Chapter 25 Government Finance in the Full-Employment Model

Government Spending and Tax Revenues In 2005 U.S. federal government spending > $2 trillion National defense, Social Security, parks State and local government spending > $1.5 trillion Schools, police, and fire In 2005, Turkish Central Government spending was 160 billion TLs It increased to 267 billion TLs by 2009.

Government Spending and Tax Revenues - USA 1980s – 1990s Government spending > tax revenues Government must borrow Government deficit = G – T; Government debt = accumulated amount owed from previous deficits and accumulated interest In 1998 federal government turned around budget situation to surplus Since 2002 tax cuts, recession and war on terrorism push federal government into deficit again

Government Spending and Tax Revenues - Turkey 1980s – 1990s Government spending > tax revenues Government must borrow Government deficit = G – T; Government debt = accumulated amount owed from previous deficits and accumulated interest After 2001 crisis the primary balance in surplus Government debt was reduced as a result of tight fiscal policy that ran primary surpluses until recently.

Composition of Government Spending and Tax Revenues Discretionary spending: decided on yearly basis Defense, government operations, education and training Non-discretionary spending: two types Interest payments on government debt Entitlements: law mandates specific benefits to individuals and families if they meet certain criteria Social Security, Medicare, Medicaid, food stamps

Composition of Government Spending (2009)

Composition of Government Tax Revenues (2009)

Composition of Government Tax Revenues (continued) USA Individual federal income taxes = 46% of total federal government revenues Corporate federal income taxes = 9% TURKEY Individual income taxes = 18% of total central government revenues Corporate income taxes = 8%

The Government and the Capital Market Government spending on goods and services increases demand in the goods market. Taxes reduce demand by reducing disposable income and lowering consumption.

Government and the Circular Flow of Income

Government Deficits and Surpluses In the capital market, if government spending exceeds tax revenues the government must borrow, competing with private borrowers. The government’s deficit, or fiscal deficit, = G ‑ T > 0 This means the government is a net borrower. A fiscal surplus occurs when G ‑ T < 0 Here the government is a net saver.

Private Savings Supply equals demand means at full employment Y f = C + I + G Households’ income is spent on consumption and taxes with the remainder going to private household savings. Y f = C + T + Sp, where Sp is private savings by households The equations above give T + Sp = I + G leakages = injections

Private Savings Covers the Gap (a) Rewriting, we get: Sp = I + (G ‑ T) Private savings must cover investment and the government deficit. Rewriting again gives: Sp + (T ‑ G) = I Sp + Sg = I, where government savings is Sg = (T- G) Or SN = I, where SN is national savings National savings must equal investment spending.

Private Savings Covers the Gap (b) The capital market equilibrium National saving SN is independent of the interest rate. Why? Sp depends on income. Sg depends on the government’s tax and spending plans and not the interest rate. So national savings is a vertical line—perfectly inelastic. Investment is a negative function of the real interest rate.

Increase in Government Spending (a) Suppose G increases.

Increase in Government Spending (b) The government deficit increases. Sg falls. SN, national savings, falls shifting the saving curve to the left. The real interest rate rises, which chokes off investment. Extra government spending crowds out investment spending.

Tax Cut Scenario A tax cut of $100 billion increases the government deficit by $100 billion at full employment. Households receive $100 billion extra disposable income. Suppose C ↑ by $90 billion, then Sp ↑ by $10 billion. But Sg ↓ by $100 billion. SN = Sp + Sg falls by $90 billion. The national saving curve shifts to the left by $90 billion. So the interest rate rises which again chokes off investment. Investment is crowded out by $90 billion.

Balanced Budget A balanced budget increase in G and T, G = T > 0. Since T ↑ disposable income ↓ so C and Sp ↓ S = Sp + Sg; S = Sp + Sg, but Sg = 0 So S < 0 from the fall in private savings. The saving curve shifts inward. Interest rates rise. Investment is crowded out.

Government Deficits and Surpluses The government deficit is the difference between government spending and tax collections in a year. The government cannot borrow the way households or firms can. The government borrows by issuing bonds and T‑bills to finance the deficit. Government debt is the accumulated amount the government owes from previous years' deficits and the accumulated interest.

Effects of Government Deficits and Surpluses Should a government run a deficit? U.S. example: Largest deficits (as a % of GDP) during WWII This debt was paid off by taxes paid by workers many years after the war ended. Since later generations benefited from the Allied victory in WWII, sharing the financial burden of the war across generations makes sense. Government borrowing shifts some of the burden of expenditures to future generations. Does this intergenerational shift make sense for spending on roads? Social Security? Government operations?

The Recent U.S. Deficit The U.S. government debt has grown over the years but so has the U.S. economy. The ratio of debt/GDP was highest in the United States immediately after World War II. The debt/GDP ratio decreased until the 1980s, when it took a dramatic upturn. Debt/GDP declined in the mid-1990s as the federal government ran a surplus. Since 2001 the government budget has returned to a deficit because of: Tax cuts Increased government spending during the recession Increased defense spending due to the war on terrorism

Recent U.S. Government Budget Experience

The Federal Government Deficit

Central Government Budget Balance (percent of GDP)

Federal Debt Stock as a Percentage of GDP

The Federal Government Debt

Central Government Debt Stock (Million TL)

Central Government Debt Stock (as percent of GDP)

Other Countries Compare structural budget deficits (or surpluses) across countries. Structural budget deficit = estimate of government budget deficit if the economy were at potential GDP (i.e. full employment) Other rich countries have structural government deficits. Excepting Japan, structural budget deficits in other industrialized countries are lower than in the United States.

International Perspective on Government Deficits