Chapter 15: Government Debt & Budget Deficit

Deficit & Debt Federal deficit occurs when government spending (purchases & transfers) exceeds tax receipts Federal debt is the amount of funds the government must borrow to cover its deficit Money is owed to government agencies, private individuals and firms, and foreign individuals, companies, and countries

Size of Debt Size of the debt is measured by the debt ratio: government debt as a percentage of the GDP Debt ratio in U.S. in 1998 = 65, less than Belgium (125), Italy (123), and Japan (93), but more than Australia (40), Finland (59) and U.K. (60)

The Debt-GDP Ratio

The Debt-GDP Ratio (US)

Change in Debt Ratio Revolutionary War = 45 Civil War = 40 WW I = 40 WW II = 120 In recent years, the ratio increased from 22 in 1970 to 40 in 1980 to 60 in 1990 and to 65 in 1998

Deficit & Debt Projections 2000 2010 2020 2030 2040 2050 T 21 20 G 22 25 30 43 Deficit -1 1 5 10 23 Debt 42 17 40 93 206 All variables are expressed as percentage of GDP

Deficit & Debt Projections Receipt shall stay constant at 20% Spending shall rise from 21% in 2000 to 22% in 2030 to 43% in 2050 Deficit shall rise from –1% in 2010 to 23% in 2050 Debt falling to 17% in 2020 shall rise to 93% in 2040 and 206% in 2050

Measurement Problem 1 Calculating deficit in “nominal” value results in an overstatement of the amount of debt required to cover the deficit Deficit and debt must be expressed in “real” values; i.e. adjusted for inflation

Measurement Problem 2 Unlike private accounting procedures, government debt does not measure the difference between government assets and liabilities Capital budgeting, that accounts for assets and liabilities, measures changes in capital

Measurement Problem 3 Government debt does not account for Social Security liabilities Unlike public debt, the government can refuse making Social Security payments if funds are insufficient

Measurement Problem 4 Deficit and debt move pro-cyclically: they fall during a slump and rise during a boom To solve this problem, the government calculates a “cyclically-adjusted” budget deficit, which the amount of deficit at full employment

Traditional View of Debt A tax cut increases disposable personal income, consumption spending, employment, and income. A higher AD results in higher income and real interest rate as the IS curve shifts to the right. In the long-run, price level will rise, lowering SRAS to reduce income to its full employment level

Ricardian View of Debt: Analysis Forward-looking consumers may not spend their additional disposable income to cause growth With a tax cut, people shall expect a future spending cut as the government would not want to run a deficit Likewise, consumers view debt accumulation as a sign of higher future taxes, thus saving money for that purpose

Ricardian View of Debt: Case Study In early 1992, President Bush reduced the federal income tax withholding requirement to increase disposable income and stimulate growth Forward-looking consumers expecting larger tax liabilities in April, did not spend the additional income to help the economy grow

Ricardian View of Debt: Burden Parents learning that debt operates as a negative future transfer payment, would not spend as much during their lifetime Parents save and accumulate assets to pass money on to their children and grand children

Position of the FED A substantial reduction in long-term prospective deficit will significantly lower long-term inflation expectations Inflationary financed growth results in increased tax revenues and government spending to cause deficit and inflation Deficit financed growth increases debt with no real income growth, but higher inflation