Fiscal Policy, Deficits, and Debt 30 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy Because of economic instability the Federal government sometimes uses budgetary actions to try to “stimulate the economy” or “rein in inflation.” Such countercyclical fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth. LO1 30-2

The adjective “fiscal” simply means financial. In 2009, Congress and the Obama Administration began a $787 billion stimulus program designed to help lift the U.S. economy out of deep recession. This fiscal policy contributed to a $1.4 trillion Federal budget deficit in 2009, which increased the size of the U.S. public debt to $11.9 trillion.

3 Budget Outcomes 1.Balanced Budget- When federal tax revenues equal government spending. This never happens. 2.Budget Surplus- When federal tax revenues exceed government spending. This happens occasionally, the last time was in Budget Deficit- When federal tax revenues are less than government spending. The federal budget has been in deficit approximately 85% since WWII.

Fiscal Policy & AD-AS Model Discretionary changes in government spending and taxes are at the discretion or option of the Federal government. They do not occur automatically. Changes that occur without Congressional action are nondiscretionary or passive. We will address nondiscretionary fiscal policy later in the chapter.

Expansionary Fiscal Policy 1.Expansionary Fiscal Policy- This policy consists of government spending increases, tax reductions, or both, designed to increase AD and therefore raise real GDP. Consider figure 30.1, where we suppose that a sharp decline in investment spending has shifted the economy’s AD curve to the left from AD1 to AD2. LO1 30-6

If the economy’s full employment or potential output is $510, and output falls to $490 then we have a negative GDP gap of $20 billion. This is assuming the price level is inflexible downward at P1. In short, the economy is experiencing both recession and cyclical unemployment.

Expansionary Fiscal Policy Real GDP (billions) Price level AD 2 AD 1 $5 billion increase in spending Full $20 billion increase in aggregate demand AS $490$510 P1P1 LO1 Recessions Decrease AD 30-8

3 Options to Stimulate the Economy The government has 3 options available to stimulate the economy.  Increase government spending  Reduce taxes  Some combination of the 2

If the Federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit- government spending in excess of tax revenues. If the MPC =.75 and the negative GDP gap is $20 billion, how much will we need to increase government spending to bring the economy back to full employment?

The answer is $5 billion. If the government chooses to cut taxes instead of increasing government spending, how large of a tax cut will be necessary to achieve the same result? Remember the tax multiplier is always 1 less than the spending multiplier and negative. The spending, multiplier is 1 ÷.25 = 4, which means the tax multiplier is -3.

If we take the negative GDP gap of $20 billion and divide by the tax multiplier of -3, we will need to cut taxes by $6.67 billion to bring the economy back to full employment. Notice the tax cut must be larger than the proposed increase in government spending to achieve the same result.

The $6.67 billion tax cut increases DI by the same amount and the MPC tells us that consumers will spend.75 of it or $5 billion. They will save the other.25 or $1.67 billion which added together equals the $6.67 billion. The government could also combine spending increases and tax cuts to produce the desired result. The government could increase spending $1.25 billion and cut taxes by $5 billion. Why would this combination work?

Contractionary Fiscal Policy 2.Contractionary Fiscal Policy- When demand-pull inflation occurs, a restrictive or contractionary fiscal policy may help control it. We could use the same 3 options listed above, but in reverse. We could cut government spending, raise taxes, or a combination of the two. Figure 30.2 illustrates this type of fiscal policy. LO

When the economy faces demand-pull inflation, fiscal policy should move toward a budget surplus- tax revenues in excess of government spending.

Contractionary Fiscal Policy Real GDP (billions) Price level AD 3 AD 4 $3 billion initial decrease in spending Full $12 billion decrease in aggregate demand AS $502 $ 522 P2P2 AD 5 $ 510 d b a P1P1 c LO

Policy Options: G or T? Which is preferable as a means of eliminating recession or inflation? The answer depends largely on one’s view as to whether the government is too large or too small. If you believe that the size of government should be preserved or expanded, you would choose spending increases during recession and tax increases during inflationary periods. LO

However, if you believe that government should be small and less intrusive, you would favor tax cuts during recession and spending cuts during times of inflation. The point here is that discretionary fiscal policy designed to stabilize the economy can be associated with either an expanding or contracting government.

