1 Chapter 12 Budget Balance and Government Debt

2 Budget Terms A Budget Surplus exists when Tax Revenues are greater than expenditures and is the difference between the two. A Budget Deficit exists when Expenditures are greater than Tax Revenues and is the difference between the two. The National Debt is the sum of deficits minus the sum of surpluses since 1776.

3 Figure 12.1 Federal Budget Deficits, and Surplus as a Percent of GDP,

4 Surpluses, Deficits and the Debt as a Percentage of GDP Nominal figures are less important than their relationship to the size of the economy. Economists tend to look at these figures as percentages of GDP.

5 High-Employment Deficit or Surplus The budget balance is altered significantly by the state of the economy. If GDP is rising quickly, then fewer people are drawing on the welfare state and more are paying taxes. The high-employment deficit or surplus is what the surplus would be if unemployment were low. Economists often prefer this measure to the actual level of the deficit or surplus when advocating policy.

6 Measuring Budget Balance On Budget vs Off Budget Social Security and the Post Office are run off budget. Since 1982 Social Security has run a considerable surplus. This money is loaned to the rest of the on budget side of the government with the bonds issued to the Social Security Administration being the Social Security Trust Fund.

7 Unified Budget The Unified Budget is the sum of the on- and off-budget deficits and surpluses. If this is a net deficit, then the government must borrow new money from the public. If it is a net surplus, then it is a net provider of capital to the private sector.

8 National Income and Product Accounts Budget The NIPA Budget does not include any transactions that finance preexisting debts, such as outlays for deposit insurance.

9 Real Surpluses and Deficits Real Surpluses and Real Deficits are expressed in inflation-adjusted terms.

10 Economic Effects of Federal Budget Deficits Unified budget deficits require additional borrowing.

11 Figure 12.2 Government Demand for Loanable Funds and the Market Rate of Interest Interest Rate Loanable Funds per Year 0 E' L2L2 i2i2 D 1 +  D G L1L1 i1i1 E S D1D1

12 Ricardian Equivalence Ricardian Equivalence is the view that deficits do not alter interest rates because citizens today see that deficits today will be financed with higher taxes tomorrow and citizens save in order to have the funds to pay those higher taxes.

13 Figure 12.3 Ricardian Equivalence: Deficits Do Not Affect Interest Rates Interest Rate 0 L1L1 E' L2L2 i2i2 i1i1 Loanable Funds per Year D 1 +  D G E S D1D1 L3L3 E'' LL S'

14 Economic Effects of Federal Budget Surpluses Unified budget surpluses allow government to provide capital to the loanable funds market.

15 Figure 12.4 Impact of a Budget Surplus on Credit Markets D E I1I1 L1L1 S LL E' I2I2 L2L2 S' = S 1 +  L Interest Rate Loanable Funds per Year 0

16 Budget Balance, National Saving, and Economic Growth An increase in the deficit contributes to a decrease in national savings, while an increase in a surplus contributes to a increase in national savings. Increases in national savings increase the potential for the economy to grow.

17 Figure 12.5 The National Savings Rate and its Components, (Ratio of Savings to GNP)

18 Incidence of Deficit Finance Lower growth rates imply lower incomes for future generations. If Ricardian Equivalence holds, then this is not the case. Deficits may also change political equilibrium so that there are increases in government infrastructure that could lead to increased future growth.

19 The Government Debt January 2003 Federal Debt $6.4 trillion State and Local Debt $1 trillion

20 Figure 12.6 Federal Debt Held by the Public as a Share of GDP (By fiscal year)

21 Net Federal Debt The Net Federal Debt is the portion of the debt not held by the federal government.

22 Gross public Debt of the US Treasury by Holder January 29, 2003 HolderAmount of Debt (Billions of Dollars) Percent of Total U.S. Govt. Agencies Trust Funds and Federal Reserve 2, Private Investors3, Total6,

23 Net Public Debt of the U.S. Treasury by Holder (Percent Distribution) June 2002 HolderPercentage of Total Depositors and Institutions7.2 Mutual Funds8.8 Insurance Companies3.9 Pension Funds10.5 State and Local Governments9.5 Foreign and International39.6 Other Investors22.5 Total100.0

24 Internal and External Debt The Internal Debt is the portion of the debt owed to our own citizens. The External Debt is the portion of the debt owed to people other than U.S. citizens.

25 State and Local Borrowing Bonds are issued by state and local governments to fund large projects. They are rated by financial companies for their risk. Similar to federal debt, much of it is held externally.

26 General Obligation vs Revenue Bonds General Obligation Bonds are backed by the state or local government’s ability to tax. Revenue Bonds are backed by the revenue that a state or local enterprise would generate.

27 Social Security and the Deficit Social Security Surpluses are used to purchase federal government debt. This will happen until benefits exceed revenues (estimated to be 2023). Thereafter it will run deficits and will be forced to sell off those bonds. Whether Social Security is on- or off-budget and whether or not there is a trust fund has no effect on the net national debt.

28 Burden of the Debt Impact on future generations: People have to pay increased taxes to pay interest on that debt. Some may inherit the original bonds. Growth rates are reduced because of higher interest rates. These impacts can be offset by the increased private savings of the generation that does the borrowing, or by returns that come from programs that were funded by the borrowing.

29 Financing Capital by State and Local Governments Capital expenditures by State and Local governments (sewers, schools, etc.) tend to benefit future generations. The benefit principle suggests that projects that yield the bulk of their benefits in the future should be financed through borrowing.

30 National Saving and Government Budget Balance National saving in the United States remains low by international standards. A compelling argument in favor of running a budget surplus is to help increase national saving to pay Social Security pensions in the 21st century.