1. Fiscal Policy, Deficits, and Debt33
Fiscal Policy, Deficits, and Debt
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Fiscal Policy
Learning objectives – After reading this chapter, students should be able to:
1. Identify and explain the purposes, tools, and limitations of fiscal policy.
2. Explain the role of built-in stabilizers in moderating business cycles.
3. Describe how the cyclically-adjusted budget reveals the status of fiscal policy.
4. Discuss the size, composition, and consequences of public debt.
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3. Fiscal Policy
One major function of the government is to stabilize the economy (prevent unemployment or inflation).
Stabilization can be achieved in part by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation.
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4. Fiscal Policy Fiscal Policy and the AD/AS Model
Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending to alter real domestic output and employment, control inflation, and stimulate economic growth. “Discretionary” means the changes are at the option of the national government.
Discretionary fiscal policy changes in the United States are often initiated by the President, on the advice of the Council of Economic Advisers (CEA).
Changes not directly resulting from congressional action are referred to as nondiscretionary (or “passive”) fiscal policy.
Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples illustrated in Figure 33.1).
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5. Fiscal Policy
Expansionary Policy needed: In Figure 33.1, a decline in investment has decreased AD from AD1 to AD2 so real GDP has fallen and also employment declined. Possible fiscal policy solutions follow:
a. An increase in government spending (shifts AD to right by more than change in G due to multiplier),
b. A decrease in taxes (raises income, and consumption rises by MPC x the change in income; AD shifts to right by a multiple of the change in consumption).
C. A combination of increased spending and reduced taxes.
If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.
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6. Expansionary Fiscal Policy
$5 billion
increase in
spending
Recessions
Decrease AD AS
Full $20 billion
increase in
aggregate demand
Price level P1
AD1
AD2
$490
$510
Real GDP (billions)
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7. Fiscal Policy
Contractionary fiscal policy needed: When demand‑pull inflation occurs as illustrated by a shift from AD3 to AD4 up the short-run aggregate supply curve in Figure Then contractionary policy is the remedy:
Policy options: G or T?
Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure.
Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.
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8. Contractionary Fiscal Policy
$3 billion initial
decrease in
spending AS
Price level
Full $12 billion
decrease in
aggregate demand d c P2 b P1 a
AD4
AD5
AD3
$502
$510
$522
Real GDP (billions)
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9. Fiscal Policy Built-In Stability
Built‑in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary. Figure 33.3 illustrates how the built-in stability system behaves.
Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.
Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.
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10. Government expenditures, G,
Built-In Stability T
Surplus
Government expenditures, G,
and tax revenues, T G
Deficit
GDP1
GDP2
GDP3
Real domestic output, GDP
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11. Fiscal Policy
The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built‑in stability. In Figure 33.3 line T is steepest with a progressive tax system.
The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur.
Automatic stability reduces instability, but does not eliminate economic instability.
IV. Evaluating Fiscal Policy
A cyclically-adjusted budget in Year 1 is illustrated in Figure 33.4(a) because budget revenues equal expenditures when full employment exists at GDP1.
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12. Cyclically Adjusted Budgets
Government expenditures, G, and
tax revenues, T (billions)
$500 G
450 c
This figure shows the cyclically adjusted deficits in this graph. The cyclically adjusted deficit is zero at the full-employment output GDP1. But it is also zero at the recessionary output GDP2 because the $500 billion of government expenditures at GDP2 equals the $500 billion of tax revenues that would be forthcoming at the full-employment GDP1. There has been no change in fiscal policy.
GDP2
GDP1
(year 2)
(year 1)
Real domestic output, GDP
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13. Fiscal Policy
At GDP2 there is unemployment and assume no discretionary government action, so lines G and T remain as shown.
Because of built‑in stability, the actual budget deficit will rise with the decline of GDP; therefore, actual budget varies with GDP.
The government is not engaging in expansionary policy since the budget is balanced at full- employment output.
The cyclically-adjusted budget measures what the Federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full employment.
Actual budget deficit or surplus may differ greatly from the cyclically-adjusted budget deficit or surplus estimates.
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14. Fiscal Policy
In Figure 33.4b, the government reduced tax rates from T1 to T2, now there is a cyclically-adjusted deficit.
Structural deficits occur when there is a deficit in the cyclically-adjusted budget as well as the actual budget.
This is expansionary policy because true expansionary policy occurs when the cyclically-adjusted budget has a deficit.
If the cyclically-adjusted deficit of zero was followed by a cyclically-adjusted budget surplus, fiscal policy is contractionary.
