medicare is
much worse than that of Social Security.
To restore long-run balance to Social Security and Medicare, the Federal
government must either reduce benefits or increase revenues. The (SSA)
says that bringing revenues and payments back into balance would require
a 16% cut in benefits, a 13% increase in taxes, or some combination of the
two.
Possible Solutions
Here are several options that have been proposed.

•
•
•
Increasing the retirement age.
Increasing the payroll tax, especially on higher income groups.
Disqualifying wealthy people from receiving benefits.
Place tax revenues into an account that you control, rather than the
government.