Copyright © 2002 by Thomson Learning, Inc. Chapter 12 Budget Balance and Government Debt Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN X

Copyright © 2002 by Thomson Learning, Inc. Budget Terms  A Budget Surplus exists when Tax Revenues are greater than Expenditures and is the difference between the two.  A Budget Deficit exists when Expenditures are greater than Tax Revenues and is the difference between the two.  The National Debt is the sum of deficits minus the sum of all surpluses since 1776.

Copyright © 2002 by Thomson Learning, Inc. Figure 12.1A Federal Budget Outlays, Receipts, Deficits, and Surpluses, Billions of Dollars Year 1,500 1,400 1,300 1,200 1, Outlays Receipts Surplus Deficit ,700 1,800 1, Deficit Surplus

Copyright © 2002 by Thomson Learning, Inc. Figure 12.1 B Federal Budget Outlays, Receipts, Deficits and Surpluses, Federal Deficit as a Percent of GDP, 1960 – Surplus Deficit

Copyright © 2002 by Thomson Learning, Inc. Surpluses, Deficits and the Debt as a Percentage of GDP  Nominal figures are less important than their relationship to the size of the economy.  Economists tend to look at these figures as a percentage of GDP.

Copyright © 2002 by Thomson Learning, Inc. Controversies Over What To Do With the Current Surpluses Options  Pay off portions of the national debt  Cut taxes  Increase spending on programs  Set surpluses aside to make Social Security and Medicare more solvent

Copyright © 2002 by Thomson Learning, Inc. High-Employment Deficit or Surplus  The budget balance is altered significantly by the state of the economy.  If GDP is rising quickly, then fewer people are drawing on the welfare state and more are paying taxes.  The high-employment deficit or surplus is what the surplus would be if unemployment were low.  Economists often prefer this measure to the actual level of the deficit or surplus when advocating policy.

Copyright © 2002 by Thomson Learning, Inc. Measuring Budget Balance  On Budget vs Off Budget  Social Security and the Post Office are run off budget.  Since 1982 Social Security has run a considerable surplus.  This money is loaned to the rest of the on budget side of the government with the bonds issued to the Social Security Administration being the Social Security Trust Fund.

Copyright © 2002 by Thomson Learning, Inc. Unified Budget  The Unified Budget is the sum of the on- and off-budget deficits and surpluses.  If this is a net deficit, then the government must borrow new money from the public.  If it is a net surplus, then it is a net provider of capital to the private sector.

Copyright © 2002 by Thomson Learning, Inc. National Income and Product Accounts Budget  The NIPA Budget does not include any transactions that finance preexisting debts such as outlays for deposit insurance.

Copyright © 2002 by Thomson Learning, Inc. Real Surpluses and Deficits  Real Surpluses and Real Deficits are expressed in inflation-adjusted terms.

Copyright © 2002 by Thomson Learning, Inc. Economic Effects of Federal Budget Deficits  Unified budget deficits require additional borrowing.

Copyright © 2002 by Thomson Learning, Inc. Figure 12.2 Government Demand for Loanable Funds and the Market Rate of Interest Interest Rate Loanable Funds per Year 0 L1L1 E' L2L2 i2i2 i1i1 E S D 1 +  D G D1D1

Copyright © 2002 by Thomson Learning, Inc. Ricardian Equivalence  Ricardian Equivalence is the view that deficits do not alter interest rates because citizens today see that deficits today will be financed with higher taxes tomorrow and citizens save in order to have the funds to pay those higher taxes.

Copyright © 2002 by Thomson Learning, Inc. Figure 12.3 Ricardian Equivalence: Deficits Do Not Affect Interest Rates Interest Rate 0 L1L1 E' L2L2 L3L3 E'' i2i2 i1i1 Loanable Funds per Year LL D 1 +  D G E S D1D1 S'

Copyright © 2002 by Thomson Learning, Inc. Economic Effects of Federal Budget Surpluses  Unified budget surpluses allow government to provide capital to the loanable funds market.

