Download The Government Budget Constraint

Fiscal Policy
The Government Budget Constraint
The Arithmetic of Deficits and Debt
– The budget deficit in year t equals:
deficit t  rBt 1  Gt  Tt
rBt 1 is the government debt at the end of year t-1.
Gt is government spending during year t.
Tt
is taxes minus transfers during year t.
The Government Budget Constraint
The change in government debt during year t is
equal to the deficit during year t:
Bt  Bt 1
change in the debt

rBt 1
interest payments
 Debt at the end of year t equals:
Bt  (1  r ) Bt 1  Gt  Tt

Gt  Tt
primary deficit
U.S. Fiscal Deficits
Financing the Deficit
Full Repayment in Year 2
Tax Cuts,
Debt
Repayment,
and Debt
Stabilization
T2  G2  (1  r )1  (1  r )
Debt Stabilization in Year 2
Tax Cuts, Debt
Repayment,
and Debt
Stabilization
B2  B1  1
B2  (1  r ) B1  (G2  T2 )
1  (1  r )  (G2  T2 )
T2  G2  (1  r )  1  r
Conclusions
An increase in the deficit today must eventually be offset by a
decrease in the deficit in the future (by increasing T or
decreasing G).
The longer the government waits or the higher the real interest
rate, the higher the eventual increase in taxes.
The legacy of deficits is higher government debt.
To stabilize the debt, the government must run a surplus equal to
the interest payments on the existing debt.
To eliminate the debt, the government must run a surplus equal
to the interest payments on the existing debt plus repayment of
the stock of debt.
The Evolution of the Debt to GDP Ratio
Bt Bt 1
Bt 1 Gt  Tt

 (r  g )

Yt Yt 1
Yt 1
Yt
If GDP grows (g increases), the ratio of debt to
GDP will grow more slowly (at a rate equal to
rg).
U.S. National Debt as % of GDP
The Evolution of the Debt-to-GDP Ratio
in OECD Countries
Bt Bt 1
Bt 1 Gt  Tt

 (r  g )

Yt Yt 1
Yt 1
Yt
In the 1960s, GDP growth was strong. As a
result, rg was negative. OECD Countries were
able to decrease their debt ratios.
In the 1970s, rg was again negative due to very
low interest rates, leading to a further decrease in
the debt ratio.
The Evolution of the Debt-to-GDP Ratio
in OECD Countries
Bt Bt 1
Bt 1 Gt  Tt

 (r  g )

Yt Yt 1
Yt 1
Yt
In the 1980s, real interest rates increased and
growth rates decreased, thus, debt ratios
increased rapidly.
Throughout the 1990s, interest rates remained
high and growth rates low. However, most
countries ran primary surpluses sufficient to imply
a steady decline in their debt ratios.
Public Debt (% of GDP)
Taxes
Sources of Tax Revenue in the United States
(2004)
Government Spending in the United States
(2004)
Foreign Aid from the Rich Countries
Issues in Fiscal Policy
Tax distortions
The danger of high debts
Reducing Tax Distortions
Very high tax rates can lead to high economic
distortions. People might work less, and engage
in illegal, untaxed activities.
Inflation (seigniorage) also distorts prices and
therefore incentives.
Tax smoothing is the idea that it is better to
maintain a relatively constant tax rate.
The Dangers of Very High Debt
Bt Bt 1
Bt 1 (Gt  Tt )

 (r  g )

Yt Yt 1
Yt 1
Yt
The higher the ratio of debt to GDP, the larger
the potential for catastrophic debt dynamics.
Expectations of higher and higher debt give a
hint that a problem may arise, which will lead to
the emergence of the problem, thereby
validating the initial expectations.
Public Debt
Surpluses and Aging
Entitlement
programs are
programs that
require the
payments of
benefits to all who
meet the eligibility
requirements
established by the
law.
Surpluses and Aging
Entitlement spending to GDP is projected to
increase for these reasons:
– Aging
– The steadily increasing cost of health care.
Projected entitlement spending would eventually
exceed revenues.
Surpluses and Aging
Since 1983, Social Security contributions have
exceeded benefits. The Social Security Trust
Fund is an account where the surpluses have
been accumulating, and now equal 12% of GDP.
The Social Security Trust Fund is expected to
reach 20% of GDP in 2020, then to decline and be
equal to zero by 2030.
Aging in a Comparative Perspective
Possible Solutions to the Medicare Problem
Cut benefits
Increase taxes on workers
Immigration
Dramatic health care reform
Retirement Accounts
– Fully-funded vs. pay-as-you-go schemes
Privatization
All of these are controversial!
Fiscal Policy in the short-, mediumand long-run
In the short run: fiscal policy and the IS-LM model (open
or closed) – moving the IS curve.
In the medium run: how will different fiscal policies
affect employment and the price level.
In the long run: how will fiscal policy affect the
investment rate (capital accumulation) and the rate of
technological progress:
– private and public savings
– incentives for R & D.