Chapter 30

Chapter 30Fiscal Policy, Deficits & DebtBecause of economic instability the Federal government sometimes uses budgetary actions to try to stimulate the economy or rein in inflation.

Fiscal policy is carried out by Congress. Such countercyclical fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth. In this case the adjective fiscal simply means a 12 month financial period running from Oct. 1 to Sept. 30.

3 Budgetary Outcomes1. Balanced Budget- When federal tax revenues equal government spending. This never happens.2. Budget Surplus- When federal tax revenues exceed government spending. This happens occasionally, the last time was in 2001.

3. Budget Deficit- When federal tax revenues are less than government spending. The federal budget has been in deficit approximately 85% since WWII.

Discretionary fiscal policy- involves changes in government spending and taxes and is at the discretion or option of the Federal government.

These changes do not occur automatically.

Expansionary Fiscal Policy- consists of government spending increases, tax reductions, or both, designed to increase (AD) and therefore raise real GDP, employment and get the economy out of a recession. (G, T) AD = C + Ig + G + Xn

A decrease in taxes will increase after tax income thereby increasing (C) and the increase in government spending (G) will create new jobs and people will spend that income which will ripple through the economy.

Price levelReal GDPASAD1P1Q1QfAD2P2For example taxes/government spending C, G AD real GDP, employment and Pl.

If the Federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit where government spending is greater than tax revenues. If (Q1) = $490 and (Qf) = $510, then how much do we need to increase (G) spending to bring the economy back to full employment assuming a (MPC) of .75?Multiplier = ______G by __________

How much of a tax cut would be necessary to achieve the same result? Remember the tax multiplier is always 1 less than the spending multiplier and negative.Tax Multiplier = _____T by _______

Key Point: The tax cut must be larger than the proposed increase in government spending to achieve the same result.

Balanced Budget Multiplier- says we can stimulate the economy without pushing the budget toward deficit by increasing government spending and taxes by the same amount. The balanced budget multiplier is = 1.

For example Lets assume we G and T by $10. With a (MPC) = .80, how much will real GDP increase?

Multiplier = _______ GDP by ________

Crowding Out Effect- the main problem with using expansionary fiscal policy is that when you cut taxes and/or increase government spending it pushes the budget toward deficit. In essence the government is spending money it doesnt have so it borrows. Borrowing drives up interest rates and crowds out some private investment (Ig) spending. With investment demand (Id) weak during a recession, the crowding out effect is likely to be small, but when the economy is operating near or at capacity, investment demand (Id) is likely to be quite strong so that crowding out is a more serious problem.

Price levelReal GDPASAD1P1Q1AD2P2Q2AD3Q3P32. Contractionary Fiscal Policy- When demand-pull inflation occurs, a restrictive or contractionary fiscal policy may help control it. We could cut government spending, raise taxes, or a combination of the two. The combination of T and G will push the budget toward surplus. (AD) will shift to the left lowering real GDP and employment and decreasing the price level.

For example taxes/government spending C, G AD real GDP, employment and Pl.

Price levelReal GDPASAD1P1Q1AD2P2Q2Policy Options? (G or T)- Which is preferable as a means of eliminating recession or inflation? The answer depends largely on ones view as to whether the government is too large or too small.

If you believe that the size of government should be preserved or expanded, you would choose spending increases during recession and tax increases during inflationary periods. This is the Democratic view.However, if you believe that government should be small and less intrusive, you would favor tax cuts during recession and spending cuts during times of inflation. This is the Republican view.

Non-discretionary Fiscal PolicyThis is fiscal policy that does not require Congress to act. These programs simply take effect when the economy moves toward recession or inflation. This built-in stability results from 2 main sources.

To some degree, government tax revenues change automatically over the course of the business cycle and in ways that stabilize the economy. The actual U.S. tax system is such that net tax revenues vary directly with GDP. Net taxes are tax revenues minus transfers and subsidies. Personal income taxes have progressive rates and thus generate more than proportionate increases in tax revenues as GDP expands. Furthermore, as GDP rises and more goods and services are purchased, revenues from corporate income taxes and from sales taxes and excise taxes also increase. And similarly, revenues from payroll taxes rise as economic expansion creates more jobs.

Conversely, when GDP falls, tax receipts from all these sources also fall.

