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CHAPTER 12
FEDERAL BUDGETS AND PUBLIC POLICY
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
The first part of this chapter explains the federal budget process and the problems associated with
budgeting. The remainder focuses on the sources and effects of the relatively large peacetime deficits that
occurred between 1980 and the late 1990s. This chapter is a blend of theory and policy, presenting a
contemporary analysis of fiscal issues. Topics introduced include the relationship between federal and
foreign trade deficits and a discussion of the burden of federal deficits and alternative solutions to the
deficit problem.
LEARNING OUTCOMES
12-1 Summarize how federal spending priorities have changed since the 1960s.
The federal budget is a plan of outlays and revenues for a specified period, usually a year. As you can
see from the figure below, national defense accounted for about half of all federal outlays in 1960.
That share declined to only 18 percent in 2013. The share going to Social Security and Medicare,
programs that aid the elderly, more than doubles between 1960 and 2013. In general, since 1960
national defense spending has declined and redistribution has increased.
12-2 Explain why the federal budget has been in deficit in most years since the Great Depression.
The federal budget has been in deficit for all but 14 years since 1929, when the Great Depression
began. The most obvious reason why federal deficits have persisted it that, unlike budgeters in 49
states, federal officials are not required to balance the budget. Elected officials maximize their
chances of getting elected and reelected by supporting spending programs but failing to raise the
needed taxes. That’s because voters like spending programs but hate taxes. Individual members of
Congress push their favorite spending programs with little regard for the overall budget. All this results in deficits in most years.
12-3 Outline what has happened to the federal debt in recent decades and how it compares with debt
levels in other countries.
The federal or national debt is a stock variable measuring the net accumulation of past deficits, the
amount owed by the federal government. Most recently the U.S. federal debt measured relative to
GDP was somewhat above the average for major industrial countries and was relatively high compared to U.S. historical levels stretching back to 1940. The recession of 2009–2010 and policy responses to it have rocketed the federal deficit above $1 trillion and sharply increased the national
debt.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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12-4 Describe how a giant federal debt could have a negative impact on the economy.
The Great Recession and policy responses to it have rocketed the federal deficit above $1 trillion and
sharply increased the national debt to a level that is not sustainable. Federal deficits of one generation can affect the standard of living of the next generation, as a larger share of the budget goes toward servicing the debt. One sign of possible problems in the United States was the downgrading of
the nation’s credit rating in 2011. For the first time in 70 years U.S. federal debt was rated as more
risky. Research suggests that a high federal debt slows the economy, and the slowdown can last for
years. To head off a fiscal crisis, policy makers must cut federal spending, raise taxes, or some combination of the two.
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDES 2-3 FOR THE FOLLOWING SECTION
The Federal Budget Process
 Federal budget: A plan for government outlays and revenues for a specified period, usually a year.
 Federal outlays: In 2013, 18% to national defense, 50% to Social Security, Medicare, and welfare, 6%
to pay interest on national debt; the remaining 26% covers everything else.
USE POWERPOINT SLIDES 4-6 FOR THE FOLLOWING SECTION
The Presidential Role in the Budget Process
 Begins a year before the budget is submitted to Congress.
 Early in the calendar year, the president submits The Budget of the United States Government to
Congress.
 Fiscal year runs from October 1 to September 30.
 The Economic Report of the President also submitted to Congress, reflects the President’s take on the
economy and includes fiscal policy recommendations.
The Congressional Role in the Budget Process
 House and Senate rework the President’s budget until total outlays and expected revenues are agreed
upon. This is a budget resolution, and it guides spending and revenue decisions.
 Budget Deficit: When outlays exceed revenues, the budget is in deficit. A deficit stimulates aggregate
demand in the short run but reduces national saving, which can impede economic growth in the long
run.
 Budget Surplus: When revenues exceed outlays, the budget is in surplus. A surplus dampens
aggregate demand in the short run but boosts domestic saving, which can promote economic growth in
the long run.
