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2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Fiscal Policy:A Summing Up

Prepared by:

Fernando Quijano and Yvonn Quijano


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2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 2 of 45

The Government

Budget Constraint26-1

Suppose that, starting from a balanced budget,the government cuts taxes, creating a budgetdeficit. What will happen to debt over time? Willthe government need to increase taxes later? If

so, by how much?

Fiscal Policy: What You Have Learned andWhereIn this chapter we look further at the implications of thebudget constraint facing the government and discuss

current issues of fiscal policy in the US.


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The Arithmetic of Deficits and Debt

The budget deficit in year tequals:

deficit rB G T t t t t 1

is the government debt at the end of year t-1.

In words: The budge deficit equals spending,including interest payments on the debt, minustaxes net of transfers.

rBt1

is government spending during year t.Gt

is taxes minus transfers during year t.Tt


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Note two characteristics of

We measure interest payments as realinterest payments rather than as actualinterest payments. The correct measure ofthe deficit is sometimes called the inflation-adjusted deficit.

G does not include transfer payments.

deficit rB G T t t t t 1


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The government budget constraint states thatthe change in government debt during year tisequal to the deficit during year t:

It is often convenient to decompose the deficitinto the sum of two terms:

Interest payments on the debt, rBt-1 The difference between spending and taxes,

Gt-Tt. This term is called the primary deficit(equivalently, TtGtis called the primarysurplus).


B B deficitt t t 1


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Or:

B B B Tt t t t t 1 1r G

change in the debt interest payments Primary deficit

B r B G Tt t t t ( )1 1


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Inflation Accounting and theMeasurement of Deficits

Official andInflation-AdjustedBudget Deficits forthe United States,

1968-2004

Figure 1


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Current Versus Future Taxes

Lets look at the implications of a 1-yeardecrease in taxes for the path of debt and futuretaxes.

We start with a balanced budget, and end theyear with the government decreasing taxes by 1for 1 year.

What happens thereafter?


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Full Repayment in Year 2

Replacing B2=0 and B1=1, and rearranging:

In words, to repay the debt fully in year 2, thegovernment must run a primary surplus equal to

(1+r).

B r B G T2 1 2 21 ( ) ( )

T G r r 2 2 1 1 1 ( ) ( )


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Tax Cuts, DebtRepayment, and DebtStabilization

(a) If debt is fully

repaid during year 2,

the decrease in taxes

of 1 in year 1 requires

an increase in taxes

equal to (1+r) in Year 2.

T G r r 2 2 1 1 1 ( ) ( )

Figure 26 - 1


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(b) If debt is fully

repaid during year 5,

the decrease in taxes

of 1 in year 1 requires

an increase in taxes

equal to (1+r)4 during

year 5.

Figure 26 - 1


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(c) If debt is stabilized

from Year 2 on, then

taxes must be

permanently higher by

r from Year 2 on.

Figure 26 - 1


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Full Repayment in Yeart

Debt at the end of year t1 is given by:

In year t, when the debt is repaid, the budgetconstraint is:

Debt at the end of year t equals zero:

B rtt

1

21( )

B r B G Tt t t t ( ) ( )1 1

0 1 1 2 ( )( ) ( )r r G T t

t t

which implies that the necessary surplus in year tto repay the debt must be:

T G rt t

t ( )1 1


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Full Repayment in Yeart

Our first set of conclusions:

If government spending is unchanged, adecrease in taxes must eventually be offsetby an increase in taxes in the future.

The longer the government waits to increasetaxes, or the higher the real interest rate, thehigher the eventual increase in taxes.


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Debt Stabilization in Yeart

From , the budgetconstraint for year 2 is

Under our assumption that debt is stabilized inYear . Replacing in the precedingequation:

Reorganizing and bringing to the leftside:

B r B G T2 1 2 21 ( ) ( )

1 12 2 ( ) ( )r G T

T G r r 2 2 1 1 ( )

B B2 1

1

B r B G Tt t t t ( )1 1

( )G T2 2


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From the preceding arithmetic of deficits anddebt we can draw these conclusions:

If government spending is unchanged, adecrease in taxes must eventually be offset byan increase in taxes in the future.

The longer the government waits to increasetaxes or the higher the real interest rate, thehigher the eventual increase in taxes.


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From the preceding arithmetic of deficits anddebt we can draw these conclusions:

The legacy of past deficits is highergovernment debt.

To stabilize the debt, the government musteliminate the deficit.

To eliminate the deficit, the government mustrun a primary surplus equal to the interestpayments on the existing debt. This requireshigher taxes forever.

Th E l ti f th


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The Evolution of the

Debt-to-GDP Ratio

In an economy in which output grows over time,it makes sense to focus on the ratio of debt tooutput.

The debt-to-GDP ratio, or debt ratio gives theevolution of the ratio of debt to GDP.


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The Arithmetic of the Debt Ratio

To derive the evolution of the debt ratio takes afew steps. Do not worry: The final equation iseasy to understand.

