Chapter 16. Fiscal Policy and the Government Budget

Chapter 16 Fiscal Policy and the Government Budget

Preview To examine the relationship between the government budget and the growth of government debt To understand the long- and short-run economic effects of budget deficits, tax cuts, and increased government spending Copyright 2015 Pearson Education, Inc. All rights reserved. 16-2

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. 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-4

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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-5

Budget Deficits and Surpluses The formula for the government spending is: Deficit = spending - tax revenues = (G + TRANSFERS + INTEREST) - TAXES Copyright 2015 Pearson Education, Inc. All rights reserved. 16-10

Government Budget Constraint The government budget constraint for financing its deficit is: Deficit = change in amount of debt (bonds) in the hands of the public = ΔB Copyright 2015 Pearson Education, Inc. All rights reserved. 16-11

Size of the Government Debt In most countries, the government runs a deficit, so that the amount of worldwide government 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, the amount of debt relative to nominal GDP, reached 99% by 2012 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-12

FIGURE 16.2 U.S. Federal Deficit and the Size of U.S. Government Debt Relative to GDP, 1940-2013 (a) Source: Economic Report of the President, Table B-79 at www.gpoaccess.gov/eop tables09.html Copyright 2015 Pearson Education, Inc. All rights reserved. 16-13

FIGURE 16.2 U.S. Federal Deficit and the Size of U.S. Government Debt Relative to GDP, 1940-2013 (b) Source: Economic Report of the President, Table B-79 at www.gpoaccess.gov/eop tables09.html Copyright 2015 Pearson Education, Inc. All rights reserved. 16-14

International Comparison: The Size of Government Debt In 2011, many countries, particularly Japan and Greece, had much higher debt-to-gdp ratios in excess of 100%, while other countries, such as Australia and Luxembourg, had low debt-to-gdp ratios of less than 50% Copyright 2015 Pearson Education, Inc. All rights reserved. 16-15

Sovereign Debt Crises A sovereign debt crisis is a collapse in the market for country s government debt The crisis can occur if the debt-to-gdp ratio rises to the point where investors become concerned about the probability of default by the sovereign government: Copyright 2015 Pearson Education, Inc. All rights reserved. 16-17

Policy and Practice: The European Sovereign Debt Crisis Economic contraction in many European countries during the financial crisis of 2007-2009 led to surges in government deficits and the debt-to-gdp ratios In 2012, Greece s debt-to-gdp ratio climbed to 160% from about 100% in 2009 The sovereign debt crisis spread to Ireland, Portugal, Span, and Italy Copyright 2015 Pearson Education, Inc. All rights reserved. 16-18

Fiscal Policy and the Economy in the Long Run 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-19

Fiscal Policy and the Economy in the Long Run (cont d) 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) 2. Value of government capital investment 3. Indebtedness to foreigners 4. Redistribution effects 5. Debt intolerance 6. Negative incentive effects Copyright 2015 Pearson Education, Inc. All rights reserved. 16-21

Fiscal Policy and the Economy in the Long Run (cont d) 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 ( pork ) spending and unproductive 3. Indebtedness to foreigners 4. Redistribution effects 5. Debt intolerance 6. Negative incentive effects Copyright 2015 Pearson Education, Inc. All rights reserved. 16-22

Fiscal Policy and the Economy in the Long Run (cont d) 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 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-23

Fiscal Policy and the Economy in the Long Run (cont d) 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-24

Fiscal Policy and the Economy in the Long Run (cont d) 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-25

Fiscal Policy and the Economy in the Long Run (cont d) 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-26

Fiscal Policy and the Economy in the Short Run As we learned, 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-27

Expenditure and Tax Multipliers The expenditure multiplier is the change in equilibrium output given a change in government purchases: DY / D G = 1/(1 -mpc) The tax multiplier is the change in equilibrium output given a change in taxes, DY / DT It is always less in absolute value than the expenditure multiplier because the initial change in spending occurs through consumption expenditure Copyright 2015 Pearson Education, Inc. All rights reserved. 16-29

Expenditure and Tax Multipliers (cont d) Some economists argue that the expenditure multiplier may be smaller than 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-30

Policy and Practice: The 2009 Debate Over Tax-Based Versus Spending-Based Fiscal Stimulus When the Obama administration proposed a fiscal stimulus package to jump start the economy in 2009, there was a vigorous policy debate: Republicans favored tax cuts on the grounds that they would stimulate spending and reduce tax distortions Democrats favored increases in government spending because they would raise aggregate demand directly, and they would raise government investment in physical and human capital Christina Romer of the Council of Economic Advisors argued that the expenditure multiplier was 1.5, which was larger in absolute value than the tax multiplier Other economists came up with the opposite conclusion on the relative sizes of the expenditure and tax multipliers Copyright 2015 Pearson Education, Inc. All rights reserved. 16-31