USE POWERPOINT SLIDE 7 FOR THE FOLLOWING SECTION
Problems with the Budget Process
 Continuing resolutions instead of budget decisions: agreements to allow agencies, in the absence of an
approved budget, to spend at the rate of the previous year’s budget
 Lengthy budget process
 Uncontrollable budget items: 75% of outlays are determined by existing laws
 No separate capital budget: capital expenditures and operating expenditures are combined into a single
budget.
 Overly detailed budget: reduces the effectiveness of discretionary fiscal policy and is subject to
political abuse.
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Chapter 13
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USE POWERPOINT SLIDE 8 FOR THE FOLLOWING SECTION
Possible Budget Reforms
 Convert annual budget to biennial budget.
 Simplify the budget, concentrating on major groupings and eliminating line items.
 Sort federal spending into a capital budget and an operating budget.
USE POWERPOINT SLIDES 9-11 FOR THE FOLLOWING SECTION
The Fiscal Impact of the Federal Budget
Rationale for Deficits:
 Justified for outlays that increase the economy’s productivity.
 Justified during recessions when economic activity slows and unemployment rises.
Budget Philosophies and Deficits
 Annually balanced budget: Increase spending during expansions and reduce spending during
recessions. Magnifies fluctuations in the business cycle.
 Cyclically balanced budget: Budget deficits during recessions are covered by budget surpluses
during expansions.
 Functional finance: Ensures that the economy produces its potential output.
USE POWERPOINT SLIDES 12-16 FOR THE FOLLOWING SECTION
Federal Deficits Since the Birth of the Nation:
 Between 1789 and 1930 (the first full year of the Great Depression), the federal budget was in deficit
33% of the years.
 Since the Great Depression, federal budgets have been in deficit 85% of the years.
 During the 1980s, large tax cuts and higher defense spending contributed to relatively large deficits.
 The 1990s saw the deficit disappear and turn into a surplus by 1998.
 During the recession of 2001, tax cuts and increased federal spending turned surpluses into deficits.
 Weak recovery and the cost of fighting the war against terrorism worsened the deficits by 2003 to
3.5% of GDP.
 A stronger economy, along with a rising stock market, increased federal revenue enough to drop the
deficit to about 1.2% of GDP in 2007.
 The global financial crisis and the recession of 2007-2009 caused the deficit to swell to $1.6 trillion by
2011, 10.9% of GDP.
Why Have Deficits Persisted? Since 1930, the federal budget has been in deficit for all but twelve years.
 Congress is not required to balance the budget.
 Voters like spending programs but dislike paying taxes.
USE POWERPOINT SLIDES 17-18 FOR THE FOLLOWING SECTION
Deficits, Surpluses, Crowding Out, and Crowding In: Impact of government deficits and surpluses on
interest rates.
 Crowding out: Deficit spending reduces the supply of national saving, thus raising interest rates
which discourage some private investment, thereby reducing the expansionary effects of the deficit.
 Crowding in: The ability of government deficits to stimulate private investment spending.
The Twin Deficits
 To finance the huge budget deficits, the U.S. Treasury must sell bonds. To get people to buy the
Treasury securities, the government must offer higher interest rates. So, funding a higher deficit
pushes up market interest rates.
 With U.S. interest rates higher, foreigners find Treasury securities more attractive.
 The greater foreign demand for dollars causes the dollar to appreciate.
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The rising dollar makes imports attractive and U.S. goods more expensive abroad. This leads to an
increase in the trade deficit.
USE POWERPOINT SLIDES 19-24 FOR THE FOLLOWING SECTION
The Short-lived Budget Surplus: In 1990 the deficit was 3.8% of GDP; by 1998 there was a surplus
which lasted through 2001.
 Tax Increases: 1990 President George H.W. Bush agreed to a package of spending cuts and tax
increases. This may have cost him reelection; it laid the foundation for erasing the budget deficit.
 In 1993 President Clinton increased taxes on high income households, increasing the top marginal tax
rate from 31% to 40%.