B

Y r

B

Y

G T

Y

t

t

t

t

t t

t

( )1

1

B

Yr

Y

Y

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1 1 1

1

1( )

BY

r g BY

G TY

t

t

t

t

t t

t

( )1 1

1

B

Y

B

Yr g

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1

1

1

1

( )


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The Arithmetic of the Debt Ratio

This took many steps, but this final relation has a

simple interpretation: The change in the debt ratio over time is

equal to the sum of two terms.

The first term is the difference between the

real interest rate and the growth rate timesthe initial debt ratio.

The second term is the ratio of the primarydeficit to GDP.

B

Y

B

Yr g

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1

1

1

1

( )

The Evolution of the Debt Ratio


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The Evolution of the Debt Ratio

in OECD Countries

This equation implies that the increase in the

ratio of debt to GDP will be larger: the higher the real interest rate,

the lower the growth rate of output,

the higher the initial debt ratio,

the higher the ratio of the primary deficit toGDP

B

Y

B

Yr g

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1

1

1

1

( )

The Evolution of the Debt to GDP


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The Evolution of the Debt-to-GDP

Ratio in OECD Countries

In the 1960s, GDP growth was strong. As a

result, rgwas negative. Countries were able

to decrease their debt ratios without having torun large primary deficits.

In the 1970s, rgwas again negative due to

very low interest rates, leading to a furtherdecrease in the debt ratio.

B

Y

B

Yr g

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1

1

1

1

( )



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In the 1980s, real interest rates increased and

growth rates decreased, thus, debt ratiosincreased rapidly.

Throughout the 1990s, interest rates remainedhigh and growth rates low. However, mostcountries ran primary surpluses sufficient to

imply a steady decline in their debt ratios. So far, during the 2000s, real interest rates are

low, but many countries are running primarydeficits, and their debt ratios are again goingup.

B

Y

B

Yr g

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1

1

1

1

( )



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Table 26-1 Debt and Primary Surpluses for the United States, theEuropean Union, and Selected Countries, 1981-2003(Percent of GDP)

Country Debt/GDP Primary Surplus/GDP

1981 1995 2000 2003 2003

United States 25.8 49.2 34.7 36.1 -1.4

European Union 24.0 53.5 47.7 52.0 0.3

Italy 56.4 108.7 98.7 93.5 2.3

Belgium 82.2 125.2 103.0 94.2 5.5

Greece 26.1 108.7 106.2 103.0 2.1


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Four Issues in Fiscal Policy

Having looked at the mechanics of thegovernment budget constraint, we cannow take up four issues in which thisconstraint plays a central role.

26-2


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Ricardian Equivalence

The Ricardian Equivalence, further developedby Robert Barro, and also known as theRicardo-Barro proposition, is the argumentthat, once the government budget constraint is

taken into account, neither deficit nor debt has aneffect on economic activity.

Consumers do not change their consumption inrespond to a tax cut if the present value of after-

tax labor income is unaffected. The effect oflower taxes today is cancelled out by highertaxes tomorrow.

Deficits Output Stabilization


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Deficits, Output Stabilization,

and the Cyclically Adjusted Deficit

The fact that budget deficits have adverse effectsimplies that deficits during recessions should beoffset by surpluses during booms.

The deficit that exists when output is at the

natural level of output is called the full-employment deficit. Other terms used aremidcycle deficit, standardized employmentdeficit, structural deficit, or cyclically adjusted

deficit.

Deficits Output Stabilization


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Deficits, Output Stabilization,

and the Cyclically Adjusted Deficit

A reliable rule of thumb is that a 1% decreasein output leads automatically to an increase inthe deficit of 0.5% of GDP.

If output is, say 5% below its natural level, the

deficit as a ratio of GDP will therefore beabout 2.5% larger than it would be if outputwas at the natural level of output.

This effect of the deficit on economic activity has

been called the automatic stabilizer.


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Wars and Deficits

The economic burden of a war affectsconsumers and firms differently depending onhow the war is paid for.

There are two good reasons to run deficits during

wars:

The first is distributional. Deficit finance is away to pass some of the burden of the war tothose alive after the war.

The second is more narrowly economic.Deficit spending helps reduce tax distortions.


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Passing on the Burden of the War

Wars lead to large increases in governmentspending.

Suppose the government relies on deficitfinance. With government spending sharply

up, there will be a very large increase in thedemand for goods.

Suppose instead that the governmentfinances the spending increase through an

increase in taxes. Consumption will declinesharply.


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Reducing Tax Distortions

Very high tax rates can lead to very higheconomic distortions. People will work less, andengage in illegal, untaxed activities.

Tax smoothing is the idea that it is better to

maintain a relatively constant tax rate, to smoothtaxes.

Tax smoothing implies large deficits whengovernment spending is high and small

surpluses the rest of the time.


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The Dangers of Very High Debt

The higher the ratio of debt to GDP, the largerthe potential for catastrophic debt dynamics.

Expectations of higher and higher debt give ahint that a problem may arise, which will lead tothe emergence of the problem, thereby validatingthe initial expectations.

Debt repudiation consists of canceling the debt,in part or in full.

B

Y

B

Yr g

B

Y

G T

Y

t

t

t

t

t

t

t t

t

1

1

1

1

( )( )

Deficits, Consumption, andInvestment in the US during WWIIBy 1944, US government spending on goods and

services increased to 45% from 15%!

