Fiscal Policy and Government Debt

Focus
Spending

Fiscal policy

distinguish between purchases and spending or outlays or expenditures

Tax revenues
distinguish between tax rates and tax revenues let t = tax rate, Y = income, then tax revenue is T = tY

Government debt

effect of deficit, debt, countercyclical policy, structural deficit, automatic stabilizers, rules versus discretion

29_02

Fiscal year 2000 Jan. 1, 1999 Apr. 1 July 1 Oct. 1 Jan. 1, 2000 Apr. 1 July 1 Oct. 1 Jan. 1, 2001

President submits budget to Congress in early February.

Congress debates, modifies, and passes budget.

Supplementary budget or changes in economy may affect actual spending.

Fiscal year is over; spending and taxes are tabulated.

Federal budget summary (billions of dollars) Fiscal year 1998 versus 1995
Tax revenues 1721.4 Expenditures 1651.4 Defense 270.4 Interest 243.4 Soc. Sec. 379.2 Medicare 192.8 Surplus 70.0 1351.8 1515.7 272.1 232.2 335.8 159.9 - 163.9

Deficit versus debt

When the government runs a deficit, it increases its debt When the government runs a surplus, it reduces its debt
surplus (98) = debt (end 97) - debt (end 98)
70 = 3771.1 - 3701.1

Government borrows by issuing bonds

and retires these bonds when in has a surplus

A graph of the deficit and the debt

29_03

BILLIONS OF DOLLARS 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 1950

Debt

Deficit

1955

1960

1965

1970

1975

1980

1985

1990

1995

Debt as a share of GDP

Debt/GDP can stay constant or even fall when there is a budget deficit Example
5% growth of GDP then ratio stays constant if
Debt/GDP = Debt(1.05)/GDP(1.05) thus $3.7 trillion times (.05) = $185 billion deficit

Debt/GDP ratio falls with balanced budget

29 _04

PER CE NT OF

GD P 80 High after WWII 70 60 50 40 30 20 10 Post-WW II bottom Steady decline with small deficits, some surpluses Big deficits start

Ratio just starting to decline Late 1980s

plateau Deficits are back

0 1950 1955 1960 1965 1970

1975 1980 1985 1990 1995

Long run effect of deficits or surpluses

The long run effect of a lower deficit or higher surplus are those of a lower the share of G in GDP---use SAM
real interest rate lower I/Y higher, leading to higher potential growth

Short run negative effects can be mitigated by being gradual, being credible, and letting Fed join in (but this is an old issue, now...

The question is how to use the projected surplus

Recent shift from deficit to surplus Leave it? Cut taxes? Increase spending? The social security problem
As baby boom generation retires, benefits will grow relative to payroll tax revenues Will need to reduce benefits or increase taxes Some suggest privatizing part of social security

Countercyclical fiscal policy

Argues that increasing government spending or reducing taxes during a recession would mitigate the recession
Suggested by Keynes in 1930s (Keynesian policy)

Rationale now for fiscal stimulus package in Japan Discretionary versus automatic

Use of countercyclical fiscal policy (G) to bring the economy back to potential
29_05

INFLATION

Potential GDP

PA ADI with increase in government purchases Old ADI REAL GDP INFLATION Potential GDP

PA Old ADI ADI with decrease in government purchases REAL GDP

Use of countercyclical fiscal policy (taxes) to bring economy back to potential

29_06

INFLATION

Potential GDP

PA

Old ADI Potential GDP

ADI with tax cut REAL GDP

INFLATION

PA

Old ADI ADI with tax increase REAL GDP

Case of good timing in using fiscal policy to hasten the return of real GDP back to potential GDP
29_08

INFLATION

Potential GDP

Path of economy without a fiscal stimulus Path of economy with a fiscal stimulus PA

ADI without stimulus

Old ADI ADI with stimulus REAL GDP

Effect of fiscal policy on the path of real GDP: good and bad timing
29_07

B IL L IO N S O F DOLLARS

29_09

B IL L IO N S O F DOLLARS

P a th o f r e a l G D P w ith a fis c a l s tim u lu s th a t c a m e to o la te

P o te n tia l G D P P o te n tia l G D P P a th o f r e a l G D P w it hfis c a l s tim u lu s P a th o f r e a l G D P w ith o u t fis c a l s tim u lu s

P a th o f re a l G D P w ith o u t c a l s tim u lu s fis

2000

2001

2002

2003

2004

2005

YEAR

2000

2001

2002

2003

2004

2005

YEAR

Effect of the economy on the budget deficit

Budget deficit is cyclical
Deficit rises in recessions Deficit falls during recoveries and expansions

To see the reason look at tax revenues and expenditures

Government tax revenues depend on the state of the economy

when real GDP grows more rapidly, tax revenues rise faster
more people working, higher incomes people move into higher tax brackets

when real GDP grows more slowly, tax revenues rise less rapidly
fewer people working, lower incomes people may move into lower tax brackets

Expenditures also depend on the economy

When real GDP grows less rapidly or falls, as in a recession, expenditures grow more rapidly
unemployment compensation rises welfare payments go up more people retire, increasing social security payments

When real GDP grows more rapidly, as in a recovery, expenditures grow less rapidly

Net effect of real GDP on deficit

deficit = government spending - tax revenue
thus in a recession the deficit will rise, and in a recovery the deficit will fall

Y implies D
government spending and tax revenues

Y implies D
government spending and tax revenues

Explains why rosy scenarios make the deficit look smaller

A NEW GRAPH to show the effect of real GDP on the deficit

29_11

B D ET U G D EFIC IT W hen real G P falls, D the deficit increases.

W hen real G P rises, D the deficit falls. D eficit 0 Surplus The budget is balanced here.

R LG P EA D

The structural deficit

The structural deficit is the deficit that would exist if real GDP = potential GDP Also called full employment deficit Purpose is to take out (control for) the effects of economic fluctuations in real GDP on the deficit Changing structural deficit requires
change in tax laws, size of government,...

Graphical illustration of the structural deficit

29_12

B D E U G T D FIC E IT

P otential G P D

A ctual deficit A this point real G P w t D ould equal potential G P D . S tructural deficit 0

R G P is less than eal D potential G P as in 1991. D ,

R A G P E L D

Automatic stabilizers
The tendency for tax revenues to fall and government spending to rise in recessions can have a stabilizing effect on the economy
the changes offset decline in demand during recession (as with countercyclical policies)

these changes are automatic

occur without executive or legal action hence fewer lags, timing is better, overall effects

Automatic changes in revenues and expenditures due to recession (FY 1991)

29_01

BILLIONS OF DOLLARS 1,400 1,233 1,200 1,170 1,054 1,000 1,324

800

600

400 270 200 63 0 Proposed Actual Proposed Actual Proposed Actual

Tax Revenue

Expenditures

Deficit

Rules versus discretion debate in fiscal policy

Problems with discretion are mainly lags recognition, implementation, impact Rules automatic stabilizers Johnson surcharge (1968) Bush stimulus package (1992) Clinton stimulus package (1993) Kennedy tax cut (1964) Reagan tax cut (1981-82)