Copyright © 2002 by Thomson Learning, Inc. Figure 12.4 Impact of a Budget Surplus on Credit Markets Interest Rate Loanable Funds per Year 0 LL D E' E I1I1 I2I2 L1L1 L2L2 S S' = S 1 +  L

Copyright © 2002 by Thomson Learning, Inc. Budget Balance, National Saving, and Economic Growth  An increase in the deficit contributes to a decrease in national savings while an increase in a surplus contributes to a increase in national savings.  Increases in national savings increases the potential for the economy to grow.

Copyright © 2002 by Thomson Learning, Inc. Figure 12.5 The National Savings Rate and its Components, (Measured as a Ratio of Savings to Gross National Product)* Gross Saving Corporate and Other Private Saving Personal Saving Gross Government Saving 25 Percent Recession

Copyright © 2002 by Thomson Learning, Inc. Incidence of Deficit Finance  Lower growth rates imply lower incomes for future generations.  If Ricardian Equivalence holds, then this is not the case.  Deficits may also change political equilibrium so that there are increases in government infrastructure that could lean to increased future growth.

Copyright © 2002 by Thomson Learning, Inc. The Government Debt  Mid-2000  Federal Debt $5.66 trillion  State and Local Debt $1 trillion

Copyright © 2002 by Thomson Learning, Inc. Figure 12.6 Federal Debt Held by the Public as a Share of GDP (By fiscal year) Percentage of GDP

Copyright © 2002 by Thomson Learning, Inc. Net Federal Debt  The Net Federal Debt is the portion of the debt not held by the federal government.

Copyright © 2002 by Thomson Learning, Inc. Gross public Debt of the US Treasury by Holder July 31, 2000 HolderAmount of Debt (Billions of Dollars) Percent of Total U.S. Govt. Agencies Trust Funds and Federal Reserve 2, Private Investors3, Total5,

Copyright © 2002 by Thomson Learning, Inc. Net Public Debt of the U.S. Treasury by Holder (Percent Distribution) December 1999 HolderPercentage of Total Depositors and Institutions7.6 Mutual Funds10.9 Insurance Companies4.2 Pension Funds13.8 State and Local Governments6.6 Foreign and International39.2 Other Investors17.7 Total100

Copyright © 2002 by Thomson Learning, Inc. Internal and External Debt  The Internal Debt is the portion of the debt owed to our own citizens.  The External Debt is the portion of the debt owed to people other than U.S. citizens.

Copyright © 2002 by Thomson Learning, Inc. State and Local Borrowing  Bonds are issued by state and local governments to fund large projects.  They are rated by financial companies for their riskiness.  Similar to federal debt, much of it is held externally.

Copyright © 2002 by Thomson Learning, Inc. General Obligation vs Revenue Bonds  General Obligation Bonds are backed by the state or local government’s ability to tax.  Revenue Bonds are backed by the revenue that a state or local enterprise would generate.

Copyright © 2002 by Thomson Learning, Inc. Social Security and the Deficit  Social Security Surpluses are used to purchase federal government debt.  This will happen until benefits exceed revenues (estimated to be 2023).  Thereafter it will run deficits and will be forced to sell off those bonds.  Whether Social Security is on- or off-budget and whether or not there is a trust fund has no effect on the net national debt.

Copyright © 2002 by Thomson Learning, Inc. Burden of the Debt  Impact on future generations:  People have to pay increased taxes to pay interest on that debt.  Some may inherit the original bonds.  Growth rates are reduced because of higher interest rates.  These impacts can be offset by the increased private savings of the generation that does the borrowing, or by returns that come from programs that were funded by the borrowing.

Copyright © 2002 by Thomson Learning, Inc. European Union  Entry into the EU required that members have  inflation rates no more than 1.5 percentage point more than that of the three lowest inflation countries.  interest rates on government debt be no more than 3 points higher than that of the three lowest interest countries.  government deficit as a percentage of GDP be no greater than 3% and debt no more than 60% of GDP.

Copyright © 2002 by Thomson Learning, Inc. EU Deficit and Debt Figures NationSurplus/Deficit as a percentage of GDP 1998 Debt as a percentage of GDP 1998 Belgium– Germany– France– Italy– Sweden United Kingdom

Copyright © 2002 by Thomson Learning, Inc. What Should be Done With Surpluses?  Social Security and Medicare solvency  Tax Cuts  Other Spending Programs  Reduce National Debt