The U S Budget: Current


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The U.S. Budget: Current

Numbers and Future Prospects

We conclude this chapter by looking atcurrent U.S. budget numbers anddiscussing the issues confronting U.S.fiscal policy, now and in the future.

26-3


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Current Numbers

There are many different definitions ofexpenditures, revenues, and deficit:

Some numbers refer to the budget of thefederal Government. Some numbers

consolidate the accounts of the federal, state,and local governments.

One set of numbers is based on thegovernment accounting system; another set

of numbers is based on the national incomeaccounting system.


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Current Numbers

Here are the main differences between thegovernment numbers and the NIPA numbers:

The government budget numbers arepresented by fiscal year.

The government budget numbers arepresented in two categories: on-budget andoff-budget.

The two accounting systems differ in how

they treat the sale of government assets.

They differ in the ways they treat governmentinvestment.


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Current Numbers

Here are the main differences between thegovernment numbers and the NIPA numbers:

The difference between the official and theNIPA measures of the deficit can be positive

or negative.

One is gross debt, the sum of the federalgovernments financial liabilities.

The other, more relevant number is net debt,

or equivalently, debt held by the public.

C t N b


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Table 26-2 U.S. Federal Budget Revenues and Expenditures, Fiscal Year 2003 (Percent of GDP) Revenues 17.2

Personal taxes 7.2

Corporate profit taxes 1.6

Indirect taxes 0.8

Social insurance contribution 7.0

Other 0.6

Expenditures, excluding interest payments 18.6

Consumption expenditures 6.0Defense 4.0

Nondefense 2.0

Transfers 8.8

Grants to state/local governments 3.0

Other 0.8

Primary surplus (1) (+ sign: surplus) -1.4

Net interest payments (2) 1.8

Real interest payments (3) 0.9

Inflation components 0.9

Official surplus: (1) minus (2) -3.2

Inflation adjusted surplus: (1) minus (3) -2.3

Memo item. Debt-to-GDP ratio 36.1

Source: Survey of Current Business, December 2001. Tables 3-2 and 3-7.

Current Numbers

M di R B d t P j ti


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Medium-Run Budget Projections

Deficits Projections:Federal GovernmentDeficit, Fiscal years2003 to 2014

Figure 26 - 2

Under current fiscal rules,the deficit nearly

disappears by 2014.

Under more realistic

assumptions about

spending and revenues,however, it remains high

throughout the period.

Th U S B d t


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The U.S. Budget

The Congressional Budget Office (or CBO forshort) is a nonpartisan agency of Congress thathelps Congress assess the costs and the effectsof fiscal decisions.

The green line presents projected deficits undercurrent rules. (These are called baselineprojections.)

The Long-Run Challenges: Low


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The Long Run Challenges: Low

Saving, Aging, and Medical Care

We just reached the conclusion that U.S. budgetdeficits are likely to remain high for at least thenext decade. There are three reasons why weshould worry: low U.S. saving, the aging of

America, and the increase in medical costs.

Deficits and the Low U.S.


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Deficits and the Low U.S.

Saving Rate

The U.S. saving rate is among the lowest in theOECD.

This low saving rate should be a matter ofconcern. The U.S. is now the largest debtor

country in the world and will have to pay largeinterest payments to the rest of the world for theindefinite future.

R ti t d M di l C


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Retirement and Medical Care

Entitlement programs are programs thatrequire the payments of benefits to all who meetthe eligibility requirements established by thelaw.

Table 26-3 Projected Spending on Social Security,Medicare, and Medicaid, 1998-2060 (Percent ofGDP)

2004 2010 2030 2050

Social Security 4.2 4.2 5.9 6.2

Medicare/Medicaid 4.1 4.8 8.4 11.5

Total 8.3 9.0 14.3 17.6

Source: The Long-Term Budget Outlook, Congressional Budget Office, December 2003.

R ti t d M di l C


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Entitlement spending to GDP is projected toincrease for these reasons:

The Aging of America: The old agedependency ratiothe ratio of the population

65 years old or more to the populationbetween 20 and 64 years oldis projected toincrease from about 20% in 1998 to above40% in 2060.

The steadily increasing cost of health care.Even if all expenditures other than transfers wereeliminated, projected entitlement spending wouldstill exceed revenues.

R ti t d M di l C


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Since 1983, Social Security contributions haveexceeded benefits. The Social Security TrustFund is an account where the surpluses havebeen accumulating, and now equal 12% of GDP.

The Social Security Trust Fund is expected toreach a peak by 2030 and then to decline andbecome equal to zero by 2045.

Key Terms


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Key Terms

inflation-adjusted deficit

government budget constraint

primary deficit (primary surplus)

debt-to-GDP ratio, debt ratio

Ricardian equivalence, Ricardo-

Barro proposition full-employment deficit

mid-cycle deficit

standardized employment deficit

structural deficit

cyclically adjusted deficit

automatic stabilizer

tax smoothing

debt repudiation

Congressional Budget Office

(CBO)

baseline projections

entitlement programs

Social Security Trust Fund

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