10. Fiscal Policy and the Government Budget

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1 10. Fiscal Policy and the Government Budget 1

2 The Government Budget The government s budget is affected by: Government spending (outlay) Tax revenue (income) 2

3 Government Spending Major components of government spending: 1. Government purchases (G), which consist of i) government consumption spending on other goods and services (G C ), and ii) government investment spending on capital goods like highways and school (G I ), so that G=G C +G I 2. Transfer payments (TRANSFERS): direct payments to individuals, e.g., unemployment insurance benefits, social security benefits and Medicare, which are known as entitlements as they are set by earlier legislation 3. Grants in aid: federal assistance to state and local governments 4. Net interest payments (INTEREST): interest payments to holders of government debt like U.S. Treasury bonds, less interest paid to the government for debts such as student loans 3

4 Revenue Major components of tax revenue (TAXES): 1. Personal taxes: income and property taxes 2. Contributions for social insurance, like Social Security taxes 3. Taxes on production and imports, like sales tax and taxes on imports (tariffs) 4. Corporate taxes: taxes on the profits on businesses 5. Grants in aid: the federal assistance to state and local governments and revenue from them 4

5 Budget Deficits and Surpluses The formula for the government spending is: Deficit = spending - tax revenues = (G + TRANSFERS + INTEREST) - TAXES When spending exceeds the revenue, the government runs a budget deficit - Federal budget deficits are the norm in the United States, except for the late 1990s 5

6 Government Budget Constraint In addition to raise taxes, governments can finance a deficit by borrowing (issuing bonds) and printing money. The government budget constraint for financing its deficit is: Deficit = [change in amount of debt (bonds) in the hands of the public] + [change in amount of money (currency and the reserves in banks)] = ΔB + ΔM 6

7 Government Budget Constraint The Arithmetic of Deficits and Debt The budget deficit in year t equals: deficit rb G T t t 1 t t B t-1 is government debt at the end of year, t 1 or, equivalently, at the beginning of year t ; r is the real interest rate, which we shall assume to be constant here. Thus rb t-1 equals the real interest payments on the government debt in year t. G t is government spending during year t. T t is taxes minus transfers during year t. In words: The budge deficit equals spending, including interest payments on the debt, minus taxes net of transfers. 7

8 Government Budget Constraint The Arithmetic of Deficits and Debt - Note two characteristics of deficit rb G T t t 1 t t We measure interest payments as real interest payments rather than as actual interest payments. The correct measure of the deficit is sometimes called the inflationadjusted deficit. G does not include transfer payments. 8 of 46

9 Government Budget Constraint The Arithmetic of Deficits and Debt - The government budget constraint states that the change in government debt during year t is equal to the deficit during year t: B B Deficit t t 1 t - Using the definition of the deficit deficit rb G T t t 1 t t - we can rewrite the government budget constraint as B B rb G T t t 1 t 1 t t 9

10 Government Budget Constraint The Arithmetic of Deficits and Debt - It is often convenient to decompose the deficit into the sum of two terms: Interest payments on the debt, rb t-1 The difference between spending and taxes, G t T t. This term is called the primary deficit (equivalently, T t G t is called the primary surplus). 10

11 Government Budget Constraint The Arithmetic of Deficits and Debt Using this decomposition, we can rewrite B B rb G T t t 1 t 1 t t Change in the debt Interest payments Primary deficit B B r B G T t t 1 t 1 t t Primary Deficit B (1 r) B G T t t 1 t t 11 of 46

12 Size of the Government Debt In most countries, the government runs a deficit, so that the amount of worldwide government debt has been growing over time Growth of U.S. government debt over time: The United States finances its government deficits primarily by selling bonds, so that is a correlation between budget deficits and the stock of government debt as a percentage of GDP The debt-to-gdp ratio reached 53% by

13 Fiscal Policy and the Economy in the Long Run Two sides to the debates over the burden of long run debt on future generations - Why High Government Debt Is Not a Burden 1. Spending in government capital like highways and schools, and human capital like education, will increase the economy s future productivity, so that additional tax revenues will go toward paying down the government debt 2. Because government debt is financed by government bonds, bond holders will eventually be repaid with future tax payments 13

