Chapter 14 – Miller

Deficit Spending and Public Debt

Did You Know That...

The U.S. federal government spends a total of more than $3 billion per day on Social Security, Medicare, and Medicaid.

Each of these guaranteed spending programs is individually nearly as large as the entire discretionary portion of the federal government’s budget.

Terms to Know

Automatic fiscal policya change in fiscal policy caused by the state of the economy

Discretionary fiscal policya policy action initiated by an Act of Congress

Expansionary fiscal policygovernment should either increase its purchases of g&s or cut its taxes. (this obviously will increase the budget deficit because in order to fund the expansion… government will have to borrow funds from private sources).

Public Deficits and Debts: Flows versus Stocks

Government Budget Deficit

Exists if the government spends more than it receives in taxes during a given period of time

Is financed by the selling of government securities (bonds)

Public Deficits and Debts:

The federal deficit is defined for a specific period of time, usually one year. Fiscal year begins October 1st

If spending equals receipts, the budget is balanced.

If receipts exceed spending, the government is running a budget surplus.

Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

*Budgeted items not including 2008–2009 financial institutions bailout expenditures.Source: Office of Management and Budget.

Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

*Budgeted items not including 2008–2009 financial institutions bailout expenditures.Sources: Economic Report of the President; Economic Indicators, various issues.

Government Finance: Spending More than Tax Collections (cont'd)

Question Why has the government’s budget recently

slipped from a surplus of 2.5% of GDP into a deficit?

Answer

Spending has increased at a faster page since the early 2000s than during any other decade since WWII.

Recent income, capital gains, and estate tax cuts

Ownership of the Debt

Total public debt can be divided into proportion held by the public (57%) latest figures… and 43% by federal agencies and Federal Reserve.

Evaluating the Rising Public Debt (cont'd)

Tax revenues tend to be stagnant during times of slow economic growth.

Tax revenues grow more quickly when overall growth enhances incomes.

As long as spending exceeds revenues, the budget deficit will persist.

2007 Tax Breakdown - Incomes

% Income Income _AGI % Taxes Paid

Top 1% $410,096 40.42%

Top 5% $160,041 60.63%

Top 10% $113,013 71.22%

Top 25% $66,532 86.59

Top 50% $32,879 97.11

Bottom 50% $32,879 2.89%

Evaluating the Rising Public Debt (cont'd)

The government must pay interest on the public debt outstanding.

The level of these payments depends on the market interest rate.

Interest payments as a percentage of GDP are likely to rise in the future.

Evaluating the Rising Public Debt (cont'd) If the economy is already at full

employment, then further provision of government goods will crowd out some private goods.

Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.

Evaluating the Rising Public Debt (cont'd) Crowding-out may place a burden on

future generations. Increased present consumption may

crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth.

Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt.

Federal Budget Deficits in an Open Economy (cont'd) We know what a budget deficit is, but

a trade deficit exists when the value of imports exceeds the value of exports.

Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.

The Related U.S. Deficits

Sources: Economic Report of the President; Economic Indicators, various issues;author’s estimates.

Federal Budget Deficits in an Open Economy (cont'd) If foreigners are using the dollars they

hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports.

This shows that a U.S. budget deficit can contribute to a trade deficit.

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)

In the long run, higher government budget deficits have no effect on equilibrium real GDP.

Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)

Thus, if the government operates with higher deficits over an extended period

The ultimate result is a shrinkage in the share of privately produced goods and services

By continually spending more than it collects, the government takes up a larger portion of economic activity.

Policy Example: A Short-Run Deficit Boosting Stimulus is Set to Give Way to Deficit-Fighting Tax Increases

In early 2008, Congress passed the Economic Stimulus Act in response to declining GDP growth rate.

This law provided for $45 billion in government spending and authorized tax “rebates” aimed at stimulating consumptions pending and preventing a short-run recessionary gap from expanding.

Policy Example: A Short-Run Deficit Boosting Stimulus is Set to Give Way to Deficit-Fighting Tax Increases (cont'd)

However, worries over an increasing budget deficit prompted Congress to authorize a significant personal income tax increase at the end of 2010. (was extended to 2012)

This rate will raise the overall U.S. personal income tax burden by 25%.

Higher tax rates could reduce long-run aggregate supply and dampen future real GDP growth.

Growing U.S. Government Deficits: Implications for U.S. Economic Performance

How could the government reduce its red ink?

Increasing taxes for everyone

Taxing only the rich

Reducing expenditures

Whittling away at entitlements

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)

In considering how expenditures might be reduced, it is important to look at entitlements.

These are federal government payments that are legislated obligations and cannot be reduced or eliminated.

Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)

Entitlements are the largest component of the U.S. federal budget.

To make a significant cut in expenditures, entitlement programs would have to be revised.

Stay Tuned…..