Introduction. Learning Objectives. Chapter 14. Deficit Spending and The Public Debt

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1 Copyright 2011 by Pearson Education, Inc. Chapter 14 Deficit Spending and The Public Debt All rights reserved. Introduction Since 2007, the ratio of the official real net public debt to real GDP has increased dramatically to more than 67 percent The real net public debt is the inflation-adjusted amount that the U.S. government owes to U.S. residents and others around the world What has caused the government s indebtedness to surge in relation to the amount of economic activity? Reading this chapter will help you answer this question 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 14-3

2 Learning Objectives 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 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: 14-5 Did You Know That... Today the federal government s budget deficit the federal government s spending in excess of its revenues is more than 5 times greater than it was in 2007? Since that year, the federal government s spending has increased by more than $1 trillion per year, but its revenues have declined In this chapter, you will learn what the government does when it spends more than it receives 14-6

3 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) 14-7 Public Deficits and Debts: Flows versus Stocks The federal deficit is a flow variable, one defined for a specific period of time, usually one year If spending equals receipts, the budget is balanced If receipts exceed spending, the government is running a budget surplus 14-8 Public Deficits and Debts: Flows versus Stocks 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 14-9

4 Public Deficits and Debts: Flows versus Stocks Government Budget Surplus An excess of government revenues over government spending during a given period of time Public Deficits and Debts: Flows versus Stocks Public Debt A stock variable The total value of all outstanding federal government securities 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 14-12

5 Figure 14-1 Federal Budget Deficits and Surpluses Since Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP Government Finance: Spending More than Tax Collections Question Why has the government s budget recently slipped from a surplus of 2.5% of GDP into a deficit? Answer Spending has increased at a faster page since the early 2000s than during any other decade since WWII Recent income, capital gains, and estate tax cuts 14-15

6 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 Evaluating the Rising Public Debt 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 Evaluating the Rising Public Debt 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 14-18

7 Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It Evaluating the Rising Public Debt (cont d) 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 Figure 14-3 The Official Net U.S. Public Debt as a Percentage of GDP 14-21

8 Evaluating the Rising Public Debt 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 Evaluating the Rising Public Debt 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 Evaluating the Rising Public Debt 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 14-24

9 International Policy Example: Why the British Government Must Pay More Interest on Its Debt Since the spring of 2009, a key bond-rating agency, Standard & Poor s (S&P) Rating Service, has placed British bonds into what it calls the negative category among highest-rated bonds The negative rating had an immediate effect on the interest rate that the British government was required to offer to induce individuals and companies to continue buying its bonds Indeed, the British government has had to pay almost $500,000 more in interest for each additional $1 billion that it has borrowed Evaluating the Rising Public Debt 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 Evaluating the Rising Public Debt 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 14-27

10 Evaluating the Rising Public Debt Our debt to foreign residents We do not owe all the debt to ourselves what about the nearly 50% owned by foreign residents? Future U.S. residents will be taxed to repay principal and interest Portions of U.S. incomes will be transferred abroad Evaluating the Rising Public Debt If deficits lead to slower growth rates, then 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 Policy Example: How a Special Contribution Increased the U.S. Debt Burden without Changing the Official Budget Deficit Recently, President Obama sought to contribute an additional $108 billion to the International Monetary Fund, which in turn would lend to countries hit hard by the worldwide recession To prevent the IMF contribution from adding to the rapidly increasing federal government budget deficit, Obama asked Congress to classify the funds as a loan instead of expenditures, thereby leaving the official budget deficit unaffected Why do you suppose economists argue that the best measure of the U.S. government s actual indebtedness is equal to the total net amount that it has borrowed? 14-30

11 Federal Budget Deficits in an Open Economy Question Is there a connection between the U.S. trade deficit and the federal government budget deficit? Federal Budget Deficits in an Open Economy 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 Figure 14-4 The Related U.S. Deficits 14-33

12 Federal Budget Deficits in an Open Economy 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 Federal Budget Deficits in an Open Economy 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 Growing U.S. Government Deficits: 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 14-36

13 Growing U.S. Government Deficits: 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 Growing U.S. Government Deficits: 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 that this would allow the government to grow even faster than at present Growing U.S. Government Deficits: Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure 14-39

14 Growing U.S. Government Deficits: 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 Growing U.S. Government Deficits: There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers 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 Growing U.S. Government Deficits: 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 14-42

15 Growing U.S. Government Deficits: 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 Growing U.S. Government Deficits: 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 Policy Example: What Is the Outlook for the U.S. Government s Share of GDP? Each year, the Office of Management and Budget makes a projection of federal government deficits for the following 10 years At the beginning of 2009, the OMB projected that the average annual budget deficit from 2010 to 2019 would be nearly $712 billion, or an extra $186-billion-per-year slice of GDP Seven months later, the OMB redid its projection, which implied that the federal government s share of GDP would be about $188 billion higher over the following 10-year period 14-45

16 Growing U.S. Government Deficits: How could the government reduce all its red ink? Increasing taxes for everyone Taxing only the rich Reducing expenditures Whittling away at entitlements Growing U.S. Government Deficits: 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 Growing U.S. Government Deficits: 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 14-48

17 Figure 14-5 Components of Federal Expenditures as Percentages of Total Federal Spending Growing U.S. Government Deficits: 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 Growing U.S. Government Deficits: Question What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid? 14-51

18 Policy Example: Medicare Is Contributing to a Higher Federal Budget Deficit Since 2008, the Medicare entitlement program has officially operated at a deficit. Congress responded by passing a law several years ago that cut allowed payments to Medicare providers by more than 20 percent Each year since, however, Congress has passed one-year amendments canceling the payment reductions while boosting Medicare costs by expanding the scope of its coverage Congress has also established an annual trust fund for Medicare entitlement, but each year it has borrowed the trust fund to spend. Medicare s trustees have determined that accumulated annual Medicare deficits will wipe out the trust fund by Issues and Applications: How Much of U.S. GDP Would Be Required to Pay Off the Net Public Debt? A measure of the burdens associated with the net public debt is the share of real GDP that would be required to pay off the inflation-adjusted net public debt Figure 14-6 shows that this share has nearly doubled since 2007, to more than 67 percent Yet, some observers suggest that the true share is much higher than this once government guarantees of housing-related debts are taken into account Figure 14-6 The Rapidly Expanding Ratio of the Inflation-Adjusted Net Public Debt to Real GDP 14-54

19 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 Summary Discussion of Learning Objectives 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 Summary Discussion of Learning Objectives 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 14-57

20 Summary Discussion of Learning Objectives Possible ways to reduce the government budget deficit Increase taxes Reduce expenditures by revising the terms of entitlement programs 14-58

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