Chapter 14: Fiscal Policy, Deficits, and Debt

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Fiscal Policy Fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Fiscal Policy and the AD-AS Model The Council of Economic Advisors (CEA) provides advice and assistance on economic matters to the president. Discretionary fiscal policy is initiated on the advise of the CEA and changes to government spending and taxes are at the option of the Federal government. Nondiscretionary fiscal policy are changes that occur automatically.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Expansionary Fiscal Policy When the economy is in recession, expansionary fiscal policy may be in order. Expansionary fiscal policy is an increase in government spending, a decrease in taxes, or some combination of the two for the purpose of increasing aggregate demand and real output. If the Federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Expansionary Fiscal Policy

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Contractionary Fiscal Policy When demand-pull inflation occurs, contractionary fiscal policy may help to control it. Contractionary fiscal policy is a decrease in government spending, an increase in taxes, or some combination of the two for the purpose of decreasing aggregate demand and halting inflation. Contractionary fiscal policy may create a budget surplus.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Contractionary Fiscal Policy

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Built-In Stability A built-in stabilizer is anything that increases the government’s budget deficit (or reduce its budget surplus) during a recession and increase its budget surplus (or reduce its budget deficit) during an expansion without requiring explicit action by policymakers. Examples include personal income taxes, payroll taxes, corporate income taxes, sales taxes and excise taxes.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Built-In Stability Taxes reduce spending and aggregate demand; in addition, reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping. Built in stability has reduced the severity of business fluctuations in the U.S..

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evaluating Fiscal Policy In evaluating the status of fiscal policy, we must adjust deficits and surpluses to eliminate automatic changes in tax revenues and compare the sizes of the adjusted budget deficits (or budget surpluses) to the level of potential GDP. The standardized budget (or full- employment budget) is used for this purpose.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evaluating Fiscal Policy The standardized budget is a measure of what the Federal budget deficit or surplus would be with existing tax rates and government spending programs if the economy had achieved its full-employment GDP in the year. The standardized budget deficit is zero at the full-employment output level.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evaluating Fiscal Policy If the economy slides into a recession, the standardized budget deficit is still zero since government expenditure equals the tax revenue that would be forthcoming at the full-employment GDP.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evaluating Fiscal Policy The deficit that arises in a recession is a cyclical deficit and is not caused by government discretionary fiscal policy. A cyclical deficit is a Federal deficit that is caused by a recession and the consequent decline in tax revenue.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Evaluating Fiscal Policy If a standardized deficit of zero in one year is followed by a standardized budget deficit in the next year, then fiscal policy is expansionary. Conversely, if a standardized deficit of zero in one year is followed by a standardized budget surplus in the next year, then fiscal policy is contractionary.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Problems, Criticisms, and Complications A number of significant problems may arise in enacting and applying fiscal policy such as: problems of timing political considerations future policy reversals offsetting state and local finance crowding-out effect

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Problems, Criticisms, and Complications Timing issues include recognition lag, administrative lag and operational lag. Political considerations include political business cycles: the alleged tendency of presidential administration and Congress to create macroeconomic instability by reducing taxes and increasing government spending before elections and to raise taxes and reduce expenditures after elections.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Problems, Criticisms, and Complications Consumption smoothing arises when taxpayers believe policy is only temporary and is likely to be reversed in the future. The fiscal policies of state and local governments are frequently pro-cyclical; they worsen rather than correct recession or inflation.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Problems, Criticisms, and Complications Another potential flaw in fiscal policy is the crowding-out effect: a decrease in private investment caused by higher interest rates that result from the Federal government’s increased borrowing to finance deficits (or debt).

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Current Thinking on Fiscal Policy Despite the many complications of fiscal policy, the current popular view is that fiscal policy can help “push the economy” in an intended direction but cannot “fine- tune it” to a specific outcome. Monetary policy is considered by many to be the best month-to-month stabilization tool for the U.S. economy.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Public Debt The national or public debt is essentially the total accumulation of the deficits (minus the surpluses) the Federal government has incurred through time. Deficits have emerged because of war financing, recessions, fiscal policy, and lack of political will by Congress.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Public Debt The total public debt represents the total amount of money owed by the Federal government to the owners of government securities. U.S. securities are Treasury bills, Treasury notes, Treasury bonds, U.S. savings bonds, and I-bonds issued by the Federal government to finance expenditures that exceed tax revenues.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Public Debt The U.S. and other highly productive nations can incur and carry a large public debt more easily than poor nations. Many economists conclude that the annual interest charge accruing on the bonds sold to finance the debt is the primary burden of the U.S. debt.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin False Concerns The large U.S. debt does not threaten to bankrupt the Federal government, leaving it unable to meet its financial obligations. One reason is the public debt is easily refinanced. Another reason is the Federal government has the option to impose new taxes or increase existing tax rates to finance the debt.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Substantive Issues The distribution of ownership of government securities is highly uneven, where ownership of the public debt is concentrated among wealthier groups. A large public debt may impair economic growth if higher taxes for interest payments on government securities dampen incentives to bear risk, to innovate, to invest, and to work.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Substantive Issues External public debt, or the part of the public debt owned by foreigners, is an economic burden to Americans. Another potentially serious problem is that the financing of the large public debt transfers a real economic burden to future generations by passing a smaller stock of capital goods on to them.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Long-Run Fiscal Imbalance: Social Security The most significant fiscal issue in the U.S. is the long-term funding imbalance in the Social Security and Medicare programs. There is a severe long-run shortfall in Social Security funding because of growing payments to retiring baby boomers. The accumulation of monies in the Social Security trust fund will be greatly inadequate for paying the retirement benefits to future retirees.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Long-Run Fiscal Imbalance: Social Security The problem is one of demographics; the percentage of the American population age 62 and older will rise substantially over the next several decades.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Long-Run Fiscal Imbalance: Social Security To help make Social Security financially sound, some suggest investing all or part of the trust fund in corporate stocks and bonds, since these presumably have higher returns relative to U.S. securities. Another option is to increase the payroll tax immediately and allocate the new revenues to individual accounts.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Long-Run Fiscal Imbalance: Social Security Yet, another idea is to place half the payroll tax into accounts that individuals would own, maintain, and bequeath. New options for reform will likely develop over time; nevertheless, society will eventually need to confront the problem of trillions of dollars of unfunded Social Security liabilities.