 The combined effects of higher taxes on the rich and a strengthening economy raised federal revenue
from 17.8% of GDP in 1990 to 20.6% of GDP in 2000.
 Slower Growth in Federal Outlays: Due to reduced U.S. military commitments abroad when the
Soviet Union collapsed and lower interest rates.
 A Reversal of Fortune in 2001: The tax rate increases and a strong economy led to a federal budget
surplus of $236 billion in 2000. But in 2001 unemployment rose, the stock market fell, and the
terrorist and anthrax attacks occurred. The federal budget returned to a deficit by 2002 and has been
in the red ever since.
USE POWERPOINT SLIDES 25-26 FOR THE FOLLOWING SECTION
The Relative Size of the Public Sector
The public sector includes state and local governments. Total government outlays in the U.S. in 2012 were
40% relative to GDP, higher than in 1994, but less than most major economies. The ten-country average
of major economies’ outlays relative to GDP remained at 45 percent.
USE POWERPOINT SLIDES 27-31 FOR THE FOLLOWING SECTION
The National Debt: Measures the net accumulation of past deficits; the amount owed by the federal
government.
Measuring the National Debt
 Gross debt: Includes U.S. Treasury securities purchased by various federal agencies.
 Debt held by the public: Includes U.S. Treasury securities held by households, firms, banks, and
foreign entities.
The National Debt since World War II: Federal debt was over 100% relative to GDP by 1946 and in
2001 the debt was cut to 33% relative to GDP. In 2004 the debt was 37% relative to GDP, where it
remained through 2007. Deficits from the 2008–2009 recession increased federal debt relative to GDP.
International Perspective on National Debt
 Net debt: Outstanding liabilities of federal, state, and local governments minus government financial
assets.
 Member countries have been forced to reduce their deficits as a condition for joining the European
Monetary Union.
USE POWERPOINT SLIDES 32-33 FOR THE FOLLOWING SECTION
Interest on the National Debt: Most government securities are short term. An increase in nominal
interest rates increases annual interest costs.
USE POWERPOINT SLIDES 34-36 FOR THE FOLLOWING SECTION
Are Persistent Deficits Sustainable?
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 At some point chronic deficits may accumulate into such a debt that lenders demand an extremely
high interest rate or refuse to lend at all. As interest rates rise, debt service costs could then overwhelm
the budget.
 The global financial panic encouraged investors around the world to buy U.S. securities as they sought
safety. This "flight to quality" drove down the interest rate the U.S. government had to pay, thus
reducing the cost of servicing our debt. But that could change.
 As long as the economy is growing at least as fast as the debt service payments, those deficits should
be manageable. But trillion dollar deficits are not sustainable.
USE POWERPOINT SLIDES 37-38 FOR THE FOLLOWING SECTION
Who Bears the Burden of the Debt? Deficit spending is a way of billing future taxpayers for current
spending. To what extent do deficits and debt shift the burden to future generations?
 We Owe It to Ourselves: Debt is not a burden to future generations; they both service the debt and
receive the payments.
 Foreign Ownership of Debt: Increases the burden of the debt on future generations of Americans
because future debt service payments no longer remain in the country.
USE POWERPOINT SLIDES 39-41 FOR THE FOLLOWING SECTION
Crowding Out and Capital Formation: The long-run effect of deficit spending depends on how the
government spends the borrowed funds.
 Investment: Public investment may enhance productivity in the long run.
 An increase in current consumption would cause the economy’s capital formation to be less than it
would otherwise have been. Declining investment in public infrastructure hurts labor productivity and
our future standard of living
CHAPTER SUMMARY
The federal budget process suffers from a variety of problems, including overlapping committee
jurisdictions, lengthy budget deliberations, budgeting by continuing resolutions, budgeting in too much
detail, failure to distinguish between operating costs and capital costs, and a lack of control over most of
the budget. Suggested improvements include instituting a biennial budget, budgeting in less detail, and
distinguishing between an operating budget and a capital budget.
