1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 12 The Government Budget, the Public Debt, and Social Security

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-2 Key Questions What difference does it make if the government runs a surplus or deficit? What will be the long-run consequence of allowing the post-2001 deficits to continue? Will a persistent government budget deficit cause the public debt to explode without limit?

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-3 Fiscal Policy, Growth, and Economic Welfare Recall: We argued that an increase in the national saving rate is likely to stimulate economic growth. – NS can be increased by fiscal policy via higher taxes or lower spending. The Rate of Time preference is the extra amount a consumer would be willing to pay to be able to obtain a given quantity of consumption goods now rather than a year from now. – The U.S. saves too little if the rate at which individuals discount future consumption is less than the rate of return on private investment. Should fiscal policy be used to increase NS or should nothing be done?

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-4 Figure 12-1 Two Alternative Paths of Consumption per Person

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-5 Government Budget Deficit, NS, and Growth Recall: National Saving is the sum of private and government saving: NS = S + (T – G) Recall: The magic equation: NS = I + NX – If NS   Either I or NX must fall The only way I can be maintained if NS falls is if the fall in NS is completely offset by a decline in foreign investment or increase in foreign borrowing. This is possible in a small open economy. In a large open economy, if NS  must cause both a decline in I and NX. To stimulate growth via higher investment spending, NS must be raised either through higher private saving or higher government saving.

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-6 Government Investment vs. Consumption The ultimate aim of policies to boost NS is to increase the ratio of investment to real GDP. Two Types of Investment – Private investment on machines and structures – Government investment, for instance, on education and highways Government investment generates a future return consisting of the benefits to future generations created by the investment. Government consumption provides only current benefits. Is government debt harmful? – The true burden of government debt depends on the extent to which government debt is used to finance government investment or consumption.

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-7 Measuring Government Debt One measure of indebtedness is the ratio of nominal federal debt to nominal GDP: D/PY – The government deficit = G – T = ∆D – The growth rate of D/PY = d – (p + y) Stability in indebtedness requires that the growth rate of D/PY equals zero  d = p + y The Allowable Deficit that keeps the debt-GDP ratio constant is: dD = (p + y)D – Implication: The debt-GDP ratio remains constant if the deficit equals the outstanding debt times the growth rate of nominal GDP.

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-8 International Perspective: The Debt-GDP Ratio: How Does the United States Compare?

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-9 When Is There Too Much Government Debt? There is a limit to the size of government debt since the government must pay interest on the debt held by the public. – The government can meet its interest bill forever by issuing more bonds without increasing the debt-GDP ratio only if the economy’s real growth rate of output equals or exceeds its real interest rate.

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-10 Figure 12-2 The Ratio of U.S. Government Debt to GDP, 1790–2008 Sources: Historical Statistics of the United States Millennial Edition and Economic Report of the President 2008. Details in Appendix C-4.

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-11 Figure 12-3 Federal Government Revenues and Expenditures as a Percent of Natural GDP, 1960–2008 Sources: Bureau of Economic Analysis NIPA Tables and Congressional Budget Office. Details in Appendix C-4.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-12 Figure 12-4 Components of Federal Government Expenditures as a Percent of Natural GDP, 1960–2007 Source: Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-13 Supply Side Economics Supply Side Economics, embraced by the Reagan administration, posits that high tax rates stifle individual initiative and saving. – Income tax reduce the after-tax reward to work and saving. – An increase in the after-tax reward to work and saving creates a significant increase in the amount of work and saving. – The resulting increase in work and saving is enough to boost tax revenue as compared to before the tax cuts. Empirical problems with supply side economics: – After Reagan’s tax cuts in 1981, the labor force participation grew more slowly. – The personal saving rate fell after rising in rising during 1977-81. – Productivity growth grew only moderately, and not nearly as quickly as after the tax hikes of 1993.

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-14 Figure 12-5 The Laffer Curve

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-15 Barro-Ricardo Equivalence Theorem In 1974, Robert Barro argued that changes in taxes would not affect output because tax cuts are balanced by an increase in saving rate rather than an increase in consumption. – Tax cuts financed by deficit spending require higher future tax payments to meet the interest on the public debt, so people will save for those future obligations. Criticisms – Decision horizons are often quite short. – 1981 tax cuts did not see an increase in saving.

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-16 The Social Security Debate The Social Security system is the basic source of retirement benefits for U.S. households. – The “Pay-As-You-Go” system works by collecting taxes from workers and uses those taxes to pay benefits to retired people and their spouses. Surplus taxes are put into the Social Security trust fund and invested in government bonds. Problem: Because of the growing number of retirees and increased longevity, the Social Security system will run continuous deficits after 2018 and will run out of money after 2046.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-17 Social Security Solvency Solutions Is there even a problem? – The projections of future benefits payments and tax receipts are based on very conservative estimates. Population may be growing faster than assumed. Immigration is assumed to be fixed. Wage growth is assumed to be very slow. Inflation may also be highly variable. A few possible solutions to the problem: – Raise the ceiling on wages subject to the payroll tax. – Increase the retirement age from 67 to 70. – Increase payroll taxes by 0.5%. Should Social Security funds be invested in the stock market?

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-18 Figure 12-6 Social Security Outlays, Revenues, and the Trust Fund, 1985–2085 (1 of 2)

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-19 Figure 12-6 Social Security Outlays, Revenues, and the Trust Fund, 1985–2085 (2 of 2) Source: Congressional Budget Office. Details in Appendix C-4.

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-20 Figure 12-6 Social Security Outlays, Revenues, and the Trust Fund, 1985–2085 Source: Congressional Budget Office. Details in Appendix C-4.

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-21 Chapter Equations

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-22 Chapter Equations