Chapter 14 Deficit Spending and The Public Debt

Introduction In recent years, total expenditures of the federal government have been considerably greater than receipts. Every discretionary federal spending program has been financed with borrowed funds. Because federal discretionary spending has exceeded $1 trillion per year, the federal government has had to borrow more than $1 trillion per year. In Chapter 14, you will contemplate the implications of federal borrowing.

Learning Objectives Explain how federal government budget deficits occur Define the public debt and understand alternative measures of the public debt Evaluate circumstances under which the public debt could be a burden to future generations

Learning Objectives (cont'd) Analyze the macroeconomic effects of government budget deficits Describe possible ways to reduce the government budget deficit

Chapter Outline Public Deficits and Debts: Flows versus Stocks Government Finance: Spending More than Tax Collections Evaluating the Rising Public Debt Federal Budget Deficits in an Open Economy Growing U.S. Government Deficits: Implications for U.S. Economic Performance

Did You Know That ... Even though government projections indicated that 2020 would be the year in which tax collections to fund Social Security would fall below beneficiary payments, the actual year was 2011? The federal government is making up the difference by allocating a portion of regular government spending towards Social Security benefits. Yet, tax revenues are insufficient to cover all of the government’s other expenditures. Consequently, current Social Security benefits are partially funded with borrowings that must be repaid in future years.

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: Flows versus Stocks (cont'd) The federal deficit is a flow variable, one defined for a specific period of time, usually one year If spending equals receipts, the budget is balanced If receipts exceed spending, the government is running a budget surplus

Public Deficits and Debts: Flows versus Stocks (cont'd) Balanced Budget A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time

Public Deficits and Debts: Flows versus Stocks (cont'd) Government Budget Surplus An excess of government revenues over government spending during a given period of time

Public Deficits and Debts: Flows versus Stocks (cont'd) Public Debt A stock variable The total value of all outstanding federal government securities

Government Finance: Spending More than Tax Collections Since 1940, the U.S. federal government has operated with a budget surplus in 13 years In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing

Figure 14-1 Federal Budget Deficits and Surpluses Since 1940 Source: Office of Management and Budget.

International Example: Cosmetic Enhancement of the U. S International Example: Cosmetic Enhancement of the U.S. Deficits and Debts? The official government deficit and net public debt may be huge, but the reality is even worse. U.S. reports typically only provide data on the federal government’s annual budget deficit and net public debt. The U.S. federal government’s budget deficit per year is about 8.5 percent of annual GDP. If state and municipal budgets were included, the figure for total indebtedness would rise to 10.5 percent of annual GDP

Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP 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 of more than 8% of GDP? Answer Spending has increased at a faster page since the early 2000s Tax rates were reduced towards the end of the recession

Evaluating the Rising Public Debt Gross Public Debt All federal government debt irrespective of who owns it Net Public Debt Gross public debt minus all government interagency borrowing

Evaluating the Rising Public Debt (cont'd) Some government bonds are held by government agencies In this case, the funds are owed from one branch of the federal government to another To arrive at the net public debt, we subtract interagency borrowings from the gross public debt

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

Evaluating the Rising Public Debt (cont’d) During World War II, the net public debt grew dramatically After the war It fell until the 1970s Started rising in the 1980s Declined once more in the 1990s And recently has been increasing again

Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It

Figure 14-3 The Official Net U.S. Public Debt as a Percentage of GDP Source: U.S. Department of the Treasury.

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) As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases Foreign residents, businesses and governments hold more than 50% of the net public debt Thus, we do not owe the debt just to ourselves

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

Evaluating the Rising Public Debt (cont'd) Paying off the public debt in the future If the debt becomes larger, each person’s share would increase Taxes would be levied, and may not be assessed equally A special tax could be levied based on a person’s ability to pay

Evaluating the Rising Public Debt (cont'd) Our debt to foreign residents We do not owe all the debt to ourselves—what about the more than 50% owned by foreign residents? Future U.S. residents will be taxed to repay principal and interest Portions of U.S. incomes will be transferred abroad

Evaluating the Rising Public Debt (cont'd) If deficits lead to slower growth rates, then future generations will be poorer Both present and future generations will be economically better off if Government expenditures are really investments The rate of return on such public investments exceeds the interest rate paid on the bonds

Federal Budget Deficits in an Open Economy Question Is there a relationship between the U.S. trade deficit and the federal government budget deficit?

