Download 11. Fiscal Policy and the Government Budget

10. Fiscal Policy and the
Government Budget
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The Government Budget
• The government’s budget is affected by:
– Government spending (outlay)
– Tax revenue (income)
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Government Spending
• Major components of government spending:
1. Government purchases (G), which consist of i)
government consumption—spending on other goods and
services (GC), and ii) government investment—spending
on capital goods like highways and school (GI), so that
G=GC+GI
2. Transfer payments (TRANSFERS): direct payments to
individuals, e.g., unemployment insurance benefits, social
security benefits and Medicare, which are known as
entitlements as they are set by earlier legislation
3. Grants in aid: federal assistance to state and local
governments
4. Net interest payments (INTEREST): interest payments
to holders of government debt like U.S. Treasury bonds,
less interest paid to the government for debts such as
student loans
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Revenue
• Major components of tax revenue (TAXES):
1. Personal taxes: income and property taxes
2. Contributions for social insurance, like
Social Security taxes
3. Taxes on production and imports, like sales
tax and taxes on imports (tariffs)
4. Corporate taxes: taxes on the profits on
businesses
5. Grants in aid: the federal assistance to state and
local governments and revenue from them
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Budget Deficits and Surpluses
• The formula for the government spending is:
Deficit = spending - tax revenues
= (G + TRANSFERS + INTEREST) - TAXES
• When spending exceeds the revenue, the
government runs a budget deficit
- Federal budget deficits are the norm in the
United States, except for the late 1990s
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Government Budget Constraint
• In addition to raise taxes, governments can
finance a deficit by borrowing (issuing bonds)
and printing money.
• The government budget constraint for
financing its deficit is:
Deficit = [change in amount of debt (bonds)
in the hands of the public] + [change in
amount of money (currency and the reserves
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in banks)] = ΔB + ΔM
Government Budget Constraint
• The Arithmetic of Deficits and Debt
–
The budget deficit in year t equals:
deficit t  rBt 1  Gt  Tt
 Bt-1 is government debt at the end of year, t – 1 or,
equivalently, at the beginning of year t ; r is the real
interest rate, which we shall assume to be constant here.
Thus rBt-1 equals the real interest payments on the
government debt in year t.
 Gt is government spending during year t.
 Tt is taxes minus transfers during year t.
In words: The budge deficit equals spending, including interest
payments on the debt, minus taxes net of transfers.
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Government Budget Constraint
• The Arithmetic of Deficits and Debt
- Note two characteristics of
deficit t  rBt 1  Gt  Tt
 We measure interest payments as real interest payments
rather than as actual interest payments. The correct
measure of the deficit is sometimes called the inflationadjusted deficit.
 G does not include transfer payments.
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Government Budget Constraint
• The Arithmetic of Deficits and Debt
- The government budget constraint states that the change in
government debt during year t is equal to the deficit during year t:
B  B  Deficit
t 1
t
t
- Using the definition of the deficit
deficit t  rBt 1  Gt  Tt
- we can rewrite the government budget constraint as
B  B  rB  G  T
t
t 1
t 1
t
t
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Government Budget Constraint
• The Arithmetic of Deficits and Debt
- It is often convenient to decompose the deficit into the sum of two
terms:
 Interest payments on the debt, rBt-1
 The difference between spending and taxes, Gt – Tt. This term
is called the primary deficit (equivalently, Tt – Gt is called the
primary surplus).
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Government Budget Constraint
• The Arithmetic of Deficits and Debt
Using this decomposition, we can rewrite
B  B  rB  G  T
t 1
t
Change in the debt
Bt  Bt 1
t 1
t
t
Primary deficit
Interest payments


rBt 1
Gt  Tt
Primary Deficit
B  (1  r ) B  G  T
t
t 1
t
t
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Size of the Government Debt
• In most countries, the government runs a
deficit, so that the amount of worldwide
government debt has been growing over
time
• Growth of U.S. government debt over time:
– The United States finances its government
deficits primarily by selling bonds, so that is a
correlation between budget deficits and the stock
of government debt as a percentage of GDP
– The debt-to-GDP ratio reached 53% by 2009
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Fiscal Policy and the Economy in the
Long Run
• Two sides to the debates over the burden of long
run debt on future generations
- Why High Government Debt Is Not a Burden
1. Spending in government capital like highways
and schools, and human capital like education,
will increase the economy’s future productivity,
so that additional tax revenues will go toward
paying down the government debt
2. Because government debt is financed by
government bonds, bond holders will eventually
be repaid with future tax payments
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Fiscal Policy and the Economy in
the Long Run
• Why High Government Debt Is a Burden
1. Reduction in national saving
– Because national saving (NS) based the uses-of-saving
identify is:
NS = (Y - T - C) +
(T-G)
=
I + NX
Private saving
Gov’t saving
– Crowding out occurs when a reduction in national
saving as a result of budget deficits means lower
private investment (I) and worse off of future
generations
2. Value of government capital investment
3. Indebtedness to foreigners
4. Redistribution effects
5. Debt intolerance
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6. Negative incentive effects
Fiscal Policy and the Economy in
the Long Run
• Why High Government Debt Is a Burden
1. Reduction in national saving
2. Value of government capital investment
–
–
3.