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15. Cyclically Adjusted Budgets
Government expenditures, G, and
tax revenues, T (billions)
$500 G
475 h
450 f
This figure shows cyclically adjusted deficits in this graph. Discretionary fiscal policy, as reflected in the downward shift of the tax line from T1 to T2, has increased the cyclically adjusted budget deficit from zero in year 3 (before the tax cut) to $25 billion in year 4 (after the tax cut). This is found by comparing the $500 billion of government spending in year 4 with the $475 billion of taxes that would accrue at the full-employment GDP3. Such a rise in the cyclically adjusted deficit (as a percentage of potential GDP) identifies an expansionary fiscal policy.
425 g
GDP4
GDP3
(year 4)
(year 3)
Real domestic output, GDP
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16. Recent U.S. Fiscal Policy
Federal Deficits (-) and Surpluses (+) as Percentages of GDP,
(1)
Year
(2)
Actual
Deficit – or
Surplus +
(3)
Cyclically
Adjusted
Surplus +*
2000
+2.4
+1.1
2001
+1.3
+0.5
2002
-1.5
-1.3
2003
-3.4
-2.7
2004
-3.5
-3.2
2005
-2.6
-2.5
2006
-1.9
-2.0
2007
-1.2
2008
-2.8
2009
-9.9
-7.3
This table shows Federal deficits (-) and surpluses (+) as percentages of GDP, 2000– Observe that the cyclically adjusted deficits are generally smaller than the actual deficits. This is because the actual deficits include cyclical deficits, whereas the cyclically adjusted deficits eliminate them. The expansionary fiscal policy of the early 1990s became contractionary from 1999 to In 2002 President Bush passed tax cuts and increased unemployment benefits, thereby increasing the cyclically adjusted deficit. The 2003 Bush tax cut increased the standardized budget deficit as a percentage of potential GDP. Federal budget deficits are expected to persist for many years to come.
As a percentage of potential GDP
Source: Congressional Budget Office,
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17. Fiscal Policy Recent U.S. fiscal policy is summarized in Table 33.1.
Observe that standardized deficits are less than actual deficits.
Column 3 indicates contractionary fiscal policy in 2000 and 2001before becoming expansionary.
Fiscal policy from 2000 – 2007
In 2001, Bush decreased taxes to help pull the economy out of a recession.
March 2002, Congress decreased taxes more and extended unemployment benefits causing the cyclically-adjusted budget to change from 1.1% to -1.3%.
The economy remained slow and government decreased taxes more in 2003 and the economy grew from 2003 – 2007.
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18. Fiscal Policy Fiscal policy during the Great Recession
In 2007, the crisis in the mortgage loans developed, threatening stability in other financial markets, pessimism grew, spending decreased, and the economy entered the steepest, longest recession since the Great Depression.
In 2008 Congress passed $152 billion in stimulus through tax breaks increasing the cyclically-adjusted deficit from -1.2% of potential output in 2007 to -2.8% in 2008 showing expansionary policy.
There were no real changes in spending from the tax breaks.
In 2009 Obama passed the American Recovery and Reinvestment Act - $787 billion stimulus with tax rebates and large expenditures on infrastructure, education, and health care.
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19. Fiscal Policy
The cyclically-adjusted budget increased from -2.8% of potential GDP in 2008 to -7.3% in 2009.
Figure 33.5 shows deficits are predicted through 2014.
F. Global Perspectives 33.1 gives a fiscal policy snapshot for selected countries.
V. Problems, Criticisms and Complications
Problems of timing
Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.
Administrative lag is the difficulty in changing policy once the problem has been recognized.
Operational lag is the time elapsed between change in policy and its impact on the economy.
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20. Fiscal Policy
Political considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy.
A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions.
Future policy reversals can prevent fiscal policy from being effective if people believe that the fiscal policy changes are temporary.
State and local finance policies may offset federal stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse
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21. Fiscal Policy
In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.
The crowding‑out effect may be caused by fiscal policy.
“Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.
Some economists argue that little crowding out will occur during a recession.
Economists agree that government deficits should not occur at F.E., it is also argued that monetary authorities could counteract the crowding‑out by increasing the money supply to accommodate the expansionary fiscal policy.
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22. Crowding-Out Effect 2 4 6 8 10 12 14 16 b c
Increase in
investment
demand b c
Real interest rate (percent) a
Crowding-out
effect
ID2
ID1 5 10 15 20 25 30 35 40
Investment (billions of dollars)
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23. Fiscal Policy Current thinking on fiscal policy
Some economists oppose the use of fiscal policy, believing that monetary policy is more effective or that the economy is sufficiently self-correcting.
Most economists support the use of fiscal policy to help “push the economy” in a desired direction, and using monetary policy more for “fine tuning.”
Economists agree that the potential impacts (positive and negative) of fiscal policy on long-term productivity growth should be evaluated and considered in the decision-making process, along with the short-run cyclical effects.
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24. Fiscal Policy Public Debt
A country’s national or public debt is the total accumulation of the government’s total deficits and surpluses that have occurred through time.
