1. DEFICIT FINANCE
Chapter 20

2. How Big Is the Deficit? Deficit Surplus On-budget deficit
Off-budget deficit

3. How Big Is the Deficit?
Source: Congressional Budget Office [2012b]

4. How Big Is the Debt?
National (Public) Debt
Stocks vs. Flows

5. How Big Is the Debt?
Source: Congressional Budget Office [2012b]

6. Interpreting Deficit, Surplus, and Debt Numbers
Government Debt held by the Federal Reserve Bank
State and Local Government
Effects of Inflation
Inflation tax
Capital versus Current Accounting
Tangible Assets
Implicit Obligations
Summing Up

7. The Burden of the Debt Statutory versus Economic Incidence
One Hand Borrows from the Other
Internal Debt
External Debt

8. Overlapping Generations Model
The Period
Young
Middle-Aged
Old
(1) Income
$12,000
12,000
(2) Government Borrowing
-6,000
(3) Government- provided consumption
4,000
The Year 2030
(4) Government raises taxes to pay back debt
-4,000
(5) Government pays back debt
+6,000
Lerner – generation is everyone alive at same time
Alternative – generation is everyone born at the same time
Each generation has equal number of people
Each lives 20 years
Each has fixed income of $12,000/year
Internal debt creates burden for future generations

9. Overlapping Generations Model
Generational Accounting
Computation of Net Tax
PV of transfers received – PV of taxes paid
OG model  using generational accounting to evaluate impact of Government fiscal policies

10. Other Models Neoclassical Model Ricardian Model
Crowding Out Hypothesis
Empirical testing of the hypothesis
Ricardian Model
Intergenerational transfers
Form of Finance is irrelevant
Empirical evidence

11. To Tax or To Borrow Benefits-Received Principle
Intergenerational Equity
Efficiency Considerations
χ = ½εLt2
Deficits and Functional Finance
Functional finance
Moral and Political Considerations
Federal Debt and the Risk of a Fiscal Crisis
Controlling the Deficit
Clicking on “Efficiency Considerations” goes to custom show showing PV of spending and taxing under alternative taxing/borrowing decisions
Clicking on “χ = ½εLt2” goes to custom show of graph of relationship between tax rate and excess burden

12. Present Value of Tax Payments Under Alternative Taxing/Borrowing Decisions
Policy
Year 1
Year 2
All Future Years
10% interest rate
Spend an additional $100 in year 1
100
Financing Options
Balanced budget: raise 100 in taxes in year 1
Deficit Finance I: borrow 100 in year 1 and pay back debt plus interest in year 2 by raising taxes
110
Deficit Finance II: borrow 100 in year 1 and pay interest on debt in all subsequent years always rolling over debt principle 10
Table shows 3 ways to finance an extra 100 in spending in year 1.
Balanced budget – finance spending by raising 100 in taxes in year 1. PV of tax payments is 100
Deficit Finance I – finance by borrowing the 100 in year 1 and paying it back plus interest in year 2. In year must be raised in taxes. PV of 110 in one year at 10% interest rate is 100
Deficit Finance II – finance by borrowing 100 in year 1 and never paying back the debt. In all subsequent years the interest on the debt must be paid so taxes must be raised 10 each year to do that. PV of 10 per year until the end of time is 100.

13. To Tax or To Borrow Excess Burden χ2 χ1 t 2t Tax rate Axes and labels
1st click – curved solid line and dashed lines
Click returns to “To tax or borrow” slide χ1 t 2t
Tax rate

14. Chapter 20 Summary
When government spending > revenues, it must borrow money: debt is the sum of past deficits & surpluses
Economic research centers on whether future generations carry the burden of government debt
Several factors influence whether government should finance expenditures through taxes or debt
From an efficiency point of view, the excess burden of tax vs. debt financing should be considered
Options for controlling the deficit include changing budget-making processes and a constitutional amendment