Chapter 14:

Fiscal Policy,
Deficits, and Debt

Fiscal Policy

Fiscal policy consists of deliberate

changes in government spending and tax
collections designed to achieve full
employment, control inflation, and
encourage economic growth.

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Fiscal Policy and

the AD-AS Model

The Council of Economic Advisors (CEA)

provides advice and assistance on
economic matters to the president.
Discretionary fiscal policy is initiated on
the advise of the CEA and changes to
government spending and taxes are at the
option of the Federal government.
Nondiscretionary fiscal policy are changes
that occur automatically.

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Expansionary Fiscal Policy

When the economy is in recession,

expansionary fiscal policy may be in order.
Expansionary fiscal policy is an increase
in government spending, a decrease in
taxes, or some combination of the two for
the purpose of increasing aggregate
demand and real output.

If the Federal budget is balanced at the outset,

expansionary fiscal policy will create a
government budget deficit.

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Expansionary Fiscal Policy

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Contractionary Fiscal Policy

When demand-pull inflation occurs,

contractionary fiscal policy may help to
control it.
Contractionary fiscal policy is a decrease
in government spending, an increase in
taxes, or some combination of the two for
the purpose of decreasing aggregate
demand and halting inflation.

Contractionary fiscal policy may create a

budget surplus.

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Contractionary Fiscal Policy

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Built-In Stability

A built-in stabilizer is anything that

increases the governments budget deficit
(or reduce its budget surplus) during a
recession and increase its budget surplus
(or reduce its budget deficit) during an
expansion without requiring explicit action
by policymakers.

Examples include personal income taxes,

payroll taxes, corporate income taxes, sales
taxes and excise taxes.

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Built-In Stability

Taxes reduce spending and aggregate

demand; in addition, reductions in
spending are desirable when the economy
is moving toward inflation, whereas
increases in spending are desirable when
the economy is slumping.
Built in stability has reduced the severity of
business fluctuations in the U.S..

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Evaluating Fiscal Policy

In evaluating the status of fiscal policy, we

must adjust deficits and surpluses to
eliminate automatic changes in tax
revenues and compare the sizes of the
adjusted budget deficits (or budget
surpluses) to the level of potential GDP.
The standardized budget (or fullemployment budget) is used for this
purpose.

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Evaluating Fiscal Policy

The standardized budget is a measure of

what the Federal budget deficit or surplus
would be with existing tax rates and
government spending programs if the
economy had achieved its full-employment
GDP in the year.

The standardized budget deficit is zero at the

full-employment output level.

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Evaluating Fiscal Policy

If the economy slides into a recession, the

standardized budget deficit is still zero
since government expenditure equals the
tax revenue that would be forthcoming at
the full-employment GDP.

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Evaluating Fiscal Policy

The deficit that arises in a recession is a

cyclical deficit and is not caused by
government discretionary fiscal policy.

A cyclical deficit is a Federal deficit that is

caused by a recession and the consequent
decline in tax revenue.

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Evaluating Fiscal Policy

If a standardized deficit of zero in one year

is followed by a standardized budget deficit
in the next year, then fiscal policy is
expansionary.
Conversely, if a standardized deficit of zero
in one year is followed by a standardized
budget surplus in the next year, then fiscal
policy is contractionary.

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Problems, Criticisms,
and Complications

A number of significant problems may

arise in enacting and applying fiscal policy
such as:

problems of timing
political considerations
future policy reversals
offsetting state and local finance
crowding-out effect

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Problems, Criticisms,
and Complications

Timing issues include recognition lag,

administrative lag and operational lag.
Political considerations include political
business cycles: the alleged tendency of
presidential administration and Congress to
create macroeconomic instability by
reducing taxes and increasing government
spending before elections and to raise taxes
and reduce expenditures after elections.

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Problems, Criticisms,
and Complications

Consumption smoothing arises when

taxpayers believe policy is only temporary
and is likely to be reversed in the future.
The fiscal policies of state and local
governments are frequently pro-cyclical;
they worsen rather than correct recession
or inflation.

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Problems, Criticisms,
and Complications

Another potential flaw in fiscal policy is the

crowding-out effect: a decrease in
private investment caused by higher
interest rates that result from the Federal
governments increased borrowing to
finance deficits (or debt).

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Current Thinking on
Fiscal Policy

Despite the many complications of fiscal

policy, the current popular view is that
fiscal policy can help push the economy
in an intended direction but cannot finetune it to a specific outcome.
Monetary policy is considered by many to
be the best month-to-month stabilization
tool for the U.S. economy.

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The Public Debt

The national or public debt is essentially

the total accumulation of the deficits
(minus the surpluses) the Federal
government has incurred through time.

Deficits have emerged because of war

financing, recessions, fiscal policy, and lack of
political will by Congress.

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The Public Debt

The total public debt represents the total

amount of money owed by the Federal
government to the owners of government
securities.

U.S. securities are Treasury bills, Treasury

notes, Treasury bonds, U.S. savings bonds,
and I-bonds issued by the Federal
government to finance expenditures that
exceed tax revenues.

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The Public Debt

The U.S. and other highly productive

nations can incur and carry a large public
debt more easily than poor nations.
Many economists conclude that the annual
interest charge accruing on the bonds sold
to finance the debt is the primary burden
of the U.S. debt.

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False Concerns

The large U.S. debt does not threaten to

bankrupt the Federal government, leaving
it unable to meet its financial obligations.

One reason is the public debt is easily

refinanced.
Another reason is the Federal government has
the option to impose new taxes or increase
existing tax rates to finance the debt.

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Substantive Issues

The distribution of ownership of

government securities is highly uneven,
where ownership of the public debt is
concentrated among wealthier groups.
A large public debt may impair economic
growth if higher taxes for interest
payments on government securities
dampen incentives to bear risk, to
innovate, to invest, and to work.

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Substantive Issues

External public debt, or the part of the

public debt owned by foreigners, is an
economic burden to Americans.
Another potentially serious problem is that
the financing of the large public debt
transfers a real economic burden to future
generations by passing a smaller stock of
capital goods on to them.

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The Long-Run Fiscal

Imbalance: Social Security

The most significant fiscal issue in the U.S.

is the long-term funding imbalance in the
Social Security and Medicare programs.

There is a severe long-run shortfall in Social

Security funding because of growing payments
to retiring baby boomers.
The accumulation of monies in the Social
Security trust fund will be greatly inadequate for
paying the retirement benefits to future retirees.

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The Long-Run Fiscal

Imbalance: Social Security

The problem is one of demographics; the

percentage of the American population age
62 and older will rise substantially over the
next several decades.

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The Long-Run Fiscal

Imbalance: Social Security

To help make Social Security financially

sound, some suggest investing all or part
of the trust fund in corporate stocks and
bonds, since these presumably have
higher returns relative to U.S. securities.
Another option is to increase the payroll
tax immediately and allocate the new
revenues to individual accounts.

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The Long-Run Fiscal

Imbalance: Social Security

Yet, another idea is to place half the

payroll tax into accounts that individuals
would own, maintain, and bequeath.
New options for reform will likely develop
over time; nevertheless, society will
eventually need to confront the problem of
trillions of dollars of unfunded Social
Security liabilities.

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