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Fiscal Policy, Deficits, and Debt
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Fiscal Policy
Learning objectives – After reading this chapter, students
should be able to:
1. Identify and explain the purposes, tools, and limitations of
fiscal policy.
2. Explain the role of built-in stabilizers in moderating business
cycles.
3. Describe how the cyclically-adjusted budget reveals the
status of fiscal policy.
4. Discuss the size, composition, and consequences of public
debt.
LO1
Fiscal Policy
• One major function of the government is to stabilize the
economy (prevent unemployment or inflation).
• Stabilization can be achieved in part by manipulating the
public budget—government spending and tax collections—to
increase output and employment or to reduce inflation.
LO1
Fiscal Policy
• Fiscal Policy and the AD/AS Model
• Discretionary fiscal policy refers to the deliberate
manipulation of taxes and government spending to alter real
domestic output and employment, control inflation, and
stimulate economic growth. “Discretionary” means the
changes are at the option of the national government.
• Discretionary fiscal policy changes in the United States are
often initiated by the President, on the advice of the Council
of Economic Advisers (CEA).
• Changes not directly resulting from congressional action are
referred to as nondiscretionary (or “passive”) fiscal policy.
• Fiscal policy choices: Expansionary fiscal policy is used to
combat a recession (see examples illustrated in Figure 33.1).
LO1
Fiscal Policy
• Expansionary Policy needed: In Figure 33.1, a decline in
investment has decreased AD from AD1 to AD2 so real GDP
has fallen and also employment declined. Possible fiscal
policy solutions follow:
– a. An increase in government spending (shifts AD to right by
more than change in G due to multiplier),
– b. A decrease in taxes (raises income, and consumption rises
by MPC x the change in income; AD shifts to right by a multiple
of the change in consumption).
– C. A combination of increased spending and reduced taxes.
• If the budget was initially balanced, expansionary fiscal policy
creates a budget deficit.
LO1
Expansionary Fiscal Policy
$5 billion
increase in
spending
Recessions
Decrease AD
Price level
AS
Full $20 billion
increase in
aggregate demand
P1
AD1
AD2
$490
$510
Real GDP (billions)
LO1
Fiscal Policy
• Contractionary fiscal policy needed: When demand-pull
inflation occurs as illustrated by a shift from AD3 to AD4 up
the short-run aggregate supply curve in Figure 33.2. Then
contractionary policy is the remedy:
• Policy options: G or T?
• Economists tend to favor higher G during recessions and
higher taxes during inflationary times if they are concerned
about unmet social needs or infrastructure.
• Others tend to favor lower T for recessions and lower G
during inflationary periods when they think government is too
large and inefficient.
LO1
Contractionary Fiscal Policy
$3 billion initial
decrease in
spending
Price level
AS
P2
P1
d
c
Full $12 billion
decrease in
aggregate demand
b
a
AD4
AD
AD3 5
$502 $510
$522
Real GDP (billions)
LO1
Fiscal Policy
• Built-In Stability
• Built-in stability arises because net taxes (taxes minus
transfers and subsidies) change with GDP (recall that taxes
reduce incomes and therefore, spending). It is desirable for
spending to rise when the economy is slumping and vice
versa when the economy is becoming inflationary. Figure
33.3 illustrates how the built-in stability system behaves.
• Taxes automatically rise with GDP because incomes rise and
tax revenues fall when GDP falls.
• Transfers and subsidies rise when GDP falls; when these
government payments (welfare, unemployment, etc.) rise, net
tax revenues fall along with GDP.
LO1
Built-In Stability
Government expenditures, G,
and tax revenues, T
T
Surplus
G
Deficit
GDP1 GDP2
GDP3
Real domestic output, GDP
LO2
Fiscal Policy
• The size of automatic stability depends on responsiveness of
changes in taxes to changes in GDP: The more progressive
the tax system, the greater the economy’s built-in stability. In
Figure 33.3 line T is steepest with a progressive tax system.
