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Chapter 14
Deficit
Spending and
The Public Debt
Introduction
In adopting the euro, European nations agreed
to abide by the Stability and Growth Pact.
The pact called for limitations on government
spending over tax collections to be no more
than 3% of GDP—yet many European
governments have since changed their tune.
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14-2
Learning Objectives
• Explain how federal government budget
deficits occur
• Define the public debt and understand
alternative measures of the public debt
• Evaluate circumstances under which
the public debt could be a burden to
future generations
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14-3
Learning Objectives (cont'd)
• Discuss why the federal budget deficit
might be measured incorrectly
• Analyze the macroeconomic effects of
government budget deficits
• Describe possible ways to reduce the
government budget deficit
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14-4
Chapter Outline
• Public Deficits and Debts: Flows
versus Stocks
• Government Finance: Spending More than
Tax Collections
• Evaluating the Rising Public Debt
• Federal Budget Deficits in an Open Economy
• Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
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14-5
Did You Know That...
• Throughout the rest of this decade, the
U.S. federal government expects to run
annual budget deficits?
• The relationship between budget
deficits and macroeconomic
performance is somewhat elusive?
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14-6
Public Deficits and Debts:
Flows versus Stocks
• Government Budget Deficit
 Exists if the government spends more
than it receives in taxes during a given
period of time
 Is financed by the selling of government
securities (bonds)
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14-7
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• The federal deficit is a flow variable,
one defined for a specific period of time,
usually one year.
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14-8
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• If spending equals receipts, the budget
is balanced.
• If receipts exceed spending, the
government is running a budget surplus.
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14-9
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Balanced Budget
 A situation in which the government’s
spending is exactly equal to the total taxes
and revenues it collects during a given
period of time
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14-10
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Government Budget Surplus
 An excess of government revenues over
government spending during a given
period of time
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14-11
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Public Debt
 A stock variable
 The total value of all outstanding
government securities
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14-12
Government Finance: Spending
More than Tax Collections
• Since 1940, the U.S. federal
government has operated with a budget
surplus in 13 years.
• In all other years, the shortfall of tax
revenues below expenditures has been
financed with borrowing.
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14-13
Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
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14-14
Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
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14-15
Government Finance: Spending
More than Tax Collections (cont'd)
• The resurgence of federal
government deficits
• Question
 Why has the government’s budget recently
slipped from a surplus of 2.5% of GDP into
a deficit?
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14-16
Policy Example: Explaining a $109
Billion Deficit Projection Turnaround
• Why was the government’s 2005 deficit
projection off by $109 billion?
• Federal tax revenues turned out to be
more than 15% higher in 2005.
• Economic growth caused taxable
incomes, hence revenues, to be much
higher than anticipated.
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14-17
Evaluating the Rising Public Debt
• Gross Public Debt
 All federal government debt irrespective of
who owns it
• Net Public Debt
 Gross public debt minus all government
interagency borrowing
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14-18
Evaluating the Rising
Public Debt (cont'd)
• Some government bonds are held by
government agencies.
 In this case, the funds are owed from
one branch of the federal government
to another.
 To arrive at the net public debt, we subtract
interagency borrowings from the gross
public debt.
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14-19
Evaluating the Rising
Public Debt (cont'd)
• Tax revenues tend to be stagnant
during times of slow economic growth.
• Tax revenues grow more quickly when
overall growth enhances incomes.
• As long as spending exceeds revenues,
the budget deficit will persist.
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14-20
Table 14-1 The Federal Deficit,
Our Public Debt, and the Interest
We Pay on It
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14-21
Figure 14-3 Net U.S. Public Debt
as a Percentage of GDP
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14-22
Net U.S. Public Debt
as a Percentage of GDP
• During World War II, the net public debt
grew dramatically.
• After the war
 It fell until the 1970s
 Started rising in the 1980s
 Declined once more in the 1990s
 And recently has been increasing again
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14-23
Evaluating the Rising
Public Debt (cont'd)
• The government must pay interest on
the public debt outstanding.
• The level of these payments depends
on the market interest rate.
• Interest payments as a percentage of
GDP are likely to rise in the future.
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14-24
Evaluating the Rising
Public Debt (cont'd)
• As more of the public debt is held by
foreigners, the amount of interest to be paid
outside the United States increases.
• Foreign residents, businesses and
governments hold nearly 50% of the net
public debt.
• Thus, we do not owe the debt just
to ourselves.
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14-25
Evaluating the Rising
Public Debt (cont'd)
• If the economy is already at full
employment, then further provision of
government goods will crowd out some
private goods.