4.
5.
6.
Most government spending is for government
consumption like on medical care and military
personnel, not capital stock
Government investment even in capital is viewed as
wasteful spending and unproductive
Indebtedness to foreigners
Redistribution effects
Debt intolerance
Negative incentive effects
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Fiscal Policy and the Economy in
the Long Run
• Why High Government Debt Is a Burden
1. Reduction in national saving
2. Value of government capital investment
3. Indebtedness to foreigners
–
–
National saving can lower net exports (in addition to
investment) and thus increase U.S. indebtedness to
foreigners
The largest holders of U.S. government debt are now
the Chinese
4. Redistribution effects
5. Debt intolerance
6. Negative incentive effects
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Fiscal Policy and the Economy in
the Long Run
• Why High Government Debt Is a Burden
1.
2.
3.
4.
Reduction in national saving
Value of government capital investment
Indebtedness to foreigners
Redistribution effects
–
Because the people paying taxes may not be the same
people who hold government bonds, so that rising
government debt involves a transfer of wealth in the
future to government bondholders, who tend to be
richer
5. Debt intolerance
6. Negative incentive effects
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Fiscal Policy and the Economy in
the Long Run
• Why High Government Debt Is a Burden
1.
2.
3.
4.
5.
Reduction in national saving
Value of government capital investment
Indebtedness to foreigners
Redistribution effects
Debt intolerance
–
–
The fear of debt repudiation—failure of paying it
back—may rise as government debt gets very large
Some countries may experience debt intolerance
with a high likelihood of default even at low debt-toGDP ratios
6. Negative incentive effects
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Fiscal Policy and the Economy in
the Long Run
• Why High Government Debt Is a Burden
1.
2.
3.
4.
5.
6.
Reduction in national saving
Value of government capital investment
Indebtedness to foreigners
Redistribution effects
Debt intolerance
Negative incentive effects
–
–
Raising taxes to pay down the debt involves
distortions, such as a lower incentive to work due to
higher income tax, and few capital stock investment
due to a higher capital gains tax
Tax wedges—the difference between what people
earn before and after taxes—reduce the efficiency and
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economic growth over time
Fiscal Policy and the Economy in the Short Run
• The fiscal policy has important effects on the
economy in the short run
- expansionary fiscal policy, either a cut in
taxes or an increase in government spending,
raises aggregate demand
- According to our aggregate demand supply
analysis, if aggregate output falls below its
potential YP, then expansionary fiscal policy
can cause a shift of the AD curve to the right
so that aggregate output rises back up to
potential while inflation also rises
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Expenditure and Tax Multipliers
• The expenditure multiplier is the change
in equilibrium output given a change in
government purchases :
Y / G  1 / (1  mpc)
• The tax multiplier is the change in Y / T
equilibrium output given a change in taxes,
Y / T = -mpc/(1-mpc)
- It is always less in absolute value than the
expenditure multiplier because the initial
change in spending occurs through
consumption expenditure
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Expenditure and Tax Multipliers
• Some economists argue that the
expenditure multiplier may be smaller shows
because:
1. Real interest rates may rise when government
purchases rise, resulting in crowding out on
investment, consumption spending, and net
exports
2. If households and businesses anticipate that
larger government deficits will lead to higher
taxes in the future, then they will reduce their
spending to pay for the anticipated tax increases
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Aggregate Supply and Fiscal Policy
• A temporary cut in the payroll tax (e.g., Social
Security tax) acts just like a temporary positive
supply shock
• The tax cut lowers the wage cost of production,
increasing aggregate supply, so the short-run
aggregate supply curve shifts downward and to the
right
• The tax cut also increases disposable income and
thus consumption expenditure, shifting the AD curve
rightward
• Suppose aggregate output is below its potential YP,
then a payroll tax cut would raise aggregate output
back to YP, while inflation may rise or fall
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Supply-Side Economics and Fiscal Policy
• Supply-siders emphasize the positive effects of tax
cuts on aggregate supply
• They believe permanent cuts in tax (income tax
cut)not only raises aggregate demand but also have
a permanent positive effect on aggregate supply
because they induce more investment and greater
work effort
• Rightward shifts in both AD and LRAS curves make
the cuts in tax highly expansionary
- supply-siders believe that the expansion in aggregate output
from the tax cut is so large that the tax revenue could go up
despite the tax cuts since the tax base (the income on which
taxes are levied) will rise: cutting taxes would not increase the
budget deficit
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Balancing the Budget:
Expansionary or Contractionary?
