Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 14 Deficit Spending and The Public Debt

Introduction Since 2007, the U.S. government’s average annual budget deficit—its flow of spending in excess of its flow of tax collections—has increased by about 400 percent. During the same period, the government’s net public debt—accumulated indebtedness—as a percentage U.S. GDP has risen by more than 100 percent. Why have U.S. government budget deficits and the net public debt increased so quickly? Reading this chapter will help you answer this question.

Learning Objectives Explain how federal government budget deficits occur Define the public debt and understand alternative measures of the public debt Evaluate circumstances under which the public debt could be a burden to future generations

Learning Objectives (cont'd) Analyze the macroeconomic effects of government budget deficits Describe possible ways to reduce the government budget deficit

Chapter Outline Public Deficits and Debts: Flows versus Stocks Government Finance: Spending More than Tax Collections Evaluating the Rising Public Debt Federal Budget Deficits in an Open Economy Growing U.S. Government Deficits: Implications for U.S. Economic Performance

Did You Know That... The typical baby born somewhere in the United States during the next few minutes already owes about $45,000 as the baby’s share of the U.S. government’s debt obligations? The rapidly accumulating debts is associated with the fact that the U.S. government has spent more than it collected in taxes. In this chapter, you will learn what the government does when it spends more than it receives.

Public Deficits and Debts: Flows versus Stocks Government Budget Deficit – Exists if the government spends more than it receives in taxes during a given period of time – Is financed by the selling of government securities (bonds)

Public Deficits and Debts: Flows versus Stocks (cont'd) The federal deficit is a flow variable, one defined for a specific period of time, usually one year If spending equals receipts, the budget is balanced If receipts exceed spending, the government is running a budget surplus

Public Deficits and Debts: Flows versus Stocks (cont'd) Balanced Budget – A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time

Public Deficits and Debts: Flows versus Stocks (cont'd) Government Budget Surplus – An excess of government revenues over government spending during a given period of time

Public Deficits and Debts: Flows versus Stocks (cont'd) Public Debt – A stock variable – The total value of all outstanding federal government securities

Government Finance: Spending More than Tax Collections Since 1940, the U.S. federal government has operated with a budget surplus in 13 years In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing

Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

Government Finance: Spending More than Tax Collections (cont'd) Question – Why has the government’s budget recently slipped from a surplus of 2.5% of GDP into a deficit of nearly 13% of GDP? Answer – Spending has increased at a faster page since the early 2000s – Recent income, capital gains, and estate tax cuts – Declines in economic activity in late 2000s reduced tax collections and raised federal expenditures

Evaluating the Rising Public Debt Gross Public Debt – All federal government debt irrespective of who owns it Net Public Debt – Gross public debt minus all government interagency borrowing

Evaluating the Rising Public Debt (cont'd) Some government bonds are held by government agencies – In this case, the funds are owed from one branch of the federal government to another – To arrive at the net public debt, we subtract interagency borrowings from the gross public debt

Evaluating the Rising Public Debt (cont'd) Tax revenues tend to be stagnant during times of slow economic growth Tax revenues grow more quickly when overall growth enhances incomes As long as spending exceeds revenues, the budget deficit will persist

Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It

Evaluating the Rising Public Debt (cont’d) During World War II, the net public debt grew dramatically After the war – It fell until the 1970s – Started rising in the 1980s – Declined once more in the 1990s – And recently has been increasing again

Figure 14-3 The Official Net U.S. Public Debt as a Percentage of GDP

Evaluating the Rising Public Debt (cont'd) The government must pay interest on the public debt outstanding The level of these payments depends on the market interest rate Interest payments as a percentage of GDP are likely to rise in the future

Evaluating the Rising Public Debt (cont'd) As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases Foreign residents, businesses and governments hold nearly 50% of the net public debt Thus, we do not owe the debt just to ourselves

Evaluating the Rising Public Debt (cont'd) If the economy is already at full employment, then further provision of government goods will crowd out some private goods Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector

International Policy Example: Why European Governments Are Paying More Interest on Debt Since 2009, bonds issued by several European governments, including those of Greece, Ireland, Italy, Portugal, Spain, and the United Kingdom, have received lower ratings from bond- rating agencies such as Standard & Poor’s. The lower ratings have raised the interest rates that governments of these nations have been required to pay to induce individuals and companies to continue buying their bonds.

