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CHAPTER 13
FEDERAL BUDGETS AND PUBLIC POLICY
In this chapter, you will find:
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Answers to the End-of-Book Questions and Problems for Chapter 13
Supplemental Cases, Exercises, and Problems
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
1
Examine the federal budget process
The federal budget is a plan of outlays and revenues for a specified period, usually a year. 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.
2
Discuss the fiscal impact of the federal budget
Historically, deficits increase during wars and severe recessions. Deficits remained high, however, 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. After peaking at $290 billion in 1992, the federal deficit turned into a surplus by
1998 because of higher tax rates and reduced outlays especially for defense. The recession of 2001 and terrorist
attacks prompted tax cuts to “get the economy moving again.” The weak recovery plus tax cuts and federal
spending increases brought about a deficit of $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 recession of 2008-2009 cut federal revenue and spurred federal spending, both of which increased the deficit to $1.6 trillion in 2011. The longer term looks even bleaker as baby boomers begin retiring.
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.
3
Explain the national debt
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 about average for
major industrial countries and was relatively low 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. Something has to give.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
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176
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 2012, 22% to national defense, 34% to Social Security and Medicare, 14% to
welfare, 7% to pay interest on national debt; the remaining 23% 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.
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.
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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.
 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.
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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?
 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.
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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.
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.
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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. If deficits continue to rise after 2011,
this may impact their future standard of living due to the increasing cost of debt service and the
possibility of long-term crowding out of 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. Foreign lending, as well as recent surpluses in the Social Security trust funds, allowed the
administration and Congress greater flexibility in dealing with the problem.
g. 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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ANSWERS TO END-OF-BOOK QUESTIONS AND PROBLEMS
1.1
(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.
2.1
(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.
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.
2.2
(Crowding Out) Is it possible for U.S. federal budget deficits to crowd out investment spending in
other countries? How could German or British investment be hurt by large U.S. budget deficits?
This is very possible. When the U.S. federal government runs large budget deficits, they are partly
financed by borrowing from the U.S. public, other federal agencies, and foreign entities. When
savers in foreign countries invest funds in the United States, they deprive firms in those countries of
credit. This puts pressure on interest rates to rise internationally. If interest rates rise in the United
States, there should be concomitant rate increases in other major industrialized nations.
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German or British investment could be hurt by large U.S. budget deficits. Government deficits tend
to increase interest rates unless accompanied by greater saving levels. This increase causes an
increased demand for dollars in the foreign exchange market because of the increased attractiveness
of dollar-denominated debt. This increased dollar demand by foreign currency holders makes the
dollar appreciate, causing U.S. exports to fall and U.S. imports to increase.
3.1
(The National Debt) Try the following exercises to better understand how the national debt is related
to the government’s budget deficit.
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.
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SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS
Case Studies
These cases are available to students online at www.cengagebrain.com.
Reforming Social Security and Medicare
Social Security is a federal redistribution program established during the Great Depression that collects
payroll taxes from current workers and their employers to pay pensions to current retirees. More than 47
million beneficiaries averaged about $1,070 per month from the program in 2010. For two-thirds of
beneficiaries, these checks account for more than half of their income. Benefits increase each year to keep
up with inflation as measured by the CPI. Medicare, established in 1965 to provide short-term medical
care for the elderly, is an in-kind transfer program funded mostly by payroll taxes on current workers and
their employers (beneficiaries also pay a small amount). Medicare in 2010 helped pay medical expenses
for about 40 million Americans age 65 and older plus about 7 million other people with disabilities.
Medicare costs averaged about $9,700 per beneficiary in 2010 and is growing much faster than inflation.
Social Security and Medicare are credited with helping reduce poverty among the elderly from about 35
percent in 1960 to under 10 percent most recently—a poverty rate below other age groups.
In the early 1980s, policy makers recognized the huge impact that baby boomers would have on such a
pay-as-you-go program. When 76 million baby boomers begin retiring in 2011, Social Security costs and,
especially, Medicare costs are set to explode. Reforms adopted in 1983 raised the payroll tax rate,
increased the tax base by the rate of inflation, gradually increased the retirement age from 65 to 67 by
2022, increased the penalty for early retirement, and offered incentives to delay retirement. These reforms
were an attempt to make sure that revenues would exceed costs at least while baby boomers remain in the
workforce. But these reforms were not enough to sustain the programs. Americans are living longer,
fertility rates have declined, and health care costs are rising faster than inflation. The 65-and-older
population will nearly double by 2030 to 72 million people, or about 20 percent of the U.S. population.
