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

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1 Chapter 14 Deficit Spending and The Public Debt Introduction The federal budget deficit often has appeared to move in tandem with the trade deficit. In the past, they were sufficiently closely related that economists began to call them the twin deficits. In recent years, however, the U.S. trade deficit has increased even as the U.S. government s budget deficit has been decreasing. Why has this divergence occurred? Are the two deficits no longer twins? 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 14-5 Did You Know That... The U.S. federal government spends a total of more than $3 billion per day on Social Security, Medicare, and Medicaid. Each of these guaranteed spending programs is individually nearly as large as the entire discretionary portion of the federal government s budget. 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 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

5 Figure 14-1 Federal Budget Deficits and Surpluses Since 1940 *Budgeted items not including financial institutions bailout expenditures. Source: Office of Management and Budget Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP *Budgeted items not including financial institutions bailout expenditures. Sources: Economic Report of the President; Economic Indicators, various issues 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

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 Net U.S. Public Debt as a Percentage of GDP Source: U.S. Department of the Treasury

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

9 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 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

10 Evaluating the Rising Public Debt 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 International Example: Who Is Most Likely to Buy U.S. Government Bonds Indirectly? The U.S. Treasury typically auctions new debt securities once or twice per week. Most direct bids come from primary dealers of government securities. Indirect bidders include private pension funds, securities brokers and dealers, and insurance companies International Example: Who Is Most Likely to Buy U.S. Government Bonds Indirectly? Many indirect bids, however, come from international sources. Why do you suppose that the U.S. Treasury does not report each bidder by name? 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 Sources: Economic Report of the President; Economic Indicators, various issues; author s estimates

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 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

13 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 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 Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure

14 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 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 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

15 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 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: A Short-Run Deficit Boosting Stimulus is Set to Give Way to Deficit-Fighting Tax Increases In early 2008, Congress passed the Economic Stimulus Act in response to declining GDP growth rate. This law provided for $45 billion in government spending and authorized tax rebates aimed at stimulating consumptions pending and preventing a short-run recessionary gap from expanding

16 Policy Example: A Short-Run Deficit Boosting Stimulus is Set to Give Way to Deficit-Fighting Tax Increases However, worries over an increasing budget deficit prompted Congress to authorize a significant personal income tax increase at the end of This rate will raise the overall U.S. personal income tax burden by 25%. Higher tax rates could reduce long-run aggregate supply and dampen future real GDP growth How could the government reduce all its red ink? Increasing taxes for everyone Taxing only the rich Reducing expenditures Whittling away at entitlements 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

17 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 Figure 14-5 Components of Federal Expenditures as Percentages of Total Federal Spending Source: Office of Management and Budget 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

18 Question What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid? Issues and Applications: Are Budget and Trade Deficits Twins or Distant Cousins? In principle, an increase in the U.S. government budget deficit should be related to lower U.S. exports and hence a higher U.S. trade deficit. There is not always a direct relationship between the twin deficits, however, as can be seen in Figure With all other things being equal, when the U.S. budget falls deeper into deficit, the U.S. trade deficit will increase and when the U.S. budget deficit moves toward a surplus, the U.S. trade deficit will tend to decline Issues and Applications: Are Budget and Trade Deficits Twins or Distant Cousins? In the real world, however, other things are not always equal. A key factor that changed during the 1990s and the early 2000s was U.S. real GDP. Economic expansions during the 1990s and mid- 2000s brought about declines in the budget deficit, but at the same time the expansions boosted the trade deficit. The two deficits diverged

19 Issues and Applications: Are Budget and Trade Deficits Twins or Distant Cousins? Other factors can also contribute to this divergence such as labor and capital productivity increasing significantly. The fact that other factors influencing the two deficits, such as real GDP and investment expenditures, change over time explains why there is not a dollar-for-dollar relationship between the two deficits. Nevertheless, over a long period of time there should be a tendency for the trade deficit to rise when the government budget deficit increases, and vice versa 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

20 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 Summary Discussion of Learning Objectives Possible ways to reduce the government budget deficit Increase taxes Reduce expenditures by revising the terms of entitlement programs 14-59