17.2 U.S. Government Spending and Revenue Introduction. Chapter 17 The Government and the Macroeconomy. In 2008, federal spending

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1 Chapter 17 The Government and the Macroeconomy By Charles I. Jones Media Slides Created By Dave Brown Penn State University 17.2 U.S. Government Spending and Revenue In 2008, federal spending Was about 21 percent of GDP Was approximately $15,000 per person 17.5 percent of GDP was collected in the form of taxes Introduction In this chapter, we consider: Government spending, taxation, budget deficits, and the debt-gdp ratio. The government s inter-temporal budget constraint. The economic consequences of budget deficits. The fiscal problem of the twenty-first century: how to finance rising health expenditures. The government is allowed to borrow or lend in a given year but the government s budget must balance in present discounted value. Budget deficits today must be offset by budget surpluses. Recent forecasts suggest current U.S. policies are unsustainable and will result in an explosion of deficits. The budget balance The difference between tax revenues and spending A budget surplus Occurs when taxes exceed spending A budget deficit Occurs when spending exceeds taxes The government must borrow from lenders by selling bonds. A balanced budget Occurs when spending equals taxes 1

2 Spending and Revenue over Time World War II Taxes and expenditures rose sharply during the war. Spending and revenues were an approximately stable fraction of GDP after the war. Systematic budget deficits emerged starting around The net debt: Government debt that is held outside of the government. The government itself holds a large amount of bonds and including these would raise the debt-gdp ratio to 94 percent (2010 data). The Debt-GDP Ratio Government debt The outstanding stock of bonds that have been issued in the past 2005 The debt-gdp ratio was 37 percent 2010 The debt-gdp ratio was 60 percent Half of the debt is owed to U.S. entities and the other half to foreigners International Evidence on Spending and Debt Among the richer OECD countries, the United States has a lower than average: Government spending to GDP ratio Debt-GDP ratio 2

3 15.3 International Evidence on Spending and Debt South Korea The debt-gdp ratio is negative. The government is a net lender. Norway Negative debt-gdp ratio Saves its surpluses 17.4 The Government Budget Constraint The flow version of the government budget constraint holds in each period. Standard accounting identity says the sources of funds to the government must equal the uses of funds. Government purchases Transfer payments Interest payments on debts Taxes New borrowing Change in the money stock Assume for this chapter The change in the stock of money is zero. Transfer payments are zero. Therefore: 3

4 The primary deficit: It excludes spending on interest. The total deficit: The intertemporal budget constraint is derived from substituting the secondperiod budget constraint into the firstperiod budget constraint. It implies that uses must equal sources, but now in present discounted value. The Intertemporal Budget Constraint Suppose an economy exists for only two periods. The budget constraint for period 1 is: Rewriting the intertemporal budget constraint by collecting the tax and spending terms on the same side of the equation: The government s budget must balance. It balances not period by period, but in present discounted value. The government must have surpluses in the future to pay off deficits today. The Intertemporal Budget Constraint The budget constraint for period 2 must equal zero: no one is willing to lend to the government in the final period because loans can never be repaid: 17.5 How Much Can the Government Borrow? When considering economic consequences of deficits and debts, we must consider Economic growth The possibility of high inflation or default Intergenerational equity The extent to which deficits crowd out investment 4

5 Economic Growth and the Debt-GDP Ratio The amount the government can borrow is limited by: The amount it can credibly be expected to pay back Partly on how large the economy s GDP is Stock of debt can grow time if GDP is growing even faster. The debt-gdp ratio will fall if this happens. Generational Accounting When the government borrows: The beneficiaries of borrowing may not be the same people who repay the debt. Example: World War II The generation that fought the war made large sacrifices. Future generations benefited from them. Future generations paid for the war. High Inflation and Default If the debt-gdp ratio becomes too high: Lenders worry about the ability of the government to repay. Investors demand higher interest rates. If lenders stop: The government may print more money to satisfy the budget. This generates inflation. Generational accounting: An approach that seeks to calculate the extent to which current policies pass on tax burdens to future generations High and rising debt-gdp ratios imply higher taxes rates on future generations. High Inflation and Default Default: Government declares it will not repay certain debts Or will repay them at less than face value Deficits and Investment The national income identity Investment equals total saving: Add and subtract tax revenues from the left side of the equation: 5

6 Investment can be financed through Saving from the private sector Government saving Saving by foreigners Disposable income The difference between income net of taxes and consumption Crowding out Budget deficits may absorb some of the savings and reduce investment The Fiscal Problem of the Twenty-First Century In the coming decades, with current policies in place, it is likely that: The share of government spending will rise to 40 percent of GDP. Annual budget deficits could reach 20 percent of GDP. Ricardian equivalence implies: Holding the present value of government spending constant, the timing of taxes does not affect consumption. Budget deficits need not crowd out investment. Economists still debate the extent to which budget deficits crowd out investment. The Problem The reason for the unsustainability of current policies: Rise in spending on Social Security, Medicare, and Medicaid. Increased generosity of entitlement programs Larger fraction of the population qualifying By 2070: Health and retirement spending will exceed the percentage of GDP collected in taxes (assuming current policies). Although Social Security accounts for some of the rise, the main factor is health care expenditures. Health care costs will grow at a rate 1 percentage point faster than the rate of GDP growth. 6

7 Case Study: Financing the Social Security Program Social Security Financed by an employment tax on wage income Pay-as-you-go is the system current workers pay the benefits of the current recipients. Possible Solutions Could the budget be balanced? Tax revenues would have to rise by about 9 percent of GDP by Health spending is growing in all advanced economies. As baby boomers retire: The ratio of workers to retirees will fall. Increased taxes and/or reduced benefits will be needed. Yet, the problem of funding Social Security is much less severe than the problem facing health expenditures. 7

8 Explanations for increasing health care expenses: Expensive medical technologies are raising expenditures. Waste and fraud in the health system probably does not explain increasing expenses. health spending is growing in virtually all rich countries Conclusion Economic growth is a factor that helps to solve budgetary problems. Yet, economic growth cannot help to solve the problem of rapidly growing expenditures on health care. A better alternative story: Consumption is subject to diminishing returns. Adding additional months of life is not subject to diminishing returns. More time to enjoy high incomes is increasingly valuable. Thus, health spending will rise by more than consumption. Summary The current U.S. fiscal situation is typical of recent decades: Spending and taxes are low relative to most other rich countries. A modest budget deficit The debt-gdp ratio is not especially high. It is likely optimal for health care expenditures to rise as a fraction of GDP as incomes rise. Possible solutions, other than raising taxes, include: Private health insurance Mandated savings in individual healthspending accounts These may create new problems of their own. Summary Absent changes in policy, this situation is likely to change for the worse in coming decades. Main reason: growth in transfer payments Health care and Social Security 8

9 The government s intertemporal budget constraint: Says that the budget must balance in a present discounted value sense The present discounted value of spending must equal the present discounted value of taxes. This concludes the Lecture Slide Set for Chapter 17 Macroeconomics Second Edition by Charles I. Jones W. W. Norton & Company Independent Publishers Since 1923 Very large debts are potentially problematic. Dangers of default and high inflation There is no magic level of debt at which this occurs. Important considerations on debt and default An economy s size and growth prospects The ability of the government to collect taxes and restrain spending The extent to which government deficits crowd out investment is unclear. The Ricardian equivalence argument Private spending should rise to offset temporary deficits, holding spending constant. This offset seems to be incomplete in the short run as government saving and the investment rate move together. 9