Fiscal Policy: A Summing Up

The Government Budget Constraint 26-1 The Arithmetic of Deficits and Debt The budget deficit in year t equals: is the government debt at the end of year t-1. is government spending during year 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.

The Government Budget Constraint The government budget constraint states that the change in government debt during year t is equal to the deficit during year t: change in the debt interest payments Primary deficit Debt at the end of year t equals:

Inflation Accounting and the Measurement of the Deficits Official Budget Deficit and Inflation-Adjusted Budget Deficit for the United States, 1968-2001 Official measures of the deficit include actual (nominal) interest payments and are therefore incorrect. The correct measure of the deficit is sometimes called the inflation-adjusted deficit.

Current Versus Future Taxes Full Repayment of the debt in year 2: Replacing B2=0 and B1=1, and rearranging: In words, to repay the debt fully in year 2, the government must run a primary surplus equal to (1+r).

Full Repayment in Year 2 Tax Cuts, Debt Repayment, and Debt Stabilization (a) If debt is fully repaid during year 2, the decrease in taxes of 1 in year 1 requires an increase in taxes equal to (1+r) in year 2.

Full Repayment in Year 5 Tax Cuts, Debt Repayment, and Debt Stabilization (b) If debt is fully repaid during year 5, the decrease in taxes of 1 in year 1 requires an increase in taxes equal to (1+r)4 during year 4.

Full Repayment in Year t Debt at the end of year t1 is given by: In year t, when the debt is repaid, the budget constraint is: Debt at the end of year t equals zero: which implies that the necessary surplus in year t to repay the debt must be:

Debt Stabilization in Year 2 Tax Cuts, Debt Repayment, and Debt Stabilization (c) If debt is stabilized from year 2 on, then taxes must be permanently higher by r from year 2 on.

Conclusions From the preceding arithmetic of deficits and debt we can draw these conclusions: If government spending is unchanged, a decrease in taxes must eventually be offset by an increase in taxes in the future. The longer the government waits to increase taxes or the higher the real interest rate, the higher the eventual increase in taxes.

Conclusions From the preceding arithmetic of deficits and debt we can draw these conclusions: The legacy of part deficits is higher government debt. To stabilize the debt, the government must eliminate the deficit. To eliminate the deficit, the government must run a surplus equal to the interest payments on the existing debt.

The Arithmetic of the Debt to GDP Ratio The debt-to-GDP ratio, or debt ratio gives the evolution of the ratio of debt to GDP.

The Evolution of the Debt to GDP Ratio The change in the debt ratio over time is the difference between the real interest rate and the growth rate times the initial debt ratio, plus the ratio of the primary deficit to GDP. If GDP grows (g increases), the ratio of debt to GDP will grow more slowly (at a rate equal to rg).

The Evolution of the Debt-to-GDP Ratio in OECD Countries We can use the equation above as a useful guide to the evolution of the debt-to-GDP ratio over the last four decades in the OECD countries. The debt to GDP ratio will be larger: the higher the real interest rate the lower the growth rate of output, the higher the initial debt ratio, The higher the ratio of the primary deficit to GDP.

The Evolution of the Debt-to-GDP Ratio in OECD Countries In the 1960s, GDP growth was strong. As a result, rg was negative. Countries were able to decrease their debt ratios without having to run large primary deficits. In the 1970s, rg was again negative due to very low interest rates, leading to a further decrease in the debt ratio.

The Evolution of the Debt-to-GDP Ratio in OECD Countries In the 1980s, real interest rates increased and growth rates decreased, thus, debt ratios increased rapidly. Throughout the 1990s, interest rates remained high and growth rates low. However, most countries ran primary surpluses sufficient to imply a steady decline in their debt ratios.

The Evolution of the Debt-to-GDP Ratio in OECD Countries Table 26-1 Debt and Primary Surpluses for the United States, the European Union, and Selected Countries, 1981-2000 (Percent of GDP) Debt/GDP (%) Primary Surplus/GDP (%) 1981 1995 2000 United States 25.8 49.2 34.7 4.8 European Union 24.0 53.5 47.7 4.1 Italy 56.4 108.7 98.7 6.0 Belgium 82.2 125.2 103.0 6.6 Greece 26.1 103.8 7.4

Four Issues in Fiscal Policy 26-2 The Ricardian Equivalence, further developed by Robert Barro, and also known as the Ricardo-Barro proposition, is the argument that, once the government budget constraint is taken into account, neither deficit nor debt has an effect on economic activity. Consumers do not change their consumption in respond to a tax cut if the present value of after-tax labor income is unaffected. The effect of lower taxes today is cancelled out by higher taxes tomorrow.

Deficits, Output Stabilization, and the Cyclically Adjusted Deficit The fact that budget deficits have adverse effects implies that deficits during recessions should be offset by surpluses during booms. The deficit that exists when output is at the natural level of output is called the full-employment deficit. Other terms used are midcycle deficit, standardized employment deficit, structural deficit, or cyclically adjusted deficit.