Transfer payments behave in the opposite way from tax revenues. Unemployment compensation payments and welfare payments decrease during economic expansion and increase during economic contraction.

Automatic or Built-in Stabilizers- are anything that increases the governments budget deficit or reduces its budget surplus during a recession and increases its budget surplus or reduces its budget deficit during an expansion without requiring explicit action by Congress. Real GDPGovt spending & Tax revenuesGTGDP1GDP2GDP3DeficitSurplusAs you can see tax revenues automatically increase as GDP rises during prosperity, and since taxes reduce household and business spending, they restrain the economic expansion. The graph above reveals that the size of the automatic budget deficits or surpluses, and therefore the amount of stability, depends on the responsiveness of tax revenues to changes in GDP. If tax revenues change sharply as GDP changes, the slope of the T line will be steep and the vertical distances between the T and G lines will be large. If tax revenues change very little when GDP changes, the slope will be gentle and built-in stability will be low. The steepness of the T line will depend on the tax system itself. In a progressive tax system, the average tax rate rises with GDP. This simply means that as income rises so does the percentage you pay in taxes.

Our federal income tax is an example.

In a proportional tax system, the average tax rate remains constant as GDP rises. This is sometimes called a flat tax or fair tax.

The medicare tax is proportional.

In a regressive tax system, the average tax rate falls as GDP rises. This tax tends to hurt poor families more than wealthier families.

An example is the state sales tax.

Key Point: Built-in stabilizers can only dampen, not counteract, swings in real GDP. Discretionary fiscal policy therefore is needed to counter a recession or inflation of any magnitude.

Budget deficits & Projections

Problems, Criticisms, & Complications1. Problems of TimingRecognition Lag- is the time between the beginning of recession or inflation and the certain awareness that it is actually happening. The economy is often 4 to 6 months into a recession or inflation before the situation is clearly discernible in the relevant statistics.

Administrative Lag- is the time the need for fiscal policy is recognized and the time action is taken. Political gridlock and partisan politics often slow the wheels of government.

Operational Lag- is the time between when action is taken and the time that action affects output, employment, or the price level. Although changes in tax rates can be put into effect relatively quickly once new laws are passed, government spending on public works requires long planning periods and even longer periods of construction. Consequently, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool.2. Political Considerations- fiscal policy is conducted in the political arena. In short, elected officials may cause so-called political business cycles resulting from election motivated fiscal policy, rather than from inherent instability in the private sector.

3. Future Policy Reversals- fiscal policy may fail to achieve its intended objectives if households expect future reversals of policy. A tax reduction thought to be temporary may not increase present consumption spending and (AD) by as much as our simple model suggests.

Ex. Payroll tax holiday. 4. Offsetting State & Local Finance- The fiscal policies of state and local governments are frequently pro- cyclical, meaning that they worsen rather than correct recession or inflation. Unlike the Federal government, most state and local governments face constitutional or other legal requirements to balance their budgets.

5. Crowding-Out Effect- An expansionary fiscal policy may increase the interest rate and reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy.

U.S. Public DebtThe U.S. national debt or public debt, is essentially the accumulation of all past Federal deficits and surpluses. The deficits have greatly exceeded the surpluses and have emerged mainly from war financing, recessions, and fiscal policy. Lets put the size of the debt into perspective.

Who Owns the Debt?Ownership- The total public debt of $11.9 trillion represents the total amount of money owed by the Federal government to the holders of U.S. securities: financial instruments issued by the Federal government to borrow money to finance expenditures that exceed tax revenues.

These U.S. securities are of 4 types. Treasury bills, which are short term securities, Treasury notes, which are medium term securities, Treasury bonds, which are long term securities, and U.S. savings bonds, which are long term, nonmarketable bonds.

The figure above shows that the public held 57% of the Federal debt in 2009 and that federal government agencies and the Federal Reserve held the remaining 43%. Public ownership consists of individuals here and abroad, state and local governments, and U.S. financial institutions.

Foreigners held about 29% of the total U.S. public debt in 2009. Of the $3.7 trillion of debt held by foreigners, China held 24%, Japan held 21%, and oil-exporting nations held 6%.