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

Figure 14-4 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) As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners The interest rate paid on bonds will need to be high enough to attract foreign investors

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

How do higher deficits affect the economy in the short run? Growing U.S. Government Deficits: Implications for U.S. Economic Performance How do higher deficits affect the economy in the short run? If the economy is below full-employment, the deficit can close the recessionary gap If the economy is already at full-employment, the deficit can create an inflationary gap

What are the long run macroeconomic effects of higher budget deficits? Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont’d) What are the long run macroeconomic effects of higher budget deficits? In the long run, higher government budget deficits have no effect on equilibrium real GDP per year Ultimately, therefore, government spending in excess of government receipts simply redistributes a larger share of real GDP per year to government-provided goods and services 36

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

What If … the government imposed a one-time tax to pay off all the net public debt? The net public debt is about $12 trillion and rising, while nominal GDP exceeds $15 trillion. Thus, if the government confiscated about three- fourths of all income generated within one year, it could repay the outstanding net public debt. To avoid creating more debt during that year, however, the government would also have to confiscate more than $3 trillion to fund its continued spending.

What If … the government imposed a one-time tax to pay off all the net public debt? (cont’d) Therefore, the government would have to confiscate nearly all of one year’s income. In theory, this could be done, but only at the expense of impoverishing the nation’s residents for twelve months.

Policy Example: Could Higher Tax Rates on “Millionaires’ Eliminate the Deficit? Is it possible to eliminate the federal deficit by imposing a 100 percent income tax rate on people earning more than $1 million per year? Figure 14-5 on the next slide shows the portion of total income received by each income bracket. The sum of all income earned by those with annual incomes of $1 million and up is less than $1 trillion. Therefore, even if the government were to confiscate all of this income, it would not be sufficient to cover the federal government deficit.

Figure 14-5 Distribution of Total Taxable Income Based on Annual Taxpayer Earnings Source: Internal Revenue Service.

How could the government reduce all its red ink? Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) How could the government reduce all 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 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

Noncontrollable Expenditures Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) Entitlements Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid Noncontrollable Expenditures Government spending that changes automatically without action by Congress

Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending Source: Office of Management and Budget.

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

Policy Example: Federal Indebtedness is Much Higher Than the Net Public Debt The U.S. government’s official net public debt has been ballooning in recent years, but its actual indebtedness has increased even more rapidly. Every year, Congress borrows to fund the on-going operation of Social Security. Also, future benefits for Medicare and Medicaid have been promised without being funded. Laurence Kotlikoff of Boston University has calculated that unfunded promises represent a total value of $200 trillion.

You Are There: A Long List of Ways to Cut the Federal Budget Deficit Gene Dodaro, head of the Government Accountability Office (GAO), issues a report listing separately funded programs with “duplicative” objectives. Among these are: 100 programs for highways and railroads 82 programs to improve teacher quality 80 programs to provide transportation for low-income people 80 programs to promote economic development 57 programs to help U.S. residents become more financially literate 52 programs to promote entrepreneurship 47 programs to assist with job training 48

You Are There: A Long List of Ways to Cut the Federal Budget Deficit (cont’d) Eliminating these programs would permit the federal government to cut about $200 billion from the annual deficit. Dodaro makes the report to Congress and leaves it up to these elected officials to decide on the budget cuts. 49

There are three causes of higher federal budget deficits since 2008: Issues & Applications: Borrowing Total Discretionary Spending – And More There are three causes of higher federal budget deficits since 2008: Lower tax revenues Higher discretionary spending Greater entitlement expenditures Figure 14-7 on the next slide displays the percentage of tax revenues available for discretionary spending. When the share of federal tax revenues allocated to discretionary spending is below zero, the government borrows more than the amount of discretionary spending.

Figure 14-7 The Percentage of Federal Tax Receipts Allocated to Federal Discretionary Spending Source: Congressional Budget Office. 51

Summary Discussion of Learning Objectives Federal government budget deficits Whenever the flow of government expenditures exceeds the flow of government revenues a budget deficit occurs The public debt Total value of all government bonds outstanding The federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt

Summary Discussion of Learning Objectives (cont'd) How the public debt might prove a burden to future generations Higher taxes will reduce private consumption Crowding out might reduce economic growth

Summary Discussion of Learning Objectives (cont'd) The macroeconomic effects of government budget deficits Because higher government deficits are caused by increased government spending or tax cuts, they contribute to a short-run rise in total planned expenditures and aggregate demand In the long run, increased deficits only redistribute resources from the private sector to the public sector

Summary Discussion of Learning Objectives (cont'd) Possible ways to reduce the government budget deficit Increase taxes Reduce expenditures by revising the terms of entitlement programs