1. Chapter 14 Deficit Spending and The Public Debt

2. Introduction
In recent years, total expenditures of the federal government have been considerably greater than receipts. Every discretionary federal spending program has been financed with borrowed funds.
Because federal discretionary spending has exceeded $1 trillion per year, the federal government has had to borrow more than $1 trillion per year.
In Chapter 14, you will contemplate the implications of federal borrowing.

3. Learning Objectives
Explain how federal government budget deficits occur
Define the public debt and understand alternative measures of the public debt
Evaluate circumstances under which the public debt could be a burden to future generations

4. Learning Objectives (cont'd)
Analyze the macroeconomic effects of government budget deficits
Describe possible ways to reduce the government budget deficit

5. Chapter Outline Public Deficits and Debts: Flows versus Stocks
Government Finance: Spending More than Tax Collections
Evaluating the Rising Public Debt
Federal Budget Deficits in an Open Economy
Growing U.S. Government Deficits: Implications for U.S. Economic Performance

6. Did You Know That ...
Even though government projections indicated that 2020 would be the year in which tax collections to fund Social Security would fall below beneficiary payments, the actual year was 2011?
The federal government is making up the difference by allocating a portion of regular government spending towards Social Security benefits.
Yet, tax revenues are insufficient to cover all of the government’s other expenditures.
Consequently, current Social Security benefits are partially funded with borrowings that must be repaid in future years.

7. Public Deficits and Debts: Flows versus Stocks
Government Budget Deficit
Exists if the government spends more than it receives in taxes during a given period of time
Is financed by the selling of government securities (bonds)

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

9. Public Deficits and Debts: Flows versus Stocks (cont'd)
Balanced Budget
A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time

10. Public Deficits and Debts: Flows versus Stocks (cont'd)
Government Budget Surplus
An excess of government revenues over government spending during a given period of time

11. Public Deficits and Debts: Flows versus Stocks (cont'd)
Public Debt
A stock variable
The total value of all outstanding federal government securities

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

13. Figure 14-1 Federal Budget Deficits and Surpluses Since 1940
Source: Office of Management and Budget.

14. International Example: Cosmetic Enhancement of the U. S
International Example: Cosmetic Enhancement of the U.S. Deficits and Debts?
The official government deficit and net public debt may be huge, but the reality is even worse.
U.S. reports typically only provide data on the federal government’s annual budget deficit and net public debt.
The U.S. federal government’s budget deficit per year is about 8.5 percent of annual GDP.
If state and municipal budgets were included, the figure for total indebtedness would rise to 10.5 percent of annual GDP

15. Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP
Sources: Economic Report of the President; Economic Indicators, various issues.

16. Government Finance: Spending More than Tax Collections (cont'd)
Question
Why has the government’s budget recently slipped from a surplus of 2.5% of GDP into a deficit of more than 8% of GDP?
Answer
Spending has increased at a faster page since the early 2000s
Tax rates were reduced towards the end of the recession

17. Evaluating the Rising Public Debt
Gross Public Debt
All federal government debt irrespective of who owns it
Net Public Debt
Gross public debt minus all government interagency borrowing

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

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

20. Evaluating the Rising Public Debt (cont’d)
During World War II, the net public debt grew dramatically
After the war
It fell until the 1970s
Started rising in the 1980s
Declined once more in the 1990s
And recently has been increasing again

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

22. Figure 14-3 The Official Net U.S. Public Debt as a Percentage of GDP
Source: U.S. Department of the Treasury.

23. Evaluating the Rising Public Debt (cont'd)
The government must pay interest on the public debt outstanding
The level of these payments depends on the market interest rate
Interest payments as a percentage of GDP are likely to rise in the future

24. Evaluating the Rising Public Debt (cont'd)
As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases
Foreign residents, businesses and governments hold more than 50% of the net public debt
Thus, we do not owe the debt just to ourselves

25. Evaluating the Rising Public Debt (cont'd)
If the economy is already at full employment, then further provision of government goods will crowd out some private goods
Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector

26. Evaluating the Rising Public Debt (cont'd)
Crowding-out may place a burden on future generations
Increased present consumption may crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth
Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt

27. Evaluating the Rising Public Debt (cont'd)
Paying off the public debt in the future
If the debt becomes larger, each person’s share would increase
Taxes would be levied, and may not be assessed equally
A special tax could be levied based on a person’s ability to pay

28. Evaluating the Rising Public Debt (cont'd)
Our debt to foreign residents
We do not owe all the debt to ourselves—what about the more than 50% owned by foreign residents?
Future U.S. residents will be taxed to repay principal and interest
Portions of U.S. incomes will be transferred abroad

29. Evaluating the Rising Public Debt (cont'd)
If deficits lead to slower growth rates, then future generations will be poorer
Both present and future generations will be economically better off if
Government expenditures are really investments
The rate of return on such public investments exceeds the interest rate paid on the bonds

30. Federal Budget Deficits in an Open Economy
Question
Is there a relationship between the U.S. trade deficit and the federal government budget deficit?

31. Federal Budget Deficits in an Open Economy (cont'd)
We know what a budget deficit is, but a trade deficit exists when the value of imports exceeds the value of exports
Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two

32. Figure 14-4 The Related U.S. Deficits
Sources: Economic Report of the President; Economic Indicators, various issues; author’s estimates.