• The U.S. tax system reduces business fluctuations by as
much as 8 to 10 percent of the change in GDP that would
otherwise occur.
• Automatic stability reduces instability, but does not eliminate
economic instability.
• IV. Evaluating Fiscal Policy
• A cyclically-adjusted budget in Year 1 is illustrated in Figure
33.4(a) because budget revenues equal expenditures when
full employment exists at GDP1.
LO1
Government expenditures, G, and
tax revenues, T (billions)
Cyclically Adjusted Budgets
T
a
b
G
$500
450
c
GDP2
(year 2)
GDP1
(year 1)
Real domestic output, GDP
LO3
30-12
Fiscal Policy
• At GDP2 there is unemployment and assume no discretionary
government action, so lines G and T remain as shown.
• Because of built-in stability, the actual budget deficit will rise
with the decline of GDP; therefore, actual budget varies with
GDP.
• The government is not engaging in expansionary policy since
the budget is balanced at full- employment output.
• The cyclically-adjusted budget measures what the Federal
budget deficit or surplus would be with existing taxes and
government spending if the economy is at full employment.
• Actual budget deficit or surplus may differ greatly from the
cyclically-adjusted budget deficit or surplus estimates.
LO1
Fiscal Policy
• In Figure 33.4b, the government reduced tax rates from T1 to
T2, now there is a cyclically-adjusted deficit.
• Structural deficits occur when there is a deficit in the
cyclically-adjusted budget as well as the actual budget.
• This is expansionary policy because true expansionary policy
occurs when the cyclically-adjusted budget has a deficit.
• If the cyclically-adjusted deficit of zero was followed by a
cyclically-adjusted budget surplus, fiscal policy is
contractionary.
LO1
Government expenditures, G, and
tax revenues, T (billions)
Cyclically Adjusted Budgets
T1
T2
d
e
G
$500
475
450
425
h
f
g
GDP4
GDP3
(year 4)
(year 3)
Real domestic output, GDP
LO3
30-15
Recent U.S. Fiscal Policy
Federal Deficits (-) and Surpluses (+) as Percentages of GDP, 2000-2009
(1)
Year
(2)
Actual
Deficit – or
Surplus +
(3)
Cyclically
Adjusted
Deficit – or
Surplus +*
2000
+2.4
+1.1
2001
+1.3
+0.5
2002
-1.5
-1.3
2003
-3.4
-2.7
2004
-3.5
-3.2
2005
-2.6
-2.5
2006
-1.9
-2.0
2007
-1.2
-1.2
2008
-3.2
-2.8
2009
-9.9
-7.3
•As a percentage of potential GDP
Source: Congressional Budget Office, http://www.cbo.gov.
LO3
30-16
Fiscal Policy
• Recent U.S. fiscal policy is summarized in Table 33.1.
• Observe that standardized deficits are less than actual
deficits.
• Column 3 indicates contractionary fiscal policy in 2000 and
2001before becoming expansionary.
• Fiscal policy from 2000 – 2007
• In 2001, Bush decreased taxes to help pull the economy out
of a recession.
• March 2002, Congress decreased taxes more and extended
unemployment benefits causing the cyclically-adjusted
budget to change from 1.1% to -1.3%.
• The economy remained slow and government decreased
taxes more in 2003 and the economy grew from 2003 –
2007.
LO1
Fiscal Policy
• Fiscal policy during the Great Recession
• In 2007, the crisis in the mortgage loans developed,
threatening stability in other financial markets, pessimism
grew, spending decreased, and the economy entered the
steepest, longest recession since the Great Depression.
• In 2008 Congress passed $152 billion in stimulus through tax
breaks increasing the cyclically-adjusted deficit from -1.2% of
potential output in 2007 to -2.8% in 2008 showing
expansionary policy.
• There were no real changes in spending from the tax breaks.