In 1940, there were 42 workers per retiree. Today, there are 3.3 workers per retiree. By 2030, only 2.1
workers will support each retiree. Based on current benefits levels, spending on Social Security and
Medicare, now 8 percent relative to GDP and 32 percent of federal outlays, by 2030 will reach 12.5
percent relative to GDP and 50 percent of federal outlays. The huge sucking sound will be the federal
deficit arising mostly from Social Security and Medicare. The Congressional Budget Office projects a
2030 deficit of 9 percent relative to GDP. All these numbers spell trouble ahead.
But you don’t have to look into the future to find trouble. Because of the 2007–2009 recession, Social
Security tax receipts declined as people lost jobs, and outlays increased as some of those out of work
decided to retire early. As a result, in 2010 Social Security payouts exceeded pay-ins for the first time in
history. That wasn’t supposed to happen until 2016, and it put more pressure on the entire federal budget.
Prior to 2010, Social Security pay-ins exceeded payouts. The idea was that this surplus would accumulate
over time, so there would be funds available when baby boomers started to retire. But Congress never
saved any of the surplus; instead they raked it off, put IOUs in the Social Security Trust Fund, then spent
it. The Trust Fund is simply a box of government IOUs. Nothing’s there.
What to do, what to do? Possible reforms include increasing taxes, reducing benefits, raising the
eligibility age, using a more accurate index to calculate the annual cost-of-living increase in benefits
(meaning smaller annual increases), reducing benefits to wealthy retirees (they are already taxed on up to
85 percent of Social Security income and pay up to three times more for one part of Medicare), and
slowing the growth of Medicare costs.
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In summary, Social Security and Medicare helped reduce poverty among the elderly, but the programs
grow more costly as the elderly population swells and as the flow of young people into the workforce
slows. When Social Security was created in the 1930s, life expectancy was 60 years, so only a minority
would ever reach 65 to get benefits. Now people live 20 years longer on average, and they collect benefits
for most of those added years. Something has to give if these programs are to be available when you retire.
President Obama and the Congress raised Medicare payroll taxes on high income households, but these
higher revenues will fund health care reform more generally, not Medicare in particular. The health care
measure also cuts Medicare funding by about $150 billion over ten years. Social Security and Medicare
remain in big trouble.
Sources: Susan Davis, “Public Faith in Social Security Drops,” Wall Street Journal, 20 July 2010; Ben
Bernanke, “Long-Term Fiscal Challenges Facing the United States,” Testimony Before the Committee on
the Budget, U.S. Senate, 18 January 2007, at http://www.federalreserve.gov/boarddocs/testimony/2007/
20070118/default.htm; Mary Williams Walsh, “Social Security to See Payout Exceed Pay-In This Year,”
New York Times, 24 March 2010; and “Status of the Social Security and Medicare Programs: A Summary
of the 2009 Annual Report,” Social Security and Medicare Boards of Trustees, at http://www.ssa.gov/
OACT/TRSUM/index.html.
An Intergenerational View of Deficits and Debt
Harvard economist Robert Barro has developed a model that assumes parents are concerned about the
welfare of their children who, in turn, are concerned about the welfare of their children, and so on for
generations. Thus, the welfare of all generations is tied together. According to Barro, parents can reduce
the burden of the federal debt on future generations. Here’s his argument. When the government runs
deficits, it keeps current taxes lower than they would otherwise be, but taxes in the future must increase to
service the higher debt. If there is no regard for the welfare of future generations, then the older people
get, the more attractive debt becomes relative to current taxes. Older people can enjoy the benefits of
public spending now but will not live long enough to help finance the debt through higher taxes or reduced
public benefits.
But parents can undo the harm that deficit financing imposes on their children by consuming less now
and saving more. As governments substitute deficits for taxes, parents will consume less and save more to
increase gifts and bequests to their children to help pay the higher taxes in the future. If greater saving
offsets federal deficits, deficit spending will not increase aggregate demand because the decline in
consumption will negate the fiscal stimulus provided by deficits. According to Barro, this intergenerational
transfer offsets the future burden of higher debt and neutralizes the effect of deficit spending on aggregate
demand, output, and employment.
The large budget deficits caused in part by tax cuts and spending increases of the 1980s would seem to
provide a natural experiment for testing Barro’s theory. The evidence fails to support his theory because
the large federal deficits coincided with lower, not higher, saving rates. Yet defenders of Barro’s view say
that maybe the saving rate was low because people were optimistic about future economic growth, an
optimism reflected by the strong performance of stock markets. Or maybe the saving rate was low because
people believed tax cuts would result not in higher future taxes but in lower government spending, as
President Reagan promised.