Deficits, Output Stabilization, and the Cyclically Adjusted Deficit A reliable rule of thumb is that a 1% decrease in output leads automatically to an increase in the deficit of 0.5% of GDP. If output is, say 5% below its natural level, the deficit as a ratio of GDP will therefore be about 2.5% larger than it would be if output was at the natural level of output. This effect of the deficit on economic activity has been called the automatic stabilizer.

Wars and Deficits The economic burden of a war affects consumers and firms differently depending on how the war is paid for. If the government relies more (less) on deficit financing and less on tax increases, the decrease in consumption will be smaller (larger) and the decrease in investment will be larger (smaller).

Reducing Tax Distortions Very high tax rates can lead to very high economic distortions. People will work less, and engage in illegal, untaxed activities. Tax smoothing is the idea that it is better to maintain a relatively constant tax rate, to smooth taxes. Tax smoothing implies large deficits when government spending is high and small surpluses the rest of the time.

The Dangers of Very High Debt The higher the ratio of debt to GDP, the larger the potential for catastrophic debt dynamics. Expectations of higher and higher debt give a hint that a problem may arise, which will lead to the emergence of the problem, thereby validating the initial expectations. Debt repudiation consists of canceling the debt, in part or in full.

The U.S. Budget 26-3 The government uses its own accounting system to present and discuss the budget in Congress. An alternative and more economically meaningful accounting system is provided in the national income and product accounts (NIPA). The two systems differ in how they treat assets and government investment.

Corporate profit taxes 2.0 Indirect taxes 1.0 Table 25-2 U.S. Federal Budget Revenues and Expenditures, Fiscal Year 2001 (Percent of GDP) Revenues 20.1 Personal taxes 10.0 Corporate profit taxes 2.0 Indirect taxes 1.0 Social insurance contributions 7.0 Expenditures, excluding interest payments 16.2 Consumption expenditures 5.0 Defense 3.3 Nondefense 1.7 Transfers 8.1 Grants to state/local governments 2.6 Other spending 0.5 Primary surplus (1) (+ sign: surplus) 3.9 Net interest payments (2) 2.4 Real interest payments (3) Inflation components 0.7 Official surplus: (1) minus (2) 1.5 Inflation adjusted surplus: (1) minus (3) 2.2 Memo item. Debt to GDP ratio 31.0 Source: Survey of Current Business, December 2001. Tables 3-2 and 3-7. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The U.S. Budget Gross debt is the sum of the federal government’s financial liabilities. At the end of 2001, gross debt was $5.6 trillion, or 55% of GDP. Net debt is the debt held by the public. At the end of 2001, net debt was $3.1 trillion, or 31% of GDP. The remaining $2.5 trillion was held by government agencies.

The U.S. Budget In 2001, the primary surplus was 3.9% of GDP, and nominal interest payments on the public debt were 2.4%. Therefore, the official surplus was 3.9%  2.4% = 1.5%. Real interest payments were 1.7% of GDP. Therefore, the correct measure of the surplus was 3.9%  1.7% = 2.2%.

The U.S. Budget The budget outlook is pessimistic because: There is pressure to cut taxes. The U.S. economy slowed down, leading to lower tax revenues. There has been an increase in government spending since September 11, 2001. Many economists believe that larger surpluses would be desirable. The U.S. private saving rate is 16.5% of GDP, or 4.5% below the average for OECD countries. Higher surpluses mean higher public saving.

Surpluses and the Aging of America Table 26-3 Projected Spending on Social Security, Medicare, and Medicaid, 1998-2060 (Percent of GDP) 1998 2010 2040 2060 Social Security 4.0 5.0 7.0 Medicare 2.0 3.0 6.0 Medicaid 1.0 Total 10.0 16.0 17.0 Source: “The Economic and Budget Outlook, Fiscal Years 1998-2060.” Congressional Budget Office, January 1999. Table 2-5. Entitlement programs are programs that require the payments of benefits to all who meet the eligibility requirements established by the law.

Surpluses and the Aging of America Entitlement spending to GDP is projected to increase for these reasons: The Aging of America: The old age dependency ratio—the ratio of the population 65 years old or more to the population between 20 and 64 years old—is projected to increase from about 20% in 1998 to above 40% in 2060. The steadily increasing cost of health care. Even if all expenditures other than transfers were eliminated, projected entitlement spending would still exceed revenues.

Surpluses and the Aging of America Since 1983, Social Security contributions have exceeded benefits. The Social Security Trust Fund is an account where the surpluses have been accumulating, and now equal 12% of GDP. The Social Security Trust Fund is expected to reach 20% of GDP in 2020, then to decline and be equal to zero by 2030.

Key Terms government budget constraint, primary deficit (primary surplus), inflation-adjusted deficit, debt-to-GDP ratio, debt ratio, Ricardian equivalence, Ricardo-Barro proposition, full-employment deficit, midcycle deficit, standardized employment deficit structural deficit, cyclically adjusted deficit, automatic stabilizer, tax smoothing, debt repudiation, entitlement programs, Social Security Trust Fund,