14 Fiscal Policy and the Economy in the Long Run Why High Government Debt Is a Burden 1. Reduction in national saving Because national saving (NS) based the uses-of-saving identify is: NS = (Y - T - C) + (T-G) = I + NX Private saving Gov t saving Crowding out occurs when a reduction in national saving as a result of budget deficits means lower private investment (I) and worse off of future generations 2. Value of government capital investment 3. Indebtedness to foreigners 4. Redistribution effects 5. Debt intolerance 6. Negative incentive effects 14

15 Fiscal Policy and the Economy in the Long Run Why High Government Debt Is a Burden 1. Reduction in national saving 2. Value of government capital investment Most government spending is for government consumption like on medical care and military personnel, not capital stock Government investment even in capital is viewed as wasteful spending and unproductive 3. Indebtedness to foreigners 4. Redistribution effects 5. Debt intolerance 6. Negative incentive effects 15

16 Fiscal Policy and the Economy in the Long Run Why High Government Debt Is a Burden 1. Reduction in national saving 2. Value of government capital investment 3. Indebtedness to foreigners National saving can lower net exports (in addition to investment) and thus increase U.S. indebtedness to foreigners The largest holders of U.S. government debt are now the Chinese 4. Redistribution effects 5. Debt intolerance 6. Negative incentive effects 16

17 Fiscal Policy and the Economy in the Long Run Why High Government Debt Is a Burden 1. Reduction in national saving 2. Value of government capital investment 3. Indebtedness to foreigners 4. Redistribution effects Because the people paying taxes may not be the same people who hold government bonds, so that rising government debt involves a transfer of wealth in the future to government bondholders, who tend to be richer 5. Debt intolerance 6. Negative incentive effects 17

18 Fiscal Policy and the Economy in the Long Run Why High Government Debt Is a Burden 1. Reduction in national saving 2. Value of government capital investment 3. Indebtedness to foreigners 4. Redistribution effects 5. Debt intolerance The fear of debt repudiation failure of paying it back may rise as government debt gets very large Some countries may experience debt intolerance with a high likelihood of default even at low debt-to- GDP ratios 6. Negative incentive effects 18

19 Fiscal Policy and the Economy in the Long Run Why High Government Debt Is a Burden 1. Reduction in national saving 2. Value of government capital investment 3. Indebtedness to foreigners 4. Redistribution effects 5. Debt intolerance 6. Negative incentive effects Raising taxes to pay down the debt involves distortions, such as a lower incentive to work due to higher income tax, and few capital stock investment due to a higher capital gains tax Tax wedges the difference between what people earn before and after taxes reduce the efficiency and economic growth over time 19

20 Fiscal Policy and the Economy in the Short Run The fiscal policy has important effects on the economy in the short run - expansionary fiscal policy, either a cut in taxes or an increase in government spending, raises aggregate demand - According to our aggregate demand supply analysis, if aggregate output falls below its potential Y P, then expansionary fiscal policy can cause a shift of the AD curve to the right so that aggregate output rises back up to potential while inflation also rises 20

21 Expenditure and Tax Multipliers The expenditure multiplier is the change in equilibrium output given a change in government purchases : Y / G 1 / (1 mpc) The tax multiplier is the change in equilibrium output given a change in taxes, Y / T = -mpc/(1-mpc) Y - It is always less in absolute value than the expenditure multiplier because the initial change in spending occurs through consumption expenditure / T 21

22 Expenditure and Tax Multipliers Some economists argue that the expenditure multiplier may be smaller shows because: 1. Real interest rates may rise when government purchases rise, resulting in crowding out on investment, consumption spending, and net exports 2. If households and businesses anticipate that larger government deficits will lead to higher taxes in the future, then they will reduce their spending to pay for the anticipated tax increases 22

23 Aggregate Supply and Fiscal Policy A temporary cut in the payroll tax (e.g., Social Security tax) acts just like a temporary positive supply shock The tax cut lowers the wage cost of production, increasing aggregate supply, so the short-run aggregate supply curve shifts downward and to the right The tax cut also increases disposable income and thus consumption expenditure, shifting the AD curve rightward Suppose aggregate output is below its potential Y P, then a payroll tax cut would raise aggregate output back to Y P, while inflation may rise or fall 23

