Chapter 14. Introduction. Learning Objectives. Deficit Spending and The Public Debt. Explain how federal government budget deficits occur

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1 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

2 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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? Copyright 2008 Pearson Addison Wesley. All rights reserved

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) Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

4 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Public Deficits and Debts: Flows versus Stocks (cont'd) Public Debt A stock variable The total value of all outstanding government securities Copyright 2008 Pearson Addison Wesley. All rights reserved

5 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 14-1 Federal Budget Deficits and Surpluses Since 1940 Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP Copyright 2008 Pearson Addison Wesley. All rights reserved

6 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? Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

7 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It Copyright 2008 Pearson Addison Wesley. All rights reserved

8 Figure 14-3 Net U.S. Public Debt as a Percentage of GDP Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

9 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

10 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

11 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 14-4 The Distribution of Foreign Holdings of U.S. Treasury Securities Copyright 2008 Pearson Addison Wesley. All rights reserved 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? Copyright 2008 Pearson Addison Wesley. All rights reserved

12 Federal Budget Deficits in an Open Economy Question Is there a connection between the U.S. trade deficit and the federal government budget deficit? Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 14-5 The Related U.S. Deficits Copyright 2008 Pearson Addison Wesley. All rights reserved

13 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

14 Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure. Copyright 2008 Pearson Addison Wesley. All rights reserved

15 Growing U.S. Government 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

16 Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government How could the government reduce all its red ink? Increasing taxes for everyone Taxing only the rich Reducing expenditures Whittling away at entitlements Copyright 2008 Pearson Addison Wesley. All rights reserved

17 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

18 Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending Copyright 2008 Pearson Addison Wesley. All rights reserved

19 Growing U.S. Government 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. Copyright 2008 Pearson Addison Wesley. All rights reserved Growing U.S. Government Question What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid? Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

20 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

21 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

22 End of Chapter 14 Deficit Spending and The Public Debt 22