DEFICIT FINANCE Chapter 20

How Big Is the Deficit? Deficit Surplus On-budget deficit Off-budget deficit

How Big Is the Deficit? Source: Congressional Budget Office [2012b]

How Big Is the Debt? National (Public) Debt Stocks vs. Flows

How Big Is the Debt? Source: Congressional Budget Office [2012b]

Interpreting Deficit, Surplus, and Debt Numbers Government Debt held by the Federal Reserve Bank State and Local Government Effects of Inflation Inflation tax Capital versus Current Accounting Tangible Assets Implicit Obligations Summing Up

The Burden of the Debt Statutory versus Economic Incidence One Hand Borrows from the Other Internal Debt External Debt

Overlapping Generations Model The Period 2010-2030 Young Middle-Aged Old (1) Income $12,000 12,000 (2) Government Borrowing -6,000 (3) Government- provided consumption 4,000 The Year 2030 (4) Government raises taxes to pay back debt -4,000 (5) Government pays back debt +6,000 Lerner – generation is everyone alive at same time Alternative – generation is everyone born at the same time Each generation has equal number of people Each lives 20 years Each has fixed income of $12,000/year Internal debt creates burden for future generations

Overlapping Generations Model Generational Accounting Computation of Net Tax PV of transfers received – PV of taxes paid OG model  using generational accounting to evaluate impact of Government fiscal policies

Other Models Neoclassical Model Ricardian Model Crowding Out Hypothesis Empirical testing of the hypothesis Ricardian Model Intergenerational transfers Form of Finance is irrelevant Empirical evidence

To Tax or To Borrow Benefits-Received Principle Intergenerational Equity Efficiency Considerations χ = ½εLt2 Deficits and Functional Finance Functional finance Moral and Political Considerations Federal Debt and the Risk of a Fiscal Crisis Controlling the Deficit Clicking on “Efficiency Considerations” goes to custom show showing PV of spending and taxing under alternative taxing/borrowing decisions Clicking on “χ = ½εLt2” goes to custom show of graph of relationship between tax rate and excess burden

Present Value of Tax Payments Under Alternative Taxing/Borrowing Decisions Policy Year 1 Year 2 All Future Years PV @ 10% interest rate Spend an additional $100 in year 1 100 Financing Options Balanced budget: raise 100 in taxes in year 1 Deficit Finance I: borrow 100 in year 1 and pay back debt plus interest in year 2 by raising taxes 110 Deficit Finance II: borrow 100 in year 1 and pay interest on debt in all subsequent years always rolling over debt principle 10 Table shows 3 ways to finance an extra 100 in spending in year 1. Balanced budget – finance spending by raising 100 in taxes in year 1. PV of tax payments is 100 Deficit Finance I – finance by borrowing the 100 in year 1 and paying it back plus interest in year 2. In year 2 110 must be raised in taxes. PV of 110 in one year at 10% interest rate is 100 Deficit Finance II – finance by borrowing 100 in year 1 and never paying back the debt. In all subsequent years the interest on the debt must be paid so taxes must be raised 10 each year to do that. PV of 10 per year until the end of time is 100.

To Tax or To Borrow Excess Burden χ2 χ1 t 2t Tax rate Axes and labels 1st click – curved solid line and dashed lines Click returns to “To tax or borrow” slide χ1 t 2t Tax rate

Chapter 20 Summary When government spending > revenues, it must borrow money: debt is the sum of past deficits & surpluses Economic research centers on whether future generations carry the burden of government debt Several factors influence whether government should finance expenditures through taxes or debt From an efficiency point of view, the excess burden of tax vs. debt financing should be considered Options for controlling the deficit include changing budget-making processes and a constitutional amendment