• Balancing the budget may have beneficial
future effects that will influence the behavior
of households and businesses today
- A sustained cut in the budget deficit, either from a
decrease in government spending or higher taxes,
implies that future taxes will be lower
- Because lower taxes will increase capital formation
and decrease distortions in the economy, measures
to balance the budget can act just like a permanent
positive supply shock resulting in the high level of
aggregate output from the increase in the long run
aggregate supply
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Budget Deficits and Inflation
• Expansionary fiscal policy that increases the
budget deficit leads to higher inflation in the
short run
• In the long run, inflation will not rise even
under the expansionary fiscal policy as long
as monetary policy focuses on price stability
and takes steps to keep inflation under
control
• However, large budget deficits make it
difficult for central banks to control inflation
in the long run
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Government-Issued Money
• Recall that a government budget deficit is
financed by either selling government bonds (ΔB)
or printing money (ΔM)
- Monetizing the debt occurs when a central
bank issues money to finance the government
debt
• Inflation rate () in the long run will move
closely with the growth rate of the money
supply:   ΔM/M
which means that large budget deficits financed by
printing money lead to high inflation
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Revenue from Seignorage
• Multiplying both sides of the both equation by M:
M    M
• Seignorage is the revenue of issuing currency,
which (in real terms) can be realized by dividing
both sides by the price level, P:
M / P    (M / P)
which is the inflation rate  multiplied by the
amount of money balances, M/P
- Seignorage is an inflation tax because the
resulting higher inflation lowers the real value of
money balances for their holders
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Budget Deficits and Ricardian
Equivalence
• Traditionally fiscal policy and budget deficits affect
the economy in both short and the long run
• But, some type of fiscal policy and budget deficits
resulting from tax cuts may not have much impact
on the economy: Ricardian equivalence
- Ricardian equivalence implies that tax cuts have
no effect on spending and national saving
- It assumes that consumers are very forward
looking, so that they will recognize that a budget
deficit today in the form of a tax cut will have to be
paid for by higher future taxes (or lower future
disposable income). As a result, consumers will not
change their spending in face of a tax cut
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Implications of Ricardian Equivalence
1. Tax cuts will not increase aggregate demand
because they will have little impact on
household spending
2. Budget deficits as a result of tax cuts do not
affect national saving, and so they will not be a
burden on future generations
3. Budget deficits as a result of tax cuts do not
raise inflation because consumer spending
remains unchanged, and households will use
their increased saving to buy government
bonds so that the government does not have to
print money to finance its budget deficit
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Bottom Line on Ricardian Equivalence
• The debate on the traditional view and the Ricardian
equivalence of the tax cuts depends on how
consumers behave.
- If consumers are forward looking, not subject to
borrowing constraints, and care a lot about their
children and their children’s children, then Ricardian
equivalence will hold and tax cuts will not burden
future generations
- On the other hand, if households are narrowminded or borrowing-constrained or don’t care
about future generations, then tax cuts will raise
consumer spending, lower national saving, and put
a burden on future generations
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Fiscal Policy
• Fiscal Policy is the purposeful movement in
government spending or tax policy designed
to direct an economy
• Discretionary Fiscal Policy: government
spending and tax changes enacted at the time
of the problem to alter the economy
• Nondiscretionary Fiscal Policy: that set of
policies that are built into the system to
stabilize the economy
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How Nondiscretionary Fiscal Policy Works
• Nondiscretionary fiscal policy consists of policies
that are built into the system so that an
expansionary or contractionary stimulus can be
given automatically.
• The welfare state and the progressive income tax
serve as the built-in policies.
– If the economy is in recession, those who lose
their jobs are granted unemployment and
welfare benefits and they owe less in taxes.
– If the economy is growing at an unsustainable
rate, people are making a lot of money and are
faced with higher tax rates and there are fewer
people eligible for government benefits.
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How Discretionary Fiscal Policy Works
• If we are in a recession the fiscal policy to
stimulate the economy would consist of
– Increases in government spending
– Decreases in taxes
• If we are in an inflationary period the
fiscal policy to contract the economy
would consist of
– Decreases in government spending
– Increases in taxes
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Evaluating Nondiscretionary Fiscal
Policy
• Most economists believe that the built-in
stabilizers have had a modestly positive
effect on diminishing the severity of
modern recessions.
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The Mistiming of
Discretionary Fiscal Policy
• Recognition Lag: the time it takes to
measure the state of the economy
• Administrative Lag: the time it takes for
Congress to agree on a course of action
with the president
• Operational Lag: the time it takes for the
full impact of a government program or
tax change to have its effect on the
economy
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Political Problems
with Fiscal Policy
• Expansionary bias is the problem where
politicians are more willing to deal with
recessions with tax cuts and spending
increases than they are to deal with
inflationary pressures with tax increases
and spending cuts.
• The Political Business Cycle suggests that
politically motivated fiscal policy is used
for short term gain just prior to elections
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