Built-In Stability To some degree, government tax revenues change automatically over the course of the business cycle and in ways that stabilize the economy. This built-in stability constitutes nondiscretionary fiscal policy. The actual U.S. tax system is such that net tax revenues vary directly with GDP. Net taxes are tax revenues minus transfers and subsidies. LO

Personal income taxes have progressive rates and thus generate more than proportionate increases in tax revenues as GDP expands. Furthermore, as GDP rises and more goods and services are purchased, revenues from corporate income taxes and from sales taxes and excise taxes also increase.

And similarly, revenues from payroll taxes rise as economic expansion creates more jobs. Conversely, when GDP falls, tax receipts from all these sources also fall. Transfer payments behave in the opposite way from tax revenues. Unemployment compensation payments and welfare payments decrease during economic expansion and increase during economic contraction.

Automatic Stabilizers 3.Automatic or Built-in Stabilizers- are anything that increases the government’s budget deficit or reduces its budget surplus during a recession and increases its budget surplus or reduces its budget deficit during an expansion without requiring explicit action by Congress. Figure 30.3 reveals, this is precisely what the U.S. tax system does.

As shown in figure 30.3, tax revenues automatically increase as GDP rises during prosperity, and since taxes reduce household and business spending, they restrain the economic expansion. The figure reveals that the size of the automatic budget deficits or surpluses, and therefore the amount of stability, depends on the responsiveness of tax revenues to changes in GDP.

If tax revenues change sharply as GDP changes, the slope of the T line will be steep and the vertical distances between the T and G lines will be large. If tax revenues change very little when GDP changes, the slope will be gentle and built-in stability will be low.

The steepness of the T line will depend on the tax system itself. In a progressive tax system, the average tax rate rises with GDP. In a proportional tax system, the average tax rate remains constant as GDP rises. In a regressive tax system, the average tax rate falls as GDP rises. The progressive system has the steepest tax line of the 3 and therefore has the greater amount of built-in stability.

Average tax rate = total tax paid ÷ total income Built-in stabilizers can only dampen, not counteract, swings in real GDP. Discretionary fiscal policy, therefore is needed to counter a recession or inflation of any magnitude.

Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T LO

Budget Deficits & Projections Figure 30.5 shows U.S. budget surpluses and deficits from 1994 through It also shows the projected future deficits through 2014, as estimated by the Congressional Budget Office (CBO).

Budget Deficits and Projections Source: Congressional Budget Office, $ Budget Deficit (-) or Surplus, Billions Actual Projected (as of March 2010) LO

Problems, Criticisms, & Complications Economists recognize that governments may encounter a number of significant problems in enacting and applying fiscal policy. LO

Timing Issues 1.Problems of Timing Recognition Lag- is the time between the beginning of recession or inflation and the certain awareness that it is actually happening. The economy is often 4 to 6 months into a recession or inflation before the situation is clearly discernible in the relevant statistics.

Administrative Lag- is the time the need for fiscal policy is recognized and the time action is taken. Political gridlock and partisan politics often slow the wheels of government.

Operational Lag- is the time between when action is taken and the time that action affects output, employment, or the price level. Although changes in tax rates can be put into effect relatively quickly once new laws are passed, government spending on public works requires long planning periods and even longer periods of construction. Consequently, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool.

Political Considerations 2.Political Considerations- Fiscal policy is conducted in a political arena. In short, elected officials may cause so-called political business cycles resulting from election motivated fiscal policy, rather than from inherent instability in the private sector.

Policy Reversals? 3.Future Policy Reversals- Fiscal policy may fail to achieve its intended objectives if households expect future reversals of policy. A tax reduction thought to be temporary may not increase present consumption spending and AD by as much as our simple model suggests.

The lesson is that tax-rate changes that households view as permanent are more likely to alter consumption and AD than tax changes they view as temporary.

State & Local Budgets 4.Offsetting State & Local Finance- The fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation. Unlike the Federal government, most state and local governments face constitutional or other legal requirements to balance their budgets.