But there are other reasons to question Barro’s theory. First, those with no children may be less
concerned about the welfare of future generations. Second, his theory assumes that people are aware of
federal spending and tax policies and about the future consequences of current policies. Until recently,
most people seemed to know little about such matters. One survey found that few adults polled had any
idea about the size of the federal deficit. In the poll, respondents were offered a range of choices, but only
1 in 10 said correctly that the deficit that year was between $100 billion and $400 billion.
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But with federal deficits topping $1 trillion, people seem more aware and more concerned about deficits
than ever. If Barro’s view is correct, recent deficits should call forth an increase in saving. That rate did
increase from 2.1 percent of disposable income in 2007 to 6.2 percent by the second quarter of 2010. That
could offer support for Barro’s view, or it could simply reflect how cautious people became about
spending with jobs scarce and the economy seemingly adrift.
Sources: Robert J. Barro, “The Ricardian Approach to Budget Deficits,” Journal of Economic
Perspectives 3 (Spring 1989); Jesus Cueresma and Gerhard Reitschuler, “Is the Ricardian Equivalence
Proposition and ‘Aerie Fairy’ Theory for Europe,” Economica, 74 (November 2007): 682–694; and
Gerald Seib, “A Plague Stalking America: The Deficit Addiction,” Wall Street Journal, 27 April 2010.
Saving rate figures are from the Bureau of Economic Analysis, U.S. Dept. of Commerce.
Experiential Exercises
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?
4. Have students access EconDebate Online at http://4ltrpress.cengage.com/. They should review the
materials on “Will Social Security Survive into the 21st Century?” and answer the question, “What are
some of the macroeconomic implications of Social Security reform?”
5. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "in defense of debt." On the
Results page, go to the Global Viewpoints Section. Click on the link for the March 15, 2010, editorial
"In Defense of Debt." Why was the author not concerned about the high U.S. national debt?
The author pointed out that the U.S. benefited from low interest rates, which made interest payments
low as a percentage of GDP. In addition, the supply of loanable funds in rapidly developing nations
should lead to steady demand for U.S. government bonds.
6. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "balanced budget." Choose one
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Chapter 13
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186
article from the past two years about your home country and one article from the past two years about a
foreign country. Compare and contrast attitudes toward balanced national budgets.
Student answers will vary, but should analyze recessionary gaps, fears of inflation, and the balance between tax increases and spending cuts.
Additional Questions and Problems
(From student Web site at www.cengagebrain.com)
1. (The Private Sector) Look at Exhibit 4. How have government outlays as a percent of GDP changed
in the industrial countries depicted between 1993 and 2012? Why have outlays declined in most of
the countries shown?
The drop is due to reduced defense spending, increased use of private markets, and growing
prosperity.
2. (The Federal Budget Process) In what sense is the executive branch of the U.S. government always
dealing with three budgets?
The executive branch deals with administering the budget in place for the current fiscal year. At the
same time, it is testifying before various Congressional committees in support of the proposed
budget for the upcoming fiscal year that was submitted in January. Finally, since development of the
president’s budget begins a full year before it is submitted to Congress, the executive branch is
simultaneously preparing the next budget for submission to Congress.
3. (The Budget Process) In terms of the policy lags described in the previous chapter, discuss the
following issues associated with the budget process:
a. Continuing resolutions
b. Uncontrollable budget items
c. Overly detailed budget
a.
b.
c.
Continuing resolutions increase the decision-making lag in fiscal policy; the implementation lag
may also increase if Congress and the president have agreed to change a certain program but
cannot agree to a budget proposal to make the change.
Uncontrollable budget items increase the decision-making lag since it is more difficult to reach
agreement about changing items such as entitlement programs. Changing entitlement programs
requires passing new laws and developing new guidelines and paperwork, so there is also an
increase in the implementation lag. If changes require determining which households are no
longer eligible or which households are newly eligible, the effectiveness lag can be significant.
Interest payments on the debt are very difficult to change in the near term—there is a
substantial implementation lag.
An overly detailed budget makes it difficult to reallocate funds among programs, so the
implementation lag is long. Using the budget for political payoffs increases the decision-making
lag as each politician tries to protect his or her special interest groups.
4. (Budget Philosophies) One alternative to balancing the budget annually or cyclically is to produce a
government budget that would be balanced if the economy were at potential output. Given the
cyclical nature of government tax revenues and spending, how would the resulting budget deficit or
surplus vary over the business cycle?