24 Supply-Side Economics and Fiscal Policy Supply-siders emphasize the positive effects of tax cuts on aggregate supply They believe permanent cuts in tax (income tax cut)not only raises aggregate demand but also have a permanent positive effect on aggregate supply because they induce more investment and greater work effort Rightward shifts in both AD and LRAS curves make the cuts in tax highly expansionary - supply-siders believe that the expansion in aggregate output from the tax cut is so large that the tax revenue could go up despite the tax cuts since the tax base (the income on which taxes are levied) will rise: cutting taxes would not increase the budget deficit 24

25 Balancing the Budget: Expansionary or Contractionary? Balancing the budget may have beneficial future effects that will influence the behavior of households and businesses today - A sustained cut in the budget deficit, either from a decrease in government spending or higher taxes, implies that future taxes will be lower - Because lower taxes will increase capital formation and decrease distortions in the economy, measures to balance the budget can act just like a permanent positive supply shock resulting in the high level of aggregate output from the increase in the long run aggregate supply 25

26 Budget Deficits and Inflation Expansionary fiscal policy that increases the budget deficit leads to higher inflation in the short run In the long run, inflation will not rise even under the expansionary fiscal policy as long as monetary policy focuses on price stability and takes steps to keep inflation under control However, large budget deficits make it difficult for central banks to control inflation in the long run 26

27 Government-Issued Money Recall that a government budget deficit is financed by either selling government bonds (ΔB) or printing money (ΔM) - Monetizing the debt occurs when a central bank issues money to finance the government debt Inflation rate ( ) in the long run will move closely with the growth rate of the money supply: ΔM/M which means that large budget deficits financed by printing money lead to high inflation 27

28 Revenue from Seignorage Multiplying both sides of the both equation by M: M M Seignorage is the revenue of issuing currency, which (in real terms) can be realized by dividing both sides by the price level, P: M / P ( M / P) which is the inflation rate multiplied by the amount of money balances, M/P - Seignorage is an inflation tax because the resulting higher inflation lowers the real value of money balances for their holders 28

29 Budget Deficits and Ricardian Equivalence Traditionally fiscal policy and budget deficits affect the economy in both short and the long run But, some type of fiscal policy and budget deficits resulting from tax cuts may not have much impact on the economy: Ricardian equivalence - Ricardian equivalence implies that tax cuts have no effect on spending and national saving - It assumes that consumers are very forward looking, so that they will recognize that a budget deficit today in the form of a tax cut will have to be paid for by higher future taxes (or lower future disposable income). As a result, consumers will not change their spending in face of a tax cut 29

30 Implications of Ricardian Equivalence 1. Tax cuts will not increase aggregate demand because they will have little impact on household spending 2. Budget deficits as a result of tax cuts do not affect national saving, and so they will not be a burden on future generations 3. Budget deficits as a result of tax cuts do not raise inflation because consumer spending remains unchanged, and households will use their increased saving to buy government bonds so that the government does not have to print money to finance its budget deficit 30

31 Bottom Line on Ricardian Equivalence The debate on the traditional view and the Ricardian equivalence of the tax cuts depends on how consumers behave. - If consumers are forward looking, not subject to borrowing constraints, and care a lot about their children and their children s children, then Ricardian equivalence will hold and tax cuts will not burden future generations - On the other hand, if households are narrowminded or borrowing-constrained or don t care about future generations, then tax cuts will raise consumer spending, lower national saving, and put a burden on future generations 31

32 Fiscal Policy Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy 32

33 How Nondiscretionary Fiscal Policy Works Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically. The welfare state and the progressive income tax serve as the built-in policies. If the economy is in recession, those who lose their jobs are granted unemployment and welfare benefits and they owe less in taxes. If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits. 33

34 How Discretionary Fiscal Policy Works If we are in a recession the fiscal policy to stimulate the economy would consist of Increases in government spending Decreases in taxes If we are in an inflationary period the fiscal policy to contract the economy would consist of Decreases in government spending Increases in taxes 34

35 Evaluating Nondiscretionary Fiscal Policy Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions. 35

36 The Mistiming of Discretionary Fiscal Policy Recognition Lag: the time it takes to measure the state of the economy Administrative Lag: the time it takes for Congress to agree on a course of action with the president Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy 36

37 Political Problems with Fiscal Policy Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts. The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections 37

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