Macroeconomics ECON 2301 Spring 2009 Marilyn Spencer, Ph.D. Professor of Economics Chapter 14

Chapter 14: Deficit Spending and the Public Debt

14-3 Learning Objectives: 4 Explain how federal government budget deficits occur 4 Define the public debt and understand alternative measures of the public debt 4 Evaluate circumstances under which the public debt could be a burden to future generations 4 Discuss why the federal budget deficit might be measured incorrectly 4 Analyze the macroeconomic effects of government budget deficits 4 Describe possible ways to reduce the government budget deficit

14-4 Public Deficits and Debts: Flows versus Stocks 4 Government Budget Deficit ÜExists if the government spends more than it receives in taxes during a given period of time ÜIs financed by the selling of government securities (bonds)

14-5 Public Deficits and Debts: Flows versus Stocks (cont'd) 4 The federal deficit is a flow variable, one defined for a specific period of time, usually one year. 4 If spending equals receipts, the budget is balanced. 4 If receipts exceed spending, the government is running a budget surplus.

14-6 Public Deficits and Debts: Flows versus Stocks (cont'd) 4 Balanced Budget ÜA situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time 4 Government Budget Surplus ÜAn excess of government revenues over government spending during a given period of time

14-7 Public Deficits and Debts: Flows versus Stocks (cont'd) 4 Public Debt ÜA stock variable ÜThe total value of all outstanding government securities

14-8 Government Finance: Spending More than Tax Collections 4 Since 1940, the U.S. federal government has operated with a budget surplus in 13 years. 4 In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.

14-9 Figure 14-1 Federal Budget Deficits and Surpluses Since 1940

14-10 Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP

14-11 Policy Example: Explaining a $109 Billion Deficit Projection Turnaround 4 Why was the government’s 2005 deficit projection off by $109 billion? 4 Federal tax revenues turned out to be more than 15% higher in Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.

14-12 Evaluating the Rising Public Debt 4 Gross Public Debt ÜAll federal government debt irrespective of who owns it 4 Net Public Debt ÜGross public debt minus all government interagency borrowing

14-13 Evaluating the Rising Public Debt (cont'd) 4 Some government bonds are held by government agencies. ÜIn this case, the funds are owed from one branch of the federal government to another. ÜTo arrive at the net public debt, we subtract interagency borrowings from the gross public debt.

14-14 Evaluating the Rising Public Debt (cont'd) 4 Tax revenues tend to be stagnant during times of slow economic growth. 4 Tax revenues grow more quickly when overall growth enhances incomes. 4 As long as spending exceeds revenues, the budget deficit will persist.

14-15 Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It

14-16 Figure 14-3 Net U.S. Public Debt as a Percentage of GDP

14-17 Net U.S. Public Debt as a Percentage of GDP 4 During World War II, the net public debt grew dramatically. 4 After the war ÜIt fell until the 1970s ÜStarted rising in the 1980s ÜDeclined once more in the 1990s ÜAnd recently has been increasing again

14-18 Evaluating the Rising Public Debt (cont'd) 4 The government must pay interest on the public debt outstanding. ÜThe level of these payments depends on the market interest rate. ÜInterest payments as a percentage of GDP are likely to rise in the future. 4 As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases. ÜForeign residents, businesses and governments hold nearly 50% of the net public debt. ÜThus, we do not owe the debt just to ourselves.

Announcement 4 We will not hold class this Thursday, April 9. 4 Instead, work on your projects: ÜMacroeconomics in the News, paper due April 16 ÜTeaching project, paper due April 23

14-20 Evaluating the Rising Public Debt (cont'd) 4 If the economy is already at full employment, then further provision of government goods will crowd out some private goods. 4 Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector. 4 Crowding-out may place a burden on future generations. ÜIncreased present consumption may crowd out investment and reduce the growth of capital goods, which could reduce a future generation’s wealth. ÜTaxes may have to be increased, imposing higher taxes on future generations in order to retire the debt.

14-21 Evaluating the Rising Public Debt (cont'd) 4 Paying off the public debt in the future ÜIf the debt becomes larger, each person’s share would increase. ÜTaxes would be levied, and may not be assessed equally. ÜA special tax could be levied based on a person’s ability to pay.

14-22 Evaluating the Rising Public Debt (cont'd) 4 Our debt to foreign residents ÜWe do not owe all the debt to ourselves. ÜFuture U.S. residents will be taxed to repay principal and interest. ÜPortions of U.S. incomes will be transferred abroad.