Debt and GDP- A wealthy, highly productive nation can incur and carry a large public debt much more easily than a poor nation can. A more meaningful measure of the public debt relates it to an economys GDP. See figure 30.7 for an illustration.

Interest Charges- Many economists conclude that the primary burden of the debt is the annual interest charge accruing on the bonds sold to finance the debt. In 2009 interest on the total public debt was $187 billion.

False Concerns About the DebtBankruptcy- The large U.S. public debt does not threaten to bankrupt the Federal government. There are 2 main reasons for this. First, as long as the U.S. public debt is viewed by lenders as manageable and sustainable, the public debt is easily refinanced. Of course, refinancing could become an issue with a high enough debt-to-GDP ratio. Some nations such as Greece have run into this problem. Secondly, the federal government has the constitutional authority to levy and collect taxes. A tax increase is a government option for gaining sufficient revenue to pay interest and principal on the public debt.Burdening Future Generations- In 2009 public debt per capita was $37,437. The United States owes a substantial portion of the public debt to itself. Although that part of the public debt is a liability to Americans, as taxpayers, it is simultaneously an asset to Americans as holders of government securities. To eliminate the American-owned part of the public debt would require a gigantic transfer payment from some Americans to other Americans.

Real Issues Concerning the DebtIncome Distribution- The distribution of ownership of government securities is highly uneven. In general, the ownership of the public debt is concentrated among wealthier groups, who own a large percentage of all stocks and bonds. Income is transferred from people who, on average, have lower incomes to the higher income bondholders. If greater income equality is one of societys goals, then this redistribution is undesirable.

Incentives- As stated earlier the current public debt requires annual interest payments of $187 billion per year. With no increase in the size of the debt, that interest charge must be paid out of tax revenues. Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work. In this way, a large public debt may impair economic growth and therefore impose a burden of reduced output on future generations.

Foreign-Owned Public Debt- The 29% of the U.S. debt held by citizens and institutions of foreign countries is an economic burden to Americans. The payment of interest and principal to foreigners enables them to buy some of our output, which would otherwise go to Americans.

Crowding-Out Effect Revisited- A potentially more serious problem is the financing, and refinancing, of the large public debt, which can transfer a real economic burden to future generations by passing on to them a smaller stock of capital goods. If the amount of current investment crowded out is extensive, future generations will inherit an economy with a smaller production capacity and, other things equal, a lower standard of living.

EX. If government borrowing increases the interest rate from 6% to 10%, investment spending will fall from $25 billion to $15 billion. As a result, $10 billion of private investment has been crowded out. With less new capital being produced, the economys economic growth rate slows down.

Expected rate of return & real interest rateInvestmentId6%2510%15Social Security & MedicareThe American population, on average, is getting decidedly older. In the future, more people will be receiving Social Security benefits and Medicare for longer periods. Each persons benefits will be paid for by fewer workers. The number of workers per Social Security and Medicare beneficiary was roughly 5:1 in 1960. Today it is 3:1, and by 2040 it will be only 2:1

The combined cost of the Social Security and Medicare programs was 7.6% of GDP in 2008, and that percentage is projected to grow to 12% of GDP in 2030 and 17.2% of GDP in 2083.

Social Security is the major public retirement program in the U.S. The program costs $615 billion annually and is financed by a 12.4% tax on earnings up to $106,800 in 2009. Half the tax, 6.2%, is paid by the worker and the other half by the employer. Social Security is largely an annual pay-as-you-go plan, meaning that most of the current revenues from the Social Security tax are paid to current Social Security retirees. The Medicare program is the U.S. health care program for people age 65 and older in the U.S. It is also a pay-as-you-go plan, meaning that current medical benefits are being funded by current tax revenues from the 2.9% Medicare tax on earnings. 1.45% of the tax is paid by the worker and the other 1.45% is paid by the employer. The financial status of Medicare is much worse than that of Social Security.

To restore long-run balance to Social Security and Medicare, the Federal government must either reduce benefits or increase revenues. The (SSA) says that bringing revenues and payments back into balance would require a 16% cut in benefits, a 13% increase in taxes, or some combination of the two.

Here are several options that have been proposed.Increasing the retirement age.Increasing the payroll tax, especially on higher income groups.Disqualifying wealthy people from receiving benefits.Place tax revenues into an account that you control, rather than the government.