Deficits increase during wars and severe recessions, but deficits remained high during the economic
expansions of the 1980s. Those deficits arose from a combination of tax cuts during the early 1980s and
growth in federal spending.
To the extent that deficits crowd out private capital formation, this decline in private investment reduces
the economy’s ability to grow. This is one cost of deficit spending. Foreign holdings of debt also impose a
burden on future generations because debt payments go to foreigners. Thus, the deficits of one generation
of Americans can reduce the standard of living of the next.
After peaking at $290 billion in 1992, the federal deficit turned into a surplus by 1998 because of higher
tax rates, reduced outlays especially for defense, declining interest rates, and a strengthening economy
fueled by growing labor productivity.
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Chapter 13
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The recession of 2001 and terrorist attacks prompted tax cuts to “get the economy moving again.” The
weak recovery plus the tax cuts and federal spending increases all contributed to a growing federal deficit,
which topped $400 billion in 2004. But by 2007 the economy added more than 8 million jobs which
helped cut the federal deficit by more than 50 percent. The deficit is projected to grow again because of
the deep recession of 2008–2009 and increased government spending on stimulus and bailout programs.
The longer term looks even bleaker as baby boomers begin retiring.
Most recently the U.S. federal debt measured relative to GDP was about average for major industrial
countries and was relatively low compared to U.S. historical levels stretching back to 1940. But the federal
debt is projected to grow and federal deficits worsen.
TEACHING POINTS
1. The potential consequences of the budget deficits should be of considerable interest to students.
You may want to have students compare the experience of the Japanese since 1993 (deficit spending
there has escalated). Stress the fact that the government is not bound by the kinds of budgetary
constraints that the private sector faces and hence will not go bankrupt. But growing deficits could
harm our future standard of living due to the increasing cost of debt service and the possibility
of long-term crowding out of private investment.
2. This chapter contains sections that deal with the practical aspects of budget making. Most people
are unfamiliar with this process, although it is of great importance. In fact, the process itself is
somewhat to blame for the extraordinary deficits now being experienced. You may wish to engage
the class in discussion about changes in the budgetary process, such as the line-item veto, designed to
improve some of the bottlenecks that have contributed to the problem.
3. A question that often arises in class is why deficits rose so much during the 1980s. There is no single answer to this question, but here are some key points to stress:
a. Taxes were cut in the early 1980s, the so-called Kemp-Roth cuts.
b. Spending shifted from domestic welfare programs to military programs.
c. Spending cuts were budgeted but never occurred.
d. Inflation was significantly (and unexpectedly) reduced, causing a reduction in tax revenues
owing to bracket creep.
e. Interest on the debt, an important component of the budget, grew because of both the increased
size of the debt and climbing interest rates.
f. The public (and some public officials) apparently cares little about such deficits because their
effects have not been uniformly felt around the country.
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SOLUTIONS TO PROBLEMS APPENDIX
1.
(Changing Budget Priorities) What spending category claimed the largest share of federal
outlays during the 1960s? How about during the most recent decade?
National defense accounted for about half of all federal outlays in 1960. That share declined
to only 18 percent in 2013. The share going to Social Security and Medicare, programs that
aid the elderly, more than doubles between 1960 and 2013. In general, since 1960 national
defense spending has declined and redistribution has increased.
2.
(The Federal Budget Process) The federal budget passed by Congress and signed by the
president shows the relationship between budgeted expenditures and projected revenues. Why
does the budget require a forecast of the economy? Under what circumstances would actual
government spending and tax revenue fail to match the budget as approved?
Certain expenditure items are not under congressional control, they are set by existing laws.
Entitlement programs provide benefits for anyone meeting the eligibility guidelines. Budgeted
expenditures must therefore estimate the number of households who will receive benefits, which
depends in part on the state of the economy. During a recession, for example, unemployment
benefits rise. Also, many entitlement programs are indexed to inflation, so expenditures
automatically rise. Inflation forecasts are therefore necessary to estimate expenditures. Interest
on the national debt also depends on the state of the economy—whether interest rates rise or
fall—since the government is constantly issuing new securities as old securities mature and
cannot change the interest in the near term. During recessions, tax revenues drop, but they rise
during expansions—so the government must again have a forecast of the state of the economy
in order to estimate revenues.