• Deficit spending may raise interest
rates, which in turn will discourage
capital formation in the private sector.
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14-26
Evaluating the Rising
Public Debt (cont'd)
• Crowding-out may place a burden on
future generations.
 Increased present consumption may crowd
out investment and reduce the growth of
capital goods—which could reduce a
future generation’s wealth.
 Taxes may have to be increased; imposing
higher taxes on future generations in order
to retire the debt.
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14-27
Evaluating the Rising
Public Debt (cont'd)
• Paying off the public debt in the future
 If the debt becomes larger, each person’s
share would increase.
 Taxes would be levied, and may not be
assessed equally.
 A special tax could be levied based on a
person’s ability to pay.
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14-28
Evaluating the Rising
Public Debt (cont'd)
• Our debt to foreign residents
 We do not owe all the debt to ourselves.
 Future U.S. residents will be taxed to
repay principal and interest.
 Portions of U.S. incomes will be
transferred abroad.
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14-29
Evaluating the Rising
Public Debt (cont'd)
• If deficits lead to slower growth rates future
generations will be poorer.
• Both present and future generations will be
economically better off if…
 Government expenditures are really investments
 The rate of return on such public investments
exceeds the interest rate paid on the bonds
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14-30
International Example: Where Are Most
Treasury Securities Held Abroad?
• More than $2 trillion in U.S. Treasury
securities of the $5 trillion in net
outstanding debt is held outside the
United States.
• Japan accounts for more than one-third
of all foreign holdings of the U.S. net
public debt.
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14-31
Figure 14-4 The Distribution of Foreign
Holdings of U.S. Treasury Securities
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14-32
International Example: Where Are Most
Treasury Securities Held Abroad? (cont'd)
• For critical analysis:
 Why might the fact that market interest
rates in Japan have hovered very close to
0% during the 2000s help explain relatively
large holdings of U.S. Treasury securities
by residents of that country?
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14-33
Federal Budget Deficits
in an Open Economy
• Question
 Is there a connection between the U.S.
trade deficit and the federal government
budget deficit?
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14-34
Federal Budget Deficits
in an Open Economy (cont'd)
• We know what a budget deficit is, but a
trade deficit exists when the value of
imports exceeds the value of exports.
• Some say it appears that there is a
relationship between trade and budget
deficits; at least there is a statistical
correlation between the two.
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14-35
Figure 14-5
The Related U.S. Deficits
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14-36
Federal Budget Deficits
in an Open Economy (cont'd)
• As the government borrows funds to
finance the deficit, and domestic private
consumption does not decrease, then
some of these funds will be borrowed
from foreigners.
• The interest rate paid on bonds will
need to be high enough to attract
foreign investors.
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14-37
Federal Budget Deficits
in an Open Economy (cont'd)
• If foreigners are using the dollars they
hold to buy U.S. government bonds,
then they will have fewer dollars to
spend on U.S. exports.
• This shows that a U.S. budget deficit
can contribute to a trade deficit.
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14-38
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance
• Which government deficit is the
true deficit?
 The government may report distorted
measures of its own budget.
 Government
has not adopted a
business-like approach to tracking
its expenditures and receipts.
 Official
government “measures” yield
lowest possible deficits and highest
reported surpluses.
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14-39
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• An operating budget includes current
outlays for on-going expenses, such as
salaries and interest payments.
• A capital budget, includes expenditures
on investment items, such as machines,
buildings, roads, and dams.
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14-40
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Capital budgeting theory
 For years, many economists have
recommended Congress create a capital
budget and remove investment outlays
from the operating budget.
 Opponents point out this would allow
the government to grow even faster than
at present.
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14-41
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Even without a distinction drawn
between the capital and operating
budgets, there is a discrepancy about
the true government deficit measure.
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14-42
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Pick a deficit, any deficit: deficit estimates are
produced both by
 The Office of Management and Budget
 The Congressional Budget Office
• They have different names
 “Baseline deficit”
 “Policy deficit”
 “On-budget deficit”
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14-43
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• There is also some disagreement as
to whether the Social Security surplus
should be used to reduce current
deficit numbers.
• So keep in mind that any one specific
deficit measure you hear is based on a
definition and a set of assumptions with
which others may disagree.
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14-44
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Question
 How do higher deficits affect the economy in the
short run?
• Answers
 If the economy is below full-employment, the
deficit can close the recessionary gap.
 If the economy is already at full-employment, the
deficit can create an inflationary gap.