33. Federal Budget Deficits in an Open Economy (cont'd)
As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners
The interest rate paid on bonds will need to be high enough to attract foreign investors

34. Federal Budget Deficits in an Open Economy (cont'd)
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
This shows that a U.S. budget deficit can contribute to a trade deficit

35. How do higher deficits affect the economy in the short run?
Growing U.S. Government Deficits: Implications for U.S. Economic Performance
How do higher deficits affect the economy in the short run?
If the economy is below full-employment, the deficit can close the recessionary gap
If the economy is already at full-employment, the deficit can create an inflationary gap

36. What are the long run macroeconomic effects of higher budget deficits?
Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont’d)
What are the long run macroeconomic effects of higher budget deficits?
In the long run, higher government budget deficits have no effect on equilibrium real GDP per year
Ultimately, therefore, government spending in excess of government receipts simply redistributes a larger share of real GDP per year to government-provided goods and services 36

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

38. What If … the government imposed a one-time tax to pay off all the net public debt?
The net public debt is about $12 trillion and rising, while nominal GDP exceeds $15 trillion.
Thus, if the government confiscated about three- fourths of all income generated within one year, it could repay the outstanding net public debt.
To avoid creating more debt during that year, however, the government would also have to confiscate more than $3 trillion to fund its continued spending.

39. What If … the government imposed a one-time tax to pay off all the net public debt? (cont’d)
Therefore, the government would have to confiscate nearly all of one year’s income.
In theory, this could be done, but only at the expense of impoverishing the nation’s residents for twelve months.

40. Policy Example: Could Higher Tax Rates on “Millionaires’ Eliminate the Deficit?
Is it possible to eliminate the federal deficit by imposing a 100 percent income tax rate on people earning more than $1 million per year?
Figure 14-5 on the next slide shows the portion of total income received by each income bracket.
The sum of all income earned by those with annual incomes of $1 million and up is less than $1 trillion.
Therefore, even if the government were to confiscate all of this income, it would not be sufficient to cover the federal government deficit.

41. Figure 14-5 Distribution of Total Taxable Income Based on Annual Taxpayer Earnings
Source: Internal Revenue Service.

42. How could the government reduce all its red ink?
Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)
How could the government reduce all its red ink?
Increasing taxes for everyone
Taxing only the rich
Reducing expenditures
Whittling away at entitlements

43. Growing U. S. Government Deficits: Implications for U. S
Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)
In considering how expenditures might be reduced, it is important to look at entitlements
These are federal government payments that are legislated obligations and cannot be reduced or eliminated

44. Noncontrollable Expenditures
Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)
Entitlements
Guaranteed benefits under a government program such as Social Security, Medicare, or Medicaid
Noncontrollable Expenditures
Government spending that changes automatically without action by Congress

45. Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending
Source: Office of Management and Budget.

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

47. Policy Example: Federal Indebtedness is Much Higher Than the Net Public Debt
The U.S. government’s official net public debt has been ballooning in recent years, but its actual indebtedness has increased even more rapidly.
Every year, Congress borrows to fund the on-going operation of Social Security.
Also, future benefits for Medicare and Medicaid have been promised without being funded.
Laurence Kotlikoff of Boston University has calculated that unfunded promises represent a total value of $200 trillion.

48. You Are There: A Long List of Ways to Cut the Federal Budget Deficit
Gene Dodaro, head of the Government Accountability Office (GAO), issues a report listing separately funded programs with “duplicative” objectives.
Among these are:
100 programs for highways and railroads
82 programs to improve teacher quality
80 programs to provide transportation for low-income people
80 programs to promote economic development
57 programs to help U.S. residents become more financially literate
52 programs to promote entrepreneurship
47 programs to assist with job training 48

49. You Are There: A Long List of Ways to Cut the Federal Budget Deficit (cont’d)
Eliminating these programs would permit the federal government to cut about $200 billion from the annual deficit.
Dodaro makes the report to Congress and leaves it up to these elected officials to decide on the budget cuts. 49

50. There are three causes of higher federal budget deficits since 2008:
Issues & Applications: Borrowing Total Discretionary Spending – And More
There are three causes of higher federal budget deficits since 2008:
Lower tax revenues
Higher discretionary spending
Greater entitlement expenditures
Figure 14-7 on the next slide displays the percentage of tax revenues available for discretionary spending.
When the share of federal tax revenues allocated to discretionary spending is below zero, the government borrows more than the amount of discretionary spending.

51. Figure 14-7 The Percentage of Federal Tax Receipts Allocated to Federal Discretionary Spending
Source: Congressional Budget Office. 51

52. Summary Discussion of Learning Objectives
Federal government budget deficits
Whenever the flow of government expenditures exceeds the flow of government revenues a budget deficit occurs
The public debt
Total value of all government bonds outstanding
The federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt

53. Summary Discussion of Learning Objectives (cont'd)
How the public debt might prove a burden to future generations
Higher taxes will reduce private consumption
Crowding out might reduce economic growth

54. Summary Discussion of Learning Objectives (cont'd)
The macroeconomic effects of government budget deficits
Because 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
In the long run, increased deficits only redistribute resources from the private sector to the public sector

55. Summary Discussion of Learning Objectives (cont'd)
Possible ways to reduce the government budget deficit
Increase taxes
Reduce expenditures by revising the terms of entitlement programs