Fiscal Multipliers at the Zero Lower Bound When the policy interest rate reaches the zero lower bound, a kinked AD curve occurs Two cases for the effects of expansionary fiscal policy on aggregate output depends: 1. Initially, the short-run AS curve intersects the AD curve where the policy rate is above zero 2. Initially, the short-run AS curve intersects the AD curve where the policy rate has hit the zero lower bound Copyright 2015 Pearson Education, Inc. All rights reserved. 16-32

Fiscal Multipliers at the Zero Lower Bound (cont d) Results: The fiscal multiplier is substantially larger when the policy rate has hit the zero lower bound than when it has not Copyright 2015 Pearson Education, Inc. All rights reserved. 16-34

Aggregate Supply and Fiscal Policy A 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, decreasing 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-35

Supply-Side Economics and Fiscal Policy Supply-siders emphasize the positive effects of tax cuts on aggregate supply They believe permanent cuts in tax cuts 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 cuts highly expansionary Copyright 2015 Pearson Education, Inc. All rights reserved. 16-37

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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-39

Policy and Practice: Two Expansionary Fiscal Contractions: Denmark and Ireland In 1982, the government of Denmark began a program to lower its budget deficit by 15% of GDP over the next 4 years: Instead of an economic contraction, real GDP remained high as consumer spending and investment rose In 1987, the government of Ireland launched a program to bring down its deficit by 7% of GDP: The Irish economy began to boom Both episodes support that fiscal retrenchments can be expansionary because they lower future taxes and raise aggregate demand and long-run aggregate supply Copyright 2015 Pearson Education, Inc. All rights reserved. 16-40

Policy and Practice: The Debate Over Fiscal Austerity in Europe European countries experiencing the sovereign debt crises have been required to reduce their budget deficits as a condition for financial assistance Arguments for austerity are: Improved budget conditions lower interest rates and thus stimulate aggregate demand Investment spending increases due to less uncertainty Lowered future taxes to finance current budget deficits encourage household and business spending Copyright 2015 Pearson Education, Inc. All rights reserved. 16-41

Policy and Practice: The Debate Over Fiscal Austerity in Europe (cont d) Arguments against austerity are: The effect of tight fiscal policy is subject to a high fiscal multiplier due to the policy rate s zero lower bound The budget deficit may not decline when declines in economic activity reduce tax revenue Declines in economic activity will reduce nominal GDP, and thus a rising debt-to-gdp ratio Copyright 2015 Pearson Education, Inc. All rights reserved. 16-42

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 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-43

Government-Issued Money Bonds to be issued to finance a budget deficit can be sold to either private investors or to the central bank: Deficit = ΔB = ΔB investors + ΔB central bank Copyright 2015 Pearson Education, Inc. All rights reserved. 16-44

Government-Issued Money (cont d) If the central bank pays for the bonds by printing money, or monetizing the debt: ΔB central bank = ΔM then: Deficit = ΔB = ΔB investors + ΔM Seignorage is the revenue the government receives from this issuance of currency. Copyright 2015 Pearson Education, Inc. All rights reserved. 16-45

Government-Issued Money (cont d) The inflation rate p in the long run will move closely with the growth rate of the money supply: p = ΔM/M which means that large budget deficits financed by printing money lead to high inflation Copyright 2015 Pearson Education, Inc. All rights reserved. 16-46

Revenue from Seignorage Multiplying both sides of the both equation by M: D M = p M Seignorage (in real terms) can be realized by dividing both sides by the price level, P: D M / P = p ( M / P) which is the inflation rate p 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 Copyright 2015 Pearson Education, Inc. All rights reserved. 16-47

Interaction between Monetary Policy and Fiscal Policy Monetary policy => Fiscal policy policy rate => cost of borrowing => budget deficit => government debt Fiscal Policy => Monetary Policy government debt => risk premium => interest rate for borrowing Copyright 2015 Pearson Education, Inc. All rights reserved. 16-48

Government Debt and Financing for Budget Deficit Domestic borrowing => interest rate => crowding-out for private sector Printing money => inflation Some Unpleasant Monetarist Arithmetic high government debt => borrowing (not printing money) => higher reel interest rate => higher government debt Copyright 2015 Pearson Education, Inc. All rights reserved. 16-49