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Chapter 12

Budget Balance and

Government Debt

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.

Figure 12.1 Federal Budget Deficits, and Surplus
as a Percent of GDP, 1959-2002

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.

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.

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


 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

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.

National Income and Product Accounts Budget

 The NIPA Budget does not include any

transactions that finance preexisting
debts, such as outlays for deposit

Real Surpluses and Deficits

 Real Surpluses and Real Deficits are

expressed in inflation-adjusted terms.

Economic Effects of Federal
Budget Deficits

 Unified budget deficits require

additional borrowing.

Figure 12.2 Government Demand for Loanable
Funds and the Market Rate of Interest
Interest Rate

i2 E'
i1 E

D 1 + ∆ DG

0 L1 L2
Loanable Funds per Year 11
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

Figure 12.3 Ricardian Equivalence:
Deficits Do Not Affect Interest Rates
Interest Rate S'

i2 E'
i1 E E''

D 1 + ∆ DG

0 L1 L2 L3
Loanable Funds per Year 13
Economic Effects of Federal Budget

 Unified budget surpluses allow

government to provide capital to the
loanable funds market.

Figure 12.4 Impact of a Budget Surplus on Credit Markets

S' = S1 + ∆ L
Interest Rate

I1 E'

0 L1 L2
Loanable Funds per Year
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.

Figure 12.5 The National Savings Rate and its
Components, 1959-2002 (Ratio of Savings to GNP)

Incidence of Deficit Finance
 Lower growth rates imply lower incomes for future

 If Ricardian Equivalence holds, then this is not the


 Deficits may also change political equilibrium so

that there are increases in government
infrastructure that could lead to increased future

The Government Debt

 January 2003

 Federal Debt $6.4 trillion

 State and Local Debt $1 trillion

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

Net Federal Debt

 The Net Federal Debt is the portion of

the debt not held by the federal

Gross public Debt of the US Treasury by
Holder January 29, 2003
Holder Amount of Percent of
Debt (Billions Total
of Dollars)

U.S. Govt. Agencies 2,769.0 43

Trust Funds and
Federal Reserve

Private Investors 3,630.3 67

Total 6,399.3 100.0

Net Public Debt of the U.S. Treasury by Holder
(Percent Distribution) June 2002
Holder Percentage of
Depositors and Institutions 7.2
Mutual Funds 8.8
Insurance Companies 3.9
Pension Funds 10.5
State and Local Governments 9.5
Foreign and International 39.6
Other Investors 22.5
Total 100.0

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.

State and Local Borrowing
 Bonds are issued by state and local governments
to fund large projects.

 They are rated by financial companies for their


 Similar to federal debt, much of it is held


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.

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.

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

 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

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.

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.