• In 2009 Obama passed the American Recovery and
Reinvestment Act - $787 billion stimulus with tax rebates and
large expenditures on infrastructure, education, and health
care.
LO1
Fiscal Policy
• The cyclically-adjusted budget increased from -2.8% of
potential GDP in 2008 to -7.3% in 2009.
• Figure 33.5 shows deficits are predicted through 2014.
• F. Global Perspectives 33.1 gives a fiscal policy snapshot
for selected countries.
• V. Problems, Criticisms and Complications
• Problems of timing
– Recognition lag is the elapsed time between the beginning of
recession or inflation and awareness of this occurrence.
– Administrative lag is the difficulty in changing policy once the problem
has been recognized.
– Operational lag is the time elapsed between change in policy and its
impact on the economy.
LO1
Fiscal Policy
• Political considerations: Government has other goals
besides economic stability, and these may conflict with
stabilization policy.
• A political business cycle may destabilize the economy:
Election years have been characterized by more
expansionary policies regardless of economic conditions.
• Future policy reversals can prevent fiscal policy from being
effective if people believe that the fiscal policy changes are
temporary.
• State and local finance policies may offset federal
stabilization policies. They are often procyclical, because
balanced-budget requirements cause states and local
governments to raise taxes in a recession or cut spending
making the recession possibly worse
LO1
Fiscal Policy
• In an inflationary period, they may increase spending or cut
taxes as their budgets head for surplus.
• The crowding-out effect may be caused by fiscal policy.
• “Crowding-out” may occur with government deficit spending.
It may increase the interest rate and reduce private spending
which weakens or cancels the stimulus of fiscal policy.
• Some economists argue that little crowding out will occur
during a recession.
• Economists agree that government deficits should not occur
at F.E., it is also argued that monetary authorities could
counteract the crowding-out by increasing the money supply
to accommodate the expansionary fiscal policy.
LO1
Crowding-Out Effect
Real interest rate (percent)
16
14
12
b
10
8
a
6
Crowding-out
effect
4
ID2
2
ID1
0
LO4
c
Increase in
investment
demand
5
10 15 20 25 30 35
Investment (billions of dollars)
40
Fiscal Policy
• Current thinking on fiscal policy
• Some economists oppose the use of fiscal policy, believing
that monetary policy is more effective or that the economy is
sufficiently self-correcting.
• Most economists support the use of fiscal policy to help “push
the economy” in a desired direction, and using monetary
policy more for “fine tuning.”
• Economists agree that the potential impacts (positive and
negative) of fiscal policy on long-term productivity growth
should be evaluated and considered in the decision-making
process, along with the short-run cyclical effects.
LO1
Fiscal Policy
• Public Debt
• A country’s national or public debt is the total accumulation of
the government’s total deficits and surpluses that have
occurred through time.
• Deficits (and by extension the debt) are the result of war
financing, recessions, and lack of political will to reduce or
avoid them.
• The U.S. public debt was $11.9 trillion in 2009.
• Ownership of the U.S. public debt (Figure 33.6)
• 1. 57 percent held by the public and 43 percent by Federal
government agencies, including the Federal Reserve.
LO1
Fiscal Policy
• Foreigners held about 29 percent of the public debt in 2009.
China held 24% while Japan held 21%.
• The Federal debt held by the public was 46.7 percent of GDP
in 2009, the highest it has been since 1970. (Figure 33.7)
• U.S. debt as a percentage of GDP increased significantly in
2008 and 2009 due to huge deficits and a decrease in GDP.
Public debt as a percentage of GDP in 2009 for a number of
countries can be seen in Global Perspective 33.2. Although
the U.S. has the highest public debt in absolute terms, a
number of countries owe more relative to their ability to
support it (through income, or GDP).