Crowding Out 5.Crowding-Out Effect- An expansionary fiscal policy may increase the interest rate and reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy. Realize that whenever the government borrows money it increases the overall demand for money.

If the Federal Reserve holds the money supply constant, the increase in demand will raise the price paid for borrowing money which is the interest rate. Because investment spending varies inversely with the interest rate, some investment will be choked off or “crowded out.”

With investment demand weak during a recession, the crowding-out effect is likely to be very small. By contrast, when the economy is operating at or near full capacity, investment demand is likely to be quite strong so that crowding-out will probably be a much more serious problem.

Current Thinking on Fiscal Policy Although there is some disagreement, most economists believe that fiscal policy remains an important, useful policy option in the government’s macroeconomic toolkit. The current popular view is that fiscal policy can help push the economy in a particular direction but cannot fine-tune it to a precise macroeconomic outcome. LO

The U.S. Public Debt The U.S. national debt or public debt, is essentially the accumulation of all past Federal deficits and surpluses. The deficits have greatly exceeded the surpluses and have emerged mainly from war financing, recessions, and fiscal policy. You can find the current size of the public debt at the Web site of the Department of Treasury, Bureau of the Public Debt, at ation=np. ation=np LO

Economists typically focus on the part of the debt that is not owned by the Federal government and the Federal Reserve.

Who Owns the Debt?  Ownership- The total public debt of $11.9 trillion represents the total amount of money owed by the Federal government to the holders of U.S. securities: financial instruments issued by the Federal government to borrow money to finance expenditures that exceed tax revenues.

These U.S. securities are of 4 types. Treasury bills, which are short term securities, Treasury notes, which are medium term securities, Treasury bonds, which are long term securities, and U.S. savings bonds, which are long term, nonmarketable bonds.

Figure 30.6 shows that the public held 57% of the Federal debt in 2009 and that federal government agencies and the Federal Reserve held the remaining 43%. Public ownership consists of individuals here and abroad, state and local governments, and U.S. financial institutions.

Foreigners held about 29% of the total U.S. public debt in Of the $3.7 trillion of debt held by foreigners, China held 24%, Japan held 21%, and oil-exporting nations held 6%.

The U.S. Public Debt LO4 Debt held outside the Federal government and the Federal Reserve: 57% Debt held by the Federal government and the Federal Reserve: 43% 30-48

Debt & GDP  Debt and GDP- A wealthy, highly productive nation can incur and carry a large public debt much more easily than a poor nation can. A more meaningful measure of the public debt relates it to an economy’s GDP. See figure 30.7 for an illustration.

The U.S. Public Debt LO

International Comparisons  International Comparisons- It is not uncommon for countries to have sizable public debts. See Global Perspective 30.2 for some comparisons with other nations.

Global Perspective Public Sector Debt as Percentage of GDP, 2009 Italy Japan Greece Belgium France United States France Germany United Kingdom Spain Netherlands Canada Source: Organization for Economic Cooperation and Development, OECD LO

Interest Charges  Interest Charges- Many economists conclude that the primary burden of the debt is the annual interest charge accruing on the bonds sold to finance the debt. In 2009 interest on the total public debt was $187 billion.

False Concerns about the Debt 1.Bankruptcy- The large U.S. public debt does not threaten to bankrupt the Federal government. There are 2 main reasons for this. First, as long as the U.S. public debt is viewed by lenders as manageable and sustainable, the public debt is easily refinanced. Of course, refinancing could become an issue with a high enough debt- to-GDP ratio. LO

Some nations such as Greece have run into this problem. Secondly, the federal government has the constitutional authority to levy and collect taxes. A tax increase is a government option for gaining sufficient revenue to pay interest and principal on the public debt.

Such tax hikes may be politically unpopular and may weaken incentives to work and invest, but they are a means of raising funds to finance the debt.

2.Burdening Future Generations- In 2009 public debt per capita was $37,437. The United States owes a substantial portion of the public debt to itself.