Evaluating the Rising Public Debt (cont'd) Crowding-out may place a burden on future generations – Increased present consumption may crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth – Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt

Evaluating the Rising Public Debt (cont'd) Paying off the public debt in the future – If the debt becomes larger, each person’s share would increase – Taxes would be levied, and may not be assessed equally – A special tax could be levied based on a person’s ability to pay

Evaluating the Rising Public Debt (cont'd) Our debt to foreign residents – We do not owe all the debt to ourselves—what about the nearly 50% owned by foreign residents? – Future U.S. residents will be taxed to repay principal and interest – Portions of U.S. incomes will be transferred abroad

Evaluating the Rising Public Debt (cont'd) If deficits lead to slower growth rates, then future generations will be poorer Both present and future generations will be economically better off if – Government expenditures are really investments – The rate of return on such public investments exceeds the interest rate paid on the bonds

International Policy Example: How Do U.S. Residents’ Foreign Debt Obligations Compare? Today, a typical U.S. resident owes about twice as much as is owed abroad by a typical Hungarian or Japanese resident and about three times as much as the typical resident of Israel or Slovenia owes to people in other nations. At the same time, the foreign debt obligations of an average U.S. resident are less than those owed by residents of a number of other industrialized nations, including Austria, Belgium, Finland, France, Germany, Ireland, and the Netherlands.

Federal Budget Deficits in an Open Economy Question – Is there a relationship between the U.S. trade deficit and the federal government budget deficit?

Federal Budget Deficits in an Open Economy (cont'd) We know what a budget deficit is, but a trade deficit exists when the value of imports exceeds the value of exports Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two

Figure 14-4 The Related U.S. Deficits

Federal Budget Deficits in an Open Economy (cont'd) As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners The interest rate paid on bonds will need to be high enough to attract foreign investors

Federal Budget Deficits in an Open Economy (cont'd) If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports This shows that a U.S. budget deficit can contribute to a trade deficit

Growing U.S. Government Deficits: Implications for U.S. Economic Performance How do higher deficits affect the economy in the short run? – If the economy is below full-employment, the deficit can close the recessionary gap – If the economy is already at full-employment, the deficit can create an inflationary gap

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont’d) What are the long run macroeconomic effects of higher budget deficits? – In the long run, higher government budget deficits have no effect on equilibrium real GDP per year – Ultimately, therefore, government spending in excess of government receipts simply redistributes a larger share of real GDP per year to government- provided goods and services

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Thus, if the government operates with higher deficits over an extended period – The ultimate result is a shrinkage in the share of privately produced goods and services – By continually spending more than it collects, the government takes up a larger portion of economic activity

Why Not … eliminate deficits and the debt by taxing the richest 1 percent more? Confiscated the incomes of the richest 1 percent of U.S. residents would cover at most the typical budget deficit of a single year during the 2010s. Thus, temporarily raising taxes on the richest 1 percent of U.S. residents could not possibly eliminate all federal budget deficits or come close to paying off the net public debt.

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) How could the government reduce all its red ink? – Increasing taxes for everyone – Taxing only the rich – Reducing expenditures – Whittling away at entitlements

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) In considering how expenditures might be reduced, it is important to look at entitlements These are federal government payments that are legislated obligations and cannot be reduced or eliminated

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements – Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid Noncontrollable Expenditures – Government spending that changes automatically without action by Congress

Figure 14-5 Components of Federal Expenditures as Percentages of Total Federal Spending

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements are the largest component of the U.S. federal budget To make a significant cut in expenditures, entitlement programs would have to be revised

You Are There: Facing the Good News and the Bad By the time your graduation day arrives (good news), the federal government’s share of economic activity will have risen to more than 25 percent, up from a historical average of about 20.5 percent. This means that about 25 cents of each dollar of pretax earnings you will receive will be put to use by the federal government—rather than you, the income earner.

Issues & Applications: The United States Is Vying for the “Lead” in Deficits and Debt The U.S. budget deficit has risen so fast that the U.S. deficit- GDP ratio now “beats” the ratios of other nations. The government budget deficit as a percentage of GDP is now twice as high in the United States as in the euro area. The U.S. net public debt–GDP ratio is also “gaining.”

Figure 14-6 Government Budget Deficit and Net Public Debt as Percentages of GDP in Selected Nations

Summary Discussion of Learning Objectives Federal government budget deficits – Whenever the flow of government expenditures exceeds the flow of government revenues a budget deficit occurs The public debt – Total value of all government bonds outstanding – The federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt

Summary Discussion of Learning Objectives (cont'd) How the public debt might prove a burden to future generations – Higher taxes will reduce private consumption – Crowding out might reduce economic growth

Summary Discussion of Learning Objectives (cont'd) The macroeconomic effects of government budget deficits – Because higher government deficits are caused by increased government spending or tax cuts, they contribute to a short-run rise in total planned expenditures and aggregate demand – In the long run, increased deficits only redistribute resources from the private sector to the public sector

Summary Discussion of Learning Objectives (cont'd) Possible ways to reduce the government budget deficit – Increase taxes – Reduce expenditures by revising the terms of entitlement programs