NS3040 Fall Term 2018 U.S. Fiscal Policy Ed Dolan, As we Move into Budget Chaos, Just How Bad is Fiscal Policy Really? EconoMonitor, October 2, 2013

U.S. Fiscal Policy I Several controversies currently dominating fiscal policy One position is that taxation and government spending are out of control and public debt is rapidly becoming unsustainable Other position is that U.S. fiscal policy has simply been mismanaged and that corrections are easy to make – the situation is not dire. Useful to make some comparisons with other countries – OECD, group of 30 wealthy democratic countries Total government expenditures in the U.S are a bit below the overage for the OECD At 39% of GDP for 2013 much less than 59% Denmark, the highest and Above 31% in Korea the lowest Government outlays increased as a % of GDP as the financial crisis developed and have fallen since that time Ed Dola

U.S. Fiscal Policy II

U.S. Fiscal Policy III Levels of Taxation Pattern very much same as with expenditures Denmark and Korea have the highest and lowest levels of taxation as with outlays The U.S. is a bit below the average of OECD countries Taxes as a share of GDP increased in all countries as incomes dropped during the global crisis Have fallen since On whole, level of taxation in the U.S. is not exceptionally high by standards of wealthy countries Only slightly higher than its 20 year average.

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U.S. Fiscal Policy V Budget Balance As of 2013 the U.S. deficit for all levels of government is somewhat greater than the OECD average but not much OECD’s greatest budget deficit for 2013 -- Japan Budget deficit much more volatile than underlying levels of taxes and spending In 2009, annual deficit for all levels of U.S. government increased to 11.9% GDP substantially more than OECD average In 2009 the U.S. deficit was greater than Japan’s Greece and Ireland had even greater deficits that year Since its low point the U.S. budget deficit has decreased by more than half, although remains larger than pre-crisis average

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U.S. Fiscal Policy VII Net Debt Pattern here is different than the earlier charts Most indebted OECD country is again Japan Japanese debt increased tremendously since long bout with deflation in min-1990s Least indebted country is Switzerland In terms of debt the U.S. is well above the OECD Average Also U.S. debt has risen more rapidly than OECD average during crisis and is running well above its own 20 year historical norm Unlike first two charts which are little cause for alarm, the 3 and 4th charts give a bleaker picture Still they do not tell the whole story

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U.S. Fiscal Policy IX Problem 1: US Fiscal Policy is Pro-cyclical Not useful to judge a country’s fiscal policy on the basis of its annual budget balance The deficit or surplus for any year is strongly sensitive to the effect of the business cycle through automatic stabilizers These are elements of tax and spending laws that move budget automatically Toward deficit when the economy contracts Toward surplus then it enjoys a boom

U.S. Fiscal Policy X Get a clearer picture of posture of country’s fiscal policy by making two adjustments First adjust for the effects of automatic stabilizers by calculating the budget balance as it would look Assuming current tax and spending laws if the economy were at full employment (zero output gap) That adjustment gives the structural balance Second need to take out the part of government outlays that go to pay interest on the accumulated deficit This gives the primary structural balance

U.S. Fiscal Policy XI Two sensible ways for a country to manage its primary structural budget balance 1. follow a cyclically neutral policy Holds the primary structural balance constant from year to year regardless of the state of the business cycle If done, annual balance would show a deficit during downturns and a surplus during booms Would average out to a level that would prevent uncontrolled accumulation of debt over time Chile follows such a cyclically neutral policy

U.S. Fiscal Policy XII 2. follow a countercyclical policy Means making discretionary tax cuts and spending increases daring a downturn Followed by offsetting tax increases and spending restraint during the next upturn Such a policy would if properly executed reduce the depth of recessions and prevent overheating during upturns While maintaining a sustainable average balance over the cycle. Sweden is an example of a country that systematically follows a counter cyclical fiscal policy

U.S. Fiscal Policy XIII Unfortunately fiscal policy in the U.S. as been pro-cyclical Means it has cut taxes and increased spending during booms, thereby encouraging overheating Then raised taxes and cut spending during periods of slack demand slowing the recovery Output gap (difference between actual and trend) should be positive when the economy is booming and negative when in a slump For the primary structural balance Cyclically neutral policy would require the primary structural balance to stay constant from year to year A countercyclical policy would require it to move toward a surplus when the output gap is positive and into deficit when the output gap turns negative.

U.S. Fiscal Policy XIV For U.S. fiscal policy has been largely pro-cyclical in recent years Years of prosperity from 2000 to 2007 accompanied by a movement toward structural deficits – large tax cuts and two unfunded wars Then came a brief counter cyclical interlude in 2008 and 2009 when the Bush and then Obama administrations undertook stimulus measures to mitigate the effects of the financial crisis However as soon as economy had reached bottom of the cycle in mid 2009, but while it was still experiencing a large negative output gap, policy turned pro-cyclical again Spending cuts and tax increases began moving the structural balance back toward surplus Resulted in a slow recovery with hardly any narrowing of he output gap over the past four years.

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U.S. Fiscal Policy XVI Problem 2: U.S. Fiscal Policy is Unsustainable The debt chart indicated the U.S. net government debt growing toward 90% of GDP – trajectory many observers feel is unsustainable Whether or not it is depends on what we mean by the term “sustainable” First perspective – country’s debt is unsustainable if its current trajectory is such that the government will one day be unable to pay its bills Nonsense for the United States -- which has its own sovereign currency – can always print money to pay bills. Government would basically resort to an inflation tax

U.S. Fiscal Policy XVII Second perspective – mathematical sustainability hinges on the projected growth path for the future debt given certain assumptions about Tax and spending laws, The rate of growth of nominal GDP and Nominal interest rates The debt will be mathematically sustainable for a country with a nominal interest rate that is higher than its rate of growth only if it maintains a small structural surplus The U.S. primary structural balance of -4.0% GDP is therefore unsustainable Existing policies may already be moving the primary structural balance toward surplus Or the Fed and Treasury could permanently hold the nominal rate of interest on government debt below nominal rate of growth

U.S. Fiscal Policy XVIII Third view – functional sustainability Country’s fiscal policy is functionally sustainable if and only if it has a set of rules and decision making procedures that adjust fiscal parameters over time to serve some rational purpose No one formula for functional sustainability Swedish countercyclical fiscal rules Chilean cyclically neutral rules both fit Even an annually balanced budget amendment would fit the criteria, although might harm economy Problem the U.S. does not have any workable fiscal policy rules at all No long run budget policy No policy for size of deficits or the rate of growth of pubic debt over a period of years

CBO Forecasts 01-2015 Nick Timiraos, Deficit Seen Falling, Then Rising in 2018, WSJ January 27, 2015

U.S. Fiscal Policy XIX Bottom Line? Is U.S in such a deep fiscal hole we can not possibly get out? Not really – our taxes, expenditures, deficit and even debt are in the moderate OECD range Current fiscal problems could be easily solved Problem: country seems to lack political ability to move forward