If the state of the economy differs from the forecasted state underlying the budget resolution,
the actual budget will not match the budget resolution. For example, if growth is slower,
spending will increase on entitlement programs and tax revenues will fall short of projections.
The deficit then will be higher than estimated.
3.
(Budget Philosophies) Explain the differences among an annually balanced budget, a cyclically
balanced budget, and functional finance. How does each affect economic fluctuations?
An annually balanced budget has government revenues matching government spending in each
year. This requires the government to decrease spending during recessions when tax revenues
drop and increase spending in expansions when tax revenues rise. This would increase the
changes in aggregate demand and thus worsen economic fluctuations.
A cyclically balanced budget calls for deficits during recessions and surpluses during
expansions so that they offset each other and the debt remains stable. Running deficits during
recessions and surpluses during expansions dampens the swings in aggregate demand and thus
reduces economic fluctuations.
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Functional finance says that the government should not be concerned with balancing the
budget. The budget is seen as a tool to keep the economy at its potential output. Chronic
deficits are seen as acceptable if needed to maintain production and employment. Thus,
advocates of functional finance seek to sharply reduce economic fluctuations.
4.
(Chronic Deficits) Why has the federal budget been in deficit in all but 14 years since 1929?
The federal budget has been in deficit for all but 14 years since 1929, when the Great Depression began. The most obvious reason why federal deficits have persisted it that, unlike
budgeters in 49 states, federal officials are not required to balance the budget. Elected officials maximize their chances of getting elected and reelected by supporting spending programs but failing to raise the needed taxes. That’s because voters like spending programs
but hate taxes. Individual members of Congress push their favorite spending programs with
little regard for the overall budget. All this results in deficits in most years.
5.
(Federal Debt) What has happened to the federal debt since 2008 as measured relative to
GDP?
The recession of 2009–2010 and policy responses to it have rocketed the federal deficit
above $1 trillion and sharply increased the national debt as a percentage of GDP. Although
that will likely trend downward if the economy continues to improve.
6.
(Net Public Debt) What’s the level of net public debt (for federal, state, and local governments) relative to U.S. GDP? How does the U.S. measure compare with that of other major
economies?
The federal or national debt is a stock variable measuring the net accumulation of past deficits, the amount owed by the federal government. Most recently the U.S. federal debt measured relative to GDP was somewhat above the average for major industrial countries and
was relatively high compared to U.S. historical levels stretching back to 1940. The recession
of 2009–2010 and policy responses to it have rocketed the federal deficit above $1 trillion
and sharply increased the national debt. Although that will likely trend downward if the
economy continues to improve.
7.
(Debt Measures) What’s the difference between gross federal debt and federal debt held by
the public?
In talking about the national debt, we should distinguish between the gross debt and debt
held by the public. The gross debt includes U.S. Treasury securities purchased by various
federal agencies. Because the federal government owes this debt to itself, analysts often focus instead on debt held by the public, which includes U.S. Treasury securities held by
households, firms, banks (including Federal Reserve Banks), and foreign entities. As of 2012,
the gross federal debt stood at $16.2 trillion, and the debt held by the public stood at $11.4
trillion.
8.
(The National Debt) Try the following exercises to better understand how the national debt is
related to the government’s budget deficit.