LO1
The U.S. Public Debt
Debt held
outside
the Federal
government
and the
Federal
Reserve:
57%
LO4
Debt held by
the Federal
government
and the
Federal
Reserve:
43%
Global Perspective
Public Sector Debt as
Percentage of GDP, 2009
0
20
40
Italy
Japan
Greece
Belgium
Hungary
United States
France
Germany
United Kingdom
Spain
Netherlands
Canada
Source: Organization for Economic Cooperation and Development, OECD
LO4
60
80
100
Fiscal Policy
• Interest charges are the main burden imposed by the debt.
• Interest on the debt was $187 billion in 2009, and is the
fourth largest item in the Federal budget.
• Interest payments were 1.3 percent of GDP in 2009. The
percentage is important because it represents the average
tax rate necessary just to cover annual interest on the debt.
Low interest rates have brought the percentage down since
2000.
• VII. False Concerns?
• False concerns about the public debt include several popular
misconceptions:
• Can a nation go bankrupt? There are reasons why it cannot
for most industrialized nations.
LO1
Fiscal Policy
• A nation can borrow more (i.e. sell new bonds) to refinance
bonds when they mature. Corporations use similar
methods—they almost always have outstanding debt.
• National governments have the power to tax, which
businesses and individuals do not have when they are in
debt.
• Does the debt impose a burden on future generations? In
2009 the per capita federal debt in the United States was
$37,437. But the public debt is a public credit—your
grandmother may own the bonds on which taxpayers are
paying interest. Some day you may inherit those bonds that
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.
LO1
Fiscal Policy
• 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.
• Substantive Issues
• 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.
• 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.
LO1
Fiscal Policy
• A higher proportion of the U.S. debt is owed to foreigners
(about 29 percent) than in the past, and this can increase the
burden since payments leave the country. But Americans
also own foreign bonds and this offsets the concern.
• Some economists believe that public borrowing crowds out
private investment, but the extent of this effect is not clear
(see Figure 33.8).
• There are some positive aspects of borrowing even with
crowding out.
• 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.
LO1
Fiscal Policy
• Public investment makes private investment more attractive.
For example, new federal buildings generate private
business; good highways help private shipping, etc.
LO1
Fiscal Policy
• LAST WORD: The Social Security and Medicare
Shortfalls
• The percentage of people aged 65 and older is expected to
rise substantially over the next few decades.
• More people will be receiving Social Security and Medicare
benefits and for longer time periods with fewer people
contributing to both programs.
– In 1960 for every individual receiving Social
Security/Medicare there were 5 workers contributing.
– Today, there are only 3 workers contributing for every
individual receiving benefits.
• Medicare and Social Security cost 7.6% of GDP in 2008 and
it is expected to rise to 12% of GDP in 2030.
LO1
Fiscal Policy
• Social Security is a pay-as-you go system with workers
paying 6.2% tax on their income up to $106,800 and the
employer paying another 6.2%.
• Extra social security tax revenue has been collected in
anticipation of the large pay-outs to baby boomers.
– The extra revenue was used to purchase U.S. Treasury
securities and put into a fund.
– In 2009 government had to start using the money in the
fund to make up for the lack of revenue to pay for the
promised benefits.
– By 2037 the trust fund is expected to be depleted at which
time the revenues will only cover 75% of the promised
benefits.
LO1
Fiscal Policy
• Medicare is also a pay-as-you go program with workers
paying 1.45% and employers paying the other 1.45% on all
earnings.
– Medicare is in worse shape than Social Security.
– Benefits covered by Medicare will fall from 81% in 2017 to
50% in 2035 and 29% in 2080.
• The Unpleasant Options
– To balance Social Security over the next 75 years
government must either make a permanent 16% reduction
in benefits and/or 13% permanent increase in tax
revenues.
LO1
Fiscal Policy
– To bring Medicare into balance, government must
increase Medicare payroll tax to 122%, and/or a 51%
reduction in Medicare payments from their projected
amounts.
– All of the options involve difficult economic costs and
dangerous political risks.
LO1