1 Federal Budgets and Public Policy Chapter 32 © 2006 Thomson/South-Western

2 Federal Budget Process  The federal budget is a plan for government outlays and revenues for a specified period, usually a year  Federal outlays include both  Government purchases  Transfer payments

3 Exhibit 1: Defense’s Share of Federal Outlays Declined Since 1960 and Redistribution Increased

4 President’s Role in Budget Process  President’s budget process usually begins a year before it is submitted to Congress  The congressional budget cycle begins in late January once Congress gets The Budget of the United States Government from the president

5 Congressional Role in the Budget Process  Once the president’s proposed budget gets to Congress, budget committees in both the House and the Senate rework until they agree on total outlays, spending by major category, and expected revenues  This agreement, called a budget resolution, establishes a framework to guide spending and revenue decisions  The fiscal year runs from October 1 of one year to September 30 of the following year

6 The Budget  The size and composition of the budget and the difference between outlays and revenues measure the budget’s fiscal impact  When outlays exceed revenues, the budget is in deficit  Stimulates aggregate demand in the short run, but reduces national saving that in the long run could impede economic growth  When revenues exceed outlays, the budget is in surplus  Dampens aggregate demand in the short run, but enhances domestic saving that in the long run could promote economic growth

7 Problems with the Federal Budget Process  Continuing Resolutions instead of Budget Decisions  Budgets typically run on continuing resolutions: agreements to allow agencies to spend at the rate of the previous year’s budget  Overlapping Committee Authority: requires the executive branch to defend the same section of the president’s budget before several committees in both House and the Senate

8 Problems with the Federal Budget Process  Lengthy budget process  Uncontrollable budget items  No separate capital budget  Overly detailed budget

9 Possible Budget Reforms  The annual budget could be converted into a two-year budget, or biennial budget.  Simplify the budget document by concentrating only on major groupings and eliminating line items  Sort federal spending into an operating budget and a capital budget

10 Fiscal Impact of the Federal Budget  When government outlays—purchases plus transfer payments—exceed government revenue, the result is a budget deficit  Deficit financing has been justified for outlays that increase the economy’s productivity— capital outlays for investments

11 Budget Philosophies and Deficits  Annually balanced budget: budget philosophy prior to the Great Depression aimed at matching annual revenues with outlays, except during times of war  Cyclically balanced budget: budget philosophy calling for budget deficits during recessions to be financed by budget surpluses during expansions  Functional finance: budget philosophy using fiscal policy to achieve the economy’s potential GDP, rather than balancing budgets either annually or over the business cycle

12 Exhibit 2: After Decades of Budget Deficits, Surpluses Appeared from 1998 to 2001, But Deficits Are Back Surplus Deficit

13 Why Have Deficits Persisted?  One widely accepted model of the public sector assumes that elected officials try to maximize their political support, including votes and campaign contributions  Voters like public spending programs but hate paying taxes, so spending programs win support and taxes lose it

14 Crowding Out  Crowding out: The displacement of interest-sensitive private investment that occurs when higher government deficits drive up interest rates  An increase in the deficit or a decrease in the surplus reduces the supply of national savings  Higher interest rates crowd out some private investment, thereby reducing the stimulating effect of the government’s deficit

15 Crowding In  Crowding in: The potential for government spending to stimulate private investment in an otherwise dead economy  An important determinant of investment is business expectations and government stimulus may improve expectations so firms more willing to invest

16 Budget Surplus  In the early 1990s, outlays started to decline relative to GDP, while revenues increased: deficit declined and, by 1998, created a budget surplus  What turned a hefty deficit into a surplus, and why has the surplus slipped lately?  Tax increases in the 1990s  Vigorous recovery during the 1990s  Slower growth in federal outlays  Reversal in 2001

17 Exhibit 3: During the 1990s, Federal Outlays Declined Relative to GDP and Revenues Increased, Turning Deficits into Surpluses, But Not For Long

18 Exhibit 4: Government Outlays as a Percentage of GDP Declined Between 1994 and 2004 in Major Economies Except Japan

19 National Debt  The national debt is a stock variable measuring the net accumulation of past deficits, the total amount owed by the federal government  Changes over time  U.S. debt levels compared to those in other countries  Interest on the debt  Prospect of paying off the debt

20 National Debt  Distinction between the gross debt and the debt held by the public  Gross debt includes U.S. Treasury securities purchased by various federal agencies: debt owed to the government itself  Debt held by the public includes debt held by households, firms, banks, and foreign entities

21 Exhibit 5: Federal Debt Held by the Public as Percent of GDP Was Slightly Lower in 2004 Than in 1940

22 Exhibit 6: Relative to GDP, U.S. Net Public Debt in 2004 Was About Average for Major Economies

23 Interest on the National Debt  Because most federal securities are short term, the national debt “turns over” rapidly  Nearly half the debt is refinanced every year – debt service payments are quite sensitive to movements in the interest rate  Interest payments peaked at 15.4% of outlays in 1996 and have declined to only 6.7% of the federal budget by 2004

24 Exhibit 7: Interest Payments of Federal Debt Held by the Public as a Percentage of Federal Outlays Peaked in 1996

25 We Owe It To Ourselves  It is often argued that the debt is not a burden to future generations because – although they must service the debt, those same generations receive the debt service payments  It’s true that if U.S. citizens forgo present consumption to buy bonds, they or their heirs will receive the interest payments – debt service payments stay in the country

26 Foreign Ownership of Debt  The “we owe it to ourselves” argument does not apply to the portion of the national debt purchased by foreigners  Foreigners who buy U.S. government bonds forgo present consumption and are paid back in the future  Reliance on foreigners increases the burden of the debt on future generations because future debt service payments no longer remain in the country

27 Crowding Out and Capital Formation  Government borrowing can drive up interest rates and crowd out some private investment by making it more costly  The long-run effect of deficit spending depends on how the government spends the borrowed funds  If they are used in public investments there may be no harmful effects on the economy’s long-run productive capabilities  If they go toward current consumption, less capital formation will result

28 Crowding Out and Capital Formation  With less investment today, there will be a smaller endowment of capital equipment and technology  Despite the large federal deficits of the 1980s and early 1990s, public investments in capital declined