14-23 Evaluating the Rising Public Debt (cont'd) 4 If deficits lead to slower growth rates future generations will be poorer. 4 Both present and future generations will be economically better off if… ÜGovernment expenditures are really investments ÜThe rate of return on such public investments exceeds the interest rate paid on the bonds

14-24 International Example: Where Are Most Treasury Securities Held Abroad? 4 More than $2 trillion in U.S. Treasury securities of the $5 trillion in net outstanding debt is held outside the United States. 4 Japan accounts for more than one-third of all foreign holdings of the U.S. net public debt.

14-25 Figure 14-4 The Distribution of Foreign Holdings of U.S. Treasury Securities

14-26 International Example: Where Are Most Treasury Securities Held Abroad? (cont'd) 4 For critical analysis: ÜWhy might the fact that market interest rates in Japan have hovered very close to 0% during the 2000s help explain relatively large holdings of U.S. Treasury securities by residents of that country?

14-27 Federal Budget Deficits in an Open Economy 4 Question: Is there a connection between the U.S. trade deficit and the federal government budget deficit? 4 A trade deficit exists when the value of imports exceeds the value of exports. 4 Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.

14-28 Figure 14-5 The Related U.S. Deficits

14-29 Federal Budget Deficits in an Open Economy (cont'd) 4 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. 4 This means that a U.S. budget deficit can contribute to a trade deficit.

14-30 Growing U.S. Government Deficits: Implications for U.S. Economic Performance 4 Which government deficit is the true deficit? ÜThe government may report distorted measures of its own budget. Government has not adopted a business-like approach to tracking its expenditures and receipts. Official government “measures” yield lowest possible deficits and highest reported surpluses.

14-31 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 An operating budget includes current outlays for on-going expenses, such as salaries and interest payments. 4 A capital budget, includes expenditures on investment items, such as machines, buildings, roads and dams.

14-32 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 Question ÜHow do higher deficits affect the economy in the short run? 4 Answers: ÜIf the economy is below full-employment, the deficit can close the recessionary gap. ÜIf the economy is already at full-employment, the deficit can create an inflationary gap.

14-33 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 In the long run, higher government budget deficits have no effect on equilibrium real GDP. 4 Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.

14-34 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 Thus, if the government operates with higher deficits over an extended period: ÜThe ultimate result is a shrinkage in the share of privately produced goods and services ÜBy continually spending more than it collects, the government takes up a larger portion of economic activity.

14-35 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 How could the government reduce all its red ink? ÜIncreasing taxes for everyone ÜTaxing only the rich ÜReducing expenditures ÜWhittling away at entitlements

14-36 Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase 4 Some estimates show increasing the top bracket from 35% to 39.6% would reduce total taxable income by at least 4%. 4 Such projections show this increase as giving the highest income taxpayers a greater incentive to incorporate and pay lower corporate-profit tax rates. 4 Thus, raising the income tax rate by 4.6% would result in less than a 4.6% increase in government tax collections – but an increase, not a decrease, as some suggest.

14-37 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 In considering how expenditures might be reduced, it is important to look at entitlements, the federal government payments that are legislated obligations and cannot be reduced or eliminated. 4 What are some of these entitlements?

14-38 Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending

14-39 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 Entitlements are the largest component of the U.S. federal budget. 4 To make a significant cut in expenditures, entitlement programs would have to be revised.

14-40 Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd) 4 Question ÜWhat are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid???

14-41 Summary of Learning Objectives 4 Federal government budget deficits ÜWhenever the flow of government expenditures exceeds the flow of government revenues a budget deficit occurs. 4 The public debt ÜTotal value of all government bonds outstanding ÜThe federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt.

14-42 Summary of Learning Objectives(cont'd) 4 How the public debt might prove a burden to future generations ÜHigher taxes will reduce private consumption. ÜCrowding out might reduce economic growth. 4 Why the federal budget deficit might be incorrectly measured ÜNo distinction between capital expenses and operating expenses ÜEach estimate is based on a set of assumptions.

14-43 Summary of Learning Objectives (cont'd) 4 The macroeconomic effects of government budget deficits ÜBecause 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. ÜIn the long run, increased deficits only redistribute resources from the private sector to the public sector.

14-44 Summary of Learning Objectives (cont'd) 4 Possible ways to reduce the government budget deficit: ÜIncrease taxes ÜReduce expenditures by revising the terms of entitlement programs

April 14 Assignment to be completed before class April 14: Read Chapter 15 & also read the end-of-chapter Problems: 15-2, 15-4, 15-6, 15-8, 15-13, & 15-15, on pp