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Chapter 13
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A federal budget that is structured to have a zero deficit when the economy is at potential GDP will
go into deficit as unemployment rises above the natural rate and into surplus as unemployment falls
below the natural rate. The increase in spending and falling revenues that accompany a contracting
economy cause federal deficits to increase.
5. (Budget Philosophies) The functional finance approach to budget deficits would set the federal
budget to promote an economy operating at potential output. What problems would you expect if the
country were to employ this kind of budgetary philosophy?
The functional finance approach requires accurate forecasts of the future state of the economy.
Policy makers need to determine whether the economy is heading above or below potential output so
they can determine appropriate measures. If policy makers disagree on what constitutes potential
GDP, they have little guidance in determining what spending and tax levels are appropriate.
6.
(Crowding Out) How might federal deficits crowd out private domestic investment? How could this
affect future living standards?
If the federal government is running deficits, the U.S. Treasury sells securities to finance the deficits.
This increases the demand for loanable funds and drives up interest rates. Higher interest rates lead
to lower private investment. If federal borrowing is used mainly for current consumption, the
government is not replacing the forgone private investment in capital. With lower capital formation,
the future productive capacity of the economy is reduced—leading to lower standards of living than
would have occurred without the deficits.
7. (Interest on the Debt) Why did interest payments on the national debt fall from 15.4% of the federal
budget in 1996 to 6.5% in 2012? Why is this percentage expected to increase in the future?
Initially, interest payments began to decrease because of the budget surplus in the late 1990s. They
continued to decrease because of low interest rates, the lowest in four decades. This percentage will
increase in the future as the interest rate begins to climb back up from its historic lows.
8. (Burden of the Debt) Suppose that budget deficits are financed to a considerable extent by
foreigners. How does this create a potential burden on future generations of Americans?
Foreign holders of U.S. debt will have dollars to spend in the future from both interest earned on
their debt holdings and the payoff when the debt matures. The future benefits to debt holders are
thus transferred out of the United States rather than accruing to U.S. residents. This represents a
transfer of purchasing power from U.S. residents to foreign residents, reducing the standard of
living of future generations in the United States.
9. (The Twin Deficits) How is the U.S. budget deficit related to the foreign trade deficit?
The term twin deficits refers to a simultaneous U.S. trade deficit and federal government budget
deficit. A foreign trade deficit means that foreign residents are, on net, selling more goods and
services to the United States than they are buying from the United States—thus accumulating U.S.
dollars. These dollars are invested in U.S. assets, lending them back to the United States and thus
helping to finance the federal deficits.
10.
(The Miraculous Budget Surplus) Why did the federal budget go from a huge deficit in 1992 to a
surplus in 1998? Explain the factors that contributed to the turnaround.
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Chapter 13
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188
Taxes were increased in 1990 by President Bush and again in 1993 when President Clinton raised
the highest marginal tax rate to 39.6%. The economy experienced a vigorous recovery during the
1990s. The growth of federal outlays slowed during the period because the fall of the Soviet Union
meant less military spending. Increased taxes and prosperity caused a rise in tax revenues. The
budget balance went into a surplus for the first time in many years.
11.
(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.
ANSWERS TO ONLINE CASE STUDIES
1.
(CaseStudy: Reforming Social Security and Medicare) Why are the Social Security and Medicare
program headed for trouble? When will the trouble begin? What solutions have been proposed?
When Baby Boomers begin retiring in large numbers around 2011, pension and Medicare costs will
explode. Reforms were adopted in 1983 to prepare for this. Congress increased the tax rate, the tax
base, the retirement age, the penalty for early retirement, and the incentives for delaying retirement
and began accumulating the surplus in the Social Security Trust Fund.
The budget surplus in 1998 would have been a $30 billion deficit had it not been for the $100 billion
surplus generated by the Social Security program.
By 2030 the fund will be empty and Social Security taxes paid in at that time will cover only threefourths of retirement outlays. Thus, additional reforms under consideration include higher payroll
taxes, reduced benefits, increasing the retirement age, and privatizing part of the system.
2.
(CaseStudy: An Intergenerational View of Deficits and Debt) Explain why Robert Barro argues that
if parents are concerned about the future welfare of their children, the effects of deficit spending on
the economy will be neutralized.
According to Barro, parents will realize that deficit spending will lead to higher future taxes to
service the resulting debt. Parents therefore consume less and save more in order to provide larger
gifts and inheritances for their children. If this increase in saving matches the deficit increase,
aggregate demand will not change. Therefore, output and employment will not change either.
© 2012 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.