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14-45
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• In the long run, higher government
budget deficits have no effect on
equilibrium real GDP.
• Ultimately, spending in excess of
receipts redistributes a larger share
of real GDP to government-provided
goods and services.
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14-46
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Thus, if the government operates with
higher deficits over an extended period
 The ultimate result is a shrinkage in
the share of privately produced goods
and services
 By continually spending more than it
collects, the government takes up a larger
portion of economic activity.
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14-47
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• How could the government reduce all
its red ink?
 Increasing taxes for everyone
 Taxing only the rich
 Reducing expenditures
 Whittling away at entitlements
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14-48
Policy Example: How Rich Taxpayers
Avoid Part of a Tax-Rate Increase
• Many have proposed raising taxes on
the highest-income earners.
• Just like everyone else high-income
individuals respond to incentives.
• The richest tax payers could use
deferred compensation plans.
• These individuals would shift income
earned in current years to future years.
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14-49
Policy Example:
How Rich Taxpayers Avoid Part
of a Tax-Rate Increase (cont'd)
• Government estimates show increasing
the top bracket from 35% to 39.6%
would reduce total taxable income by
at least 4%.
• Projections show the increase would
give the highest income taxpayers a
greater incentive to incorporate and pay
lower corporate-profit tax rates.
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14-50
Policy Example:
How Rich Taxpayers Avoid Part
of a Tax-Rate Increase (cont'd)
• Thus, raising the income tax rate
by 4.6 percentage points would result
in less than a 4.6% increase in
government tax collections.
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14-51
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• In considering how expenditures
might be reduced, it is important to
look at entitlements.
• These are federal government
payments that are legislated obligations
and cannot be reduced or eliminated.
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14-52
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Entitlements
 Guaranteed benefits under a government
program such as Social Security,
Medicare, or Medicaid
• Noncontrollable Expenditures
 Government spending that changes
automatically without action by Congress
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14-53
Figure 14-6 Components of Federal
Expenditures as Percentages of Total
Federal Spending
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14-54
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Entitlements are the largest component
of the U.S. federal budget.
• To make a significant cut in
expenditures, entitlement programs
would have to be revised.
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14-55
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Question
 What are the political costs of reducing
entitlement payments for Social Security,
Medicare, and Medicaid?
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14-56
Issues and Applications: Budget Deficit
Rules Made to Be Broken?
• Under the Stability and Growth Pact
each EU member nation agreed on
net public debt and annual budget
deficit percentages.
• Net public debt as a percentage of GDP
should be no higher than 60%, with the
annual budget deficit no higher than 3%
of GDP.
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14-57
Issues and Applications: Budget Deficit
Rules Made to Be Broken? (cont'd)
• All EU nations satisfied the 60%
constraint on net public debt as a
proportion of GDP.
• Several EU countries failed to satisfy
the 3% limitation on the ratio of the
budget deficit to GDP.
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14-58
Issues and Applications: Budget Deficit
Rules Made to Be Broken? (cont'd)
• During the 2000s, many nations were
experiencing deficits in excess of 3% of GDP
as economies slowed, entitlements grew, and
tax revenues were stagnant.
• Several governments that violated the 3%
limit did so hoping expansionary fiscal
policies would boost aggregate demand
and prevent recessions.
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14-59
Summary Discussion
of Learning Objectives
• Federal government budget deficits
 Whenever the flow of government expenditures
exceeds the flow of government revenues a
budget deficit occurs.
• The public debt
 Total value of all government bonds outstanding
 The federal budget deficit is a flow, whereas
accumulated deficits are a stock, called the
public debt.
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14-60
Summary Discussion
of Learning Objectives (cont'd)
• How the public debt might prove a burden to
future generations
 Higher taxes will reduce private consumption.
 Crowding out might reduce economic growth.
• Why the federal budget deficit might be
incorrectly measured
 No distinction between capital expenses and
operating expenses
 Each estimate is based on a set of assumptions.
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14-61
Summary Discussion
of Learning Objectives (cont'd)
• The macroeconomic effects of government
budget deficits
 Because higher government deficits are caused
by increased government spending or tax cuts,
they contribute to a short-run rise in total planned
expenditures and aggregate demand.
 In the long run, increased deficits only
redistribute resources from the private sector
to the public sector.
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14-62
Summary Discussion
of Learning Objectives (cont'd)
• Possible ways to reduce the
government budget deficit
 Increase taxes
 Reduce expenditures by revising the terms
of entitlement programs
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14-63
End of
Chapter 14
Deficit
Spending and
The Public Debt