Chapter 5 -- The Federal Budget zBudget = Tax Revenues - Government Expenditure (over a given period) zBudget = Tax Revenues - (Government purchases of goods and services + Transfer Payments + Interest on the National Debt)

Budget Definitions zBudget < 0 -- Budget Deficit zBudget > 0 -- Budget Surplus zBudget = 0 -- Balanced Budget zRealistic Goal -- Balanced Budget when Y = Y N.

The Federal Budget: 2006 (Billions of Dollars) zGovernment Receipts = $ zGovernment Expenditure = $ zBudget = -$220.0 zSource: Economic Indicators, February 2008

Breakdown of Government Receipts zPersonal Income Taxes = $ zCorporate Profits Taxes = $373.1 zTaxes on Production and Imports = $98.6 zContributions for Social Insurance = $901.6 zMiscellaneous = $69.3

Breakdown of Government Expenditure zConsumption Expenditures (G) = $812.8 zTransfer Payments = $ zNet Interest Paid = $277.5 zMiscellaneous = $49.4

The Budget: In Our Notation Recall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

The Budget and The Size of the Deficit zBudget = T - G zSize of Deficit = G - T

The National Debt zThe National Debt -- The total accumulated stock of debt owed by the government to its lenders. Debt 2011 = Debt Deficit 2011

National Debt -- Realistic Goal zRealistic Goal -- consider the Debt-Income Ratio = (National Debt)/(GDP). zFor US in 2007 = ($5035.1)/($ ) = 0.364

Decomposition of Deficit zPurpose -- break up deficit for more precise analysis of causes. zConsider the deficit, with the income tax function for net taxes.  Deficit = G - (T 0 + tY*) zAdd and subtract the term tY N  Deficit = [G - (T 0 + tY N )] + t(Y N - Y*)

The Cyclical Deficit zThe Cyclical Deficit = t(Y N - Y*) -- the deficit that arises when the economy is not at its natural level. zSluggish economy (Y* < Y N )  positive cyclical deficit. zEconomy with accelerating inflation (Y* > Y N )  negative cyclical deficit.

More on the Cyclical Deficit zConnected with Automatic Stabilization -- net tax revenues change automatically in directions that work to stabilize the economy. zCyclical deficit -- not considered a special problem. It’s resolved when Y = Y N.

The Structural Deficit zThe Structural Deficit = [G - (T 0 + tY N )]. zInterpretation -- the deficit that remains after Y* = Y N. zConstitutes a problem, with a need for special deficit policy. zRealistic Goal (Budget) -- zero structural deficit.

Analyzing the Deficit -- A Numerical Example Year Structural + Cyclical = Total (Y* > Y N ) (Y* < Y N ) (Y* = Y N )

Main Results From Example zOverstimulated economy can mask a deficit problem. zSluggish economies tend to have larger deficits. zTwo step strategy -- deficits (1) Get Y* = Y N. (2) Take steps to reduce deficit that remains.

Why are the Debt and Deficits a Problem? zHampers the use of fiscal policy. zGetting the benefits without considering the costs. zCrowding Out Effect -- higher deficits may increase interest rates, reducing investment and possibly net exports.

The Crowding Out Effect zConsider “magic equation”: S + (T - G) + -NX = I. zLess government saving (T - G), more reliance on foreign borrowing (NX  ) or lower investment (I  ). zParticularly damaging if investment decreases (more later).

The Increased Debt: Burden on Future Generations zIn general, older generations enjoy benefits from the debt. But younger generations have to sacrifice in the future to repay the debt, maintain interest payments, or be deprived of new initiatives.

The Crowding Out Effect: A More Sober Implication zCrowding Out Effect – Expansion of Federal Deficit and Debt increases interest rates, lowers investment (and possibly consumption) zLower investment retards development of the capital stock, the economy’s productive capacity for future generations.

Maybe Effects of Deficits and Debt Aren’t so Bad zRiccardian Equivalence -- Given an increased deficit, older people correspondingly increase their saving. zOlder generations provide the means to pay debt and interest.

Riccardian Equivalence -- No Crowding Out Effect zWithin the macro identity: S + (T - G) + -NX = I. zRiccardian Equivalence  when (T - G) , S  simultaneously  interest rates and therefore Investment are unaffected.

Another Reason Why Debt May Not Be Overly Harmful zThe government (in reality) as producer as well as spender. zSome G is in fact government investment (e.g. buildings) zSome investment government can do better than the private sector (infrastructure).

Reducing a Structural Deficit = [G - (T 0 + tY N )] zIncrease Taxes (income or consumption-based) zAdvantages: smaller multiplier, can focus on higher incomes, undesirable behavior. zDisadvantages: implicit permission for government to be inefficient in its spending.

Reducing a Structural Deficit = [G - (T 0 + tY N )] zDecrease Transfer Payments. zAdvantages: smaller multiplier, largest component of government expenditure, holds the line on taxes. zDisadvantages: very painful to the groups affected (often vulnerable).

Reducing a Structural Deficit = [G - (T 0 + tY N )] zDecrease Government Purchases of Goods and Services zAdvantages: permanence, gives discipline to government, encourages (often more efficient) private sector to replace government programs. zDisadvantages: largest multiplier, most painful way.

Reducing a Structural Deficit = [G - (T 0 + tY N )] zAll three are contractionary measures, will reduce Y*. -- shifts E P curve downward -- shifts IS curve leftward zHopefully, i* will decrease (IS-LM),  I , with its associated benefits. zOne more possibility -- can we make Y N  ? -- Discussed later.

The Clinton Surpluses: What Happened? zMarginal tax rate increases on higher incomes, sales tax increases in zHolding the line on transfer payments, government purchases. zUnusually large growth in the natural level of real GDP (Y N ).