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Fiscal policy and the government budget in the long run

Discuss basic facts about the U.S. government’s fiscal situation.

Explain when fiscal policy is sustainable and when it is not sustainable.

Understand how fiscal policy affects the economy in the long run.

Explain the fiscal challenges facing the United States.

Appendix: Derive the conditions for a sustainable fiscal policy.

Appendix: Derive the equation showing the relationship between budget deficits and private expenditure.

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Learning Objectives
After studying this chapter, you should be able to:
15.1
15.2
15.3
15.4
15.A
15.B

Drowning in a sea of debt?

In June 2012, the national debt of the U.S. was $15.9 trillion--$50,000 for every person in the U.S.

The debt is rising.

Many other high-income countries also have high national debts.

Debts are the result of accumulated budget deficits—where government spending exceeds revenue.

Deficits above 3% of GDP become difficult to sustain in the long run.

U.S. and other nations are projected to have high budget deficits in the future, especially given aging populations.

What should be done about deficits and the national debt?

National Association for Business Economists ranks the federal deficit (and hence the debt) as the country’s biggest long-term problem.

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In 2012, the federal government’s budget deficit and the national debt were on course to rise to unsustainable levels.

How can the United States solve its long-run fiscal problem?

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Key Issue and Question

Issue:

Question:

Discuss basic facts about the U.S. government’s fiscal situation.

15.1

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Learning Objective

Debts and deficits in historical perspective

To discuss how fiscal policy affects an economy in the long run, it is important to review some historical facts and key definitions.

Gross federal debt held by the public Debt that includes the bonds and other securities issued by the U.S. Treasury (and a small amount of securities issued by federal agencies) not held by the federal government.

Federal debt has tended to rise during wars and fall during times of peace.

Exceptions: Great Depression, 1980s, 2000-2012.

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The government’s budget constraint

Government expenditures

Government purchases of goods and services (G)

Transfer payments to households (TR)

Interest payments on existing debt:

where i is the nominal interest rate, and B the outstanding bonds.

Government receipts

Tax revenue (T)

Issuance of new bonds ()

Seigniorage, or the change in the monetary base ()

Seigniorage The government’s profit from issuing fiat money; also called the inflation tax.

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The government’s budget constraint

Therefore the government’s budget constraint in year t is:

Moving taxes to the left hand side, we get:

where the left hand side represents the budget deficit.

Budget deficit The difference between government expenditure and tax revenue.

We can see the budget deficit is financed by issuing bonds and/or increasing the monetary base.

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The budget deficit and the primary budget deficit

In order to focus on government operations, we define the primary budget deficit.

Primary budget deficit (PD) The difference between government purchases of goods and services plus transfer payments minus tax revenue.

The total budget deficit and primary budget deficit for the U.S., 1962-2011

Figure 15.1

Therefore we can rewrite the equation for the budget deficit as:

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The relationship between the deficit and the debt

The debt is a stock variable, the total value of all government bonds outstanding.

The deficit is a flow variable, representing the yearly flow of new government bonds

Examine deficits when studying the effects of fiscal policy on an annual level.

Examine debt when we want to know if a government’s fiscal policy is sustainable.

Sustainable fiscal policy is when the debt-to-GDP ratio is constant or decreasing.

Unsustainable fiscal policy when the debt-to-GDP ratio is rising.

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Gross federal debt

Gross federal debt The total dollar value of Treasury bonds and other federal agency bonds plus the dollar value of the small amount of bonds and other securities issued by other federal agencies.

Gross federal debt and gross federal debt held by the public for the U.S., 1939-2011

Figure 15.2

Some of the gross federal debt is held by the U.S. government itself.

Example: When Social Security taxes are greater than payments in a given year, the surplus must be used to buy Treasury bonds.

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Gross federal debt held by the public/private investors

Gross federal debt and gross federal debt held by the public for the U.S., 1939-2011

Figure 15.2

Further, because the Fed is technically a public-private agency, its $1,660 billion of federal debt is counted as “owned by the public”.

So total debt held by private investors was $9,413 billion—this is what economists tend to concentrate on.

At the end of June 2012, the gross federal debt was $15,880 billion:

$11,073 billion of federal debt was owned by the public.

$4,807 billion was owned by various federal agencies.

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The debt-to-GDP ratio

Of the 34 OECD countries, the U.S. has a debt-to-GDP ratio that is about average.

U.S. debt-to-GDP ratio was 61.3% in 2010 vs. 51.3% for other OECD countries.

Central government debt for countries in the OECD, 1980-2010

Figure 15.3

Other countries like Japan and Italy have much higher debt-to-GDP ratios.

Further, we can see that the debt-to-GDP ratio in the U.S. is not substantially higher than it was in the early-mid 1990s.

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Composition of federal government revenue

The federal government receives most of its revenue from taxes:

Primarily individual income and social insurance (Social Security and Medicare) taxes.

Composition of federal government revenue, 1962-2011

Figure 15.4

“Other” includes tariff revenues, estate and excise taxes.

Since 1962, federal revenues have averaged about 18% of GDP.

Seigniorage is relatively small for the U.S.; about 0.2% of GDP.

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Federal government expenditures

Over the period from 1962 to 2011, federal government expenditure averaged 20.6% of GDP.

25.2% of GDP in 2009 due partly to 2007-2009 recession.

Composition of federal government expenditure, 1962-2011

Figure 15.5

Defense spending has decreased substantially as a fraction of GDP over this period.

Spending on health care services and Social Security has risen considerably.

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Explain when fiscal policy is sustainable and when it is not sustainable.

15.2

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Learning Objective

Expressing the deficit as a percentage of GDP