Although that part of the public debt is a liability to Americans, as taxpayers, it is simultaneously an asset to Americans as holders of government securities. To eliminate the American-owned part of the public debt would require a gigantic transfer payment from some Americans to other Americans.

Substantive Issues 1.Income Distribution- The distribution of ownership of government securities is highly uneven. In general, the ownership of the public debt is concentrated among wealthier groups, who own a large percentage of all stocks and bonds. Income is transferred from people who, on average, have lower incomes to the higher income bondholders. If greater income equality is one of society’s goals, then this redistribution is undesirable. LO

2.Incentives- As stated earlier the current public debt requires annual interest payments of $187 billion per year. With no increase in the size of the debt, that interest charge must be paid out of tax revenues. Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work. In this way, a large public debt may impair economic growth and therefore impose a burden of reduced output on future generations.

3.Foreign-Owned Public Debt- The 29% of the U.S. debt held by citizens and institutions of foreign countries is an economic burden to Americans. The payment of interest and principal to foreigners enables them to buy some of our output, which would otherwise go to Americans.

4.Crowding-Out Effect Revisited- A potentially more serious problem is the financing, and refinancing, of the large public debt, which can transfer a real economic burden to future generations by passing on to them a smaller stock of capital goods. If the amount of current investment crowded out is extensive, future generations will inherit an economy with a smaller production capacity and, other things equal, a lower standard of living.

Take a look at figure 30.8 and recall the investment demand curve (ID1) from chapter 27. If government borrowing increases the interest rate from 6% to 10%, investment spending will fall from $25 billion to $15 billion. As a result, $10 billion of private investment has been crowded out.

Crowding-Out Effect Real interest rate (percent) Investment (billions of dollars) ID 1 ID 2 a bc Increase in investment demand Crowding-out effect LO

Even with crowding out, 2 factors could partly or fully offset the net economic burden to future generations. First, if part of the government spending enabled by the public debt is for public investment outlays such as highways, mass transit systems, power facilities, or education, this public investment could increase the economy’s future production capacity.

The greater stock of public capital may offset the diminished stock of private capital leaving overall production capacity unimpaired. Second, some public and private investments are complementary. The public investment financed through debt could spur some private-sector investment by increasing its expected rate of return.

For example, a new Federal building in a city may encourage private investment in the form of nearby office buildings, shops, and restaurants. Through its complementary effect, the spending on public capital may shift the private investment demand curve outward from (ID1) to (ID2) in figure 30.8.

Social Security, Medicare Shortfalls The American population, on average, is getting decidedly older. In the future, more people will be receiving Social Security benefits and Medicare for longer periods. Each person’s benefits will be paid for by fewer workers. The number of workers per Social Security and Medicare beneficiary was roughly 5:1 in Today it is 3:1, and by 2040 it will be only 2:

The combined cost of the Social Security and Medicare programs was 7.6% of GDP in 2008, and that percentage is projected to grow to 12% of GDP in 2030 and 17.2% of GDP in

Social Security Program Social Security is the major public retirement program in the U.S. The program costs $615 billion annually and is financed by a 12.4% tax on earnings up to $106,800 in Half the tax, 6.2%, is paid by the worker and the other half by the employer. Social Security is largely an annual “pay-as-you-go” plan, meaning that most of the current revenues from the Social Security tax are paid to current Social Security retirees.

Medicare Program The Medicare program is the U.S. health care program for people age 65 and older in the U.S. It is also a pay-as-you-go plan, meaning that current medical benefits are being funded by current tax revenues from the 2.9% Medicare tax on earnings. 1.45% of the tax is paid by the worker and the other 1.45% is paid by the employer. The financial status of Medicare is much worse than that of Social Security.

To restore long-run balance to Social Security and Medicare, the Federal government must either reduce benefits or increase revenues. The (SSA) says that bringing revenues and payments back into balance would require a 16% cut in benefits, a 13% increase in taxes, or some combination of the two.

Possible Solutions Here are several options that have been proposed. Increasing the retirement age. Increasing the payroll tax, especially on higher income groups. Disqualifying wealthy people from receiving benefits. Place tax revenues into an account that you control, rather than the government.