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Chapter 13
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a. Assume that the gross national debt initially is equal to $3 trillion and the federal government then runs a deficit of $300 billion:
i. What is the new level of gross national debt?
ii. If 100 percent of the deficit is financed by the sale of securities to federal agencies, what
happens to the amount of debt held by the public? What happens to the level of gross
debt?
iii. If GDP increased by 5 percent in the same year that the deficit is run, what happens to
gross debt as a percentage of GDP? What happens to the level of debt held by the public
as a percentage of GDP?
b. Now suppose that the gross national debt initially is equal to $2.5 trillion and the federal
government then runs a deficit of $100 billion:
i. What is the new level of gross national debt?
ii. If 100 percent of the deficit is financed by the sale of securities to the public, what
happens to the level of debt held by the public? What happens to the level of gross debt?
iii. If GDP increases by 6 percent in the same year as the deficit is run, what happens to gross
debt as a percentage of GDP? What happens to the level of debt held by the public as a
percent of GDP?
a. i. The new debt is $3.3 trillion.
ii. There is no change in the debt held by the public, but gross debt rises by $300 billion.
iii. Gross debt increases by 10 percent, thereby rising as a percent of GDP, while debt held
by the public remains constant, thereby falling as a percent of GDP.
b. i. The new debt is $2.6 trillion.
ii. Both gross debt and debt held by the public rise by $100 billion.
iii. Both gross debt and debt held by the public rise by 4 percent, thereby falling as a percent
of GDP.
9.
(Crowding Out and Capital Formation) In earlier chapters, we’ve seen that the government can
increase GDP in the short run by running a budget deficit. What are some long-term effects of
deficit spending?
The long-term effects of deficit spending depend on how the government spends the borrowed
dollars. If additional outlays are used for investment, the public investment may be as productive as
any private investment forgone. However, if the additional outlays are used for current consumption
items, the economy’s capital formation will be less than it would otherwise be. With less investment
today, there will be a smaller endowment of capital equipment and technology for future
generations.
10.
(Sustainability of Federal Debt) Are large federal deficits and a growing federal debt sustainable? What can be learned from the experiences of other countries?
The Great Recession and policy responses to it have rocketed the federal deficit above $1
trillion and sharply increased the national debt to a level that is not sustainable. Federal
deficits of one generation can affect the standard of living of the next generation, as a larger
share of the budget goes toward servicing the debt. One sign of possible problems in the
United States was the downgrading of the nation’s credit rating in 2011. For the first time in
70 years U.S. federal debt was rated as more risky. Research suggests that a high federal
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 13
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184
debt slows the economy, and the slowdown can last for years. To head off a fiscal crisis, policy makers must cut federal spending, raise taxes, or some combination of the two.
Indebted countries such as Greece, Ireland, Spain, and Portugal all received rescue
packages from international institutions, yet they continued to struggle, some with violent
public protests against deficit cutting remedies that reduced public spending and increased
taxes. One sign of possible problems in the United States was the downgrading of the nation’s
credit risk by the chief credit-rating agency in 2011. For the first time in 70 years, debt issued
by some U.S. “government entities” such as the Federal Farm Credit System and the Federal
Deposit Insurance Corporation was judged to be more risky. But, perhaps this way due to the
threat of Congress to not raise the debt limit which could have caused default on our national
debt.
Experiential Assignments
1. Have students try their hand at balancing the federal budget by using Nathan Newman’s National
Budget Simulation at http://www.nathannewman.org/nbs/. Questions for students:
a. Develop a budget and see what happens. Were you successful in balancing the budget? If not, how
much of a deficit or surplus did you end up with? What does this exercise tell you about the
process of creating a balanced budget?
b. Reexamine the budget cuts or increases you made. What problems would such changes pose for a
politician facing reelection? c. This budget simulator allows you only to change spending and tax
expenditures over a one-year period. What problems does this pose to finding a realistic economic
solution?
2. The government pays billions of dollars in interest each year to finance the national debt. Those
debt payments are sensitive to changes in the nominal interest rate. Ask students to check the
“Treasury Issues” table in the Money and Investing section of today’s Wall Street Journal. Have interest rates on Treasury bonds and bills been increasing or decreasing lately? What are the implications of interest rate changes for bond prices and for debt finance?
3. Send students to the Web site for the Bureau of the Public Debt at
http://www.treasurydirect.gov/govt/govt.htm. The site contains information on the current public
debt of the United States, holders of the debt, and historical information. What is the current value of
the national debt? How has this changed over the past year?
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.