Deficits (and by extension the debt) are the result of war financing, recessions, and lack of political will to reduce or avoid them.
The U.S. public debt was $11.9 trillion in 2009.
Ownership of the U.S. public debt (Figure 33.6)
percent held by the public and 43 percent by Federal government agencies, including the Federal Reserve.
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25. Fiscal Policy
Foreigners held about 29 percent of the public debt in China held 24% while Japan held 21%.
The Federal debt held by the public was 46.7 percent of GDP in 2009, the highest it has been since (Figure 33.7)
U.S. debt as a percentage of GDP increased significantly in 2008 and 2009 due to huge deficits and a decrease in GDP. Public debt as a percentage of GDP in 2009 for a number of countries can be seen in Global Perspective Although the U.S. has the highest public debt in absolute terms, a number of countries owe more relative to their ability to support it (through income, or GDP).
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26. The U.S. Public Debt Debt held outside the Federal government and the
Federal Reserve:
57%
Debt held by
the Federal
government and the
Federal Reserve:
43%
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27. Global Perspective Public Sector Debt as Percentage of GDP, 2009 Italy
Italy
Japan
Greece
Belgium
Hungary
United States
France
Germany
United Kingdom
Spain
Netherlands
Canada
Source: Organization for Economic Cooperation and Development, OECD
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28. Fiscal Policy
Interest charges are the main burden imposed by the debt.
Interest on the debt was $187 billion in 2009, and is the fourth largest item in the Federal budget.
Interest payments were 1.3 percent of GDP in The percentage is important because it represents the average tax rate necessary just to cover annual interest on the debt. Low interest rates have brought the percentage down since 2000.
VII. False Concerns?
False concerns about the public debt include several popular misconceptions:
Can a nation go bankrupt? There are reasons why it cannot for most industrialized nations.
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29. Fiscal Policy
A nation can borrow more (i.e. sell new bonds) to refinance bonds when they mature. Corporations use similar methods—they almost always have outstanding debt.
National governments have the power to tax, which businesses and individuals do not have when they are in debt.
Does the debt impose a burden on future generations? In 2009 the per capita federal debt in the United States was $37,437. But the public debt is a public credit—your grandmother may own the bonds on which taxpayers are paying interest. Some day you may inherit those bonds that are assets to those who have them. The true burden is borne by those who pay taxes or loan government money today to finance government spending.
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30. Fiscal Policy
If the spending is for productive purposes, it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline. Borrowing allows growth to occur when it is invested in productive capital.
Substantive Issues
Repayment of the debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality.
Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.
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31. Fiscal Policy
A higher proportion of the U.S. debt is owed to foreigners (about 29 percent) than in the past, and this can increase the burden since payments leave the country. But Americans also own foreign bonds and this offsets the concern.
Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear (see Figure 33.8).
There are some positive aspects of borrowing even with crowding out.
If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.
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32. Fiscal Policy
Public investment makes private investment more attractive. For example, new federal buildings generate private business; good highways help private shipping, etc.
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33. Fiscal Policy LAST WORD: The Social Security and Medicare Shortfalls
The percentage of people aged 65 and older is expected to rise substantially over the next few decades.
More people will be receiving Social Security and Medicare benefits and for longer time periods with fewer people contributing to both programs.
In 1960 for every individual receiving Social Security/Medicare there were 5 workers contributing.
Today, there are only 3 workers contributing for every individual receiving benefits.
Medicare and Social Security cost 7.6% of GDP in 2008 and it is expected to rise to 12% of GDP in 2030.
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34. Fiscal Policy
Social Security is a pay-as-you go system with workers paying 6.2% tax on their income up to $106,800 and the employer paying another 6.2%.
Extra social security tax revenue has been collected in anticipation of the large pay-outs to baby boomers.
The extra revenue was used to purchase U.S. Treasury securities and put into a fund.
In 2009 government had to start using the money in the fund to make up for the lack of revenue to pay for the promised benefits.
By 2037 the trust fund is expected to be depleted at which time the revenues will only cover 75% of the promised benefits.
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35. Fiscal Policy
Medicare is also a pay-as-you go program with workers paying 1.45% and employers paying the other 1.45% on all earnings.
Medicare is in worse shape than Social Security.
Benefits covered by Medicare will fall from 81% in 2017 to 50% in 2035 and 29% in 2080.
The Unpleasant Options
To balance Social Security over the next 75 years government must either make a permanent 16% reduction in benefits and/or 13% permanent increase in tax revenues.
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36. Fiscal Policy
To bring Medicare into balance, government must increase Medicare payroll tax to 122%, and/or a 51% reduction in Medicare payments from their projected amounts.
All of the options involve difficult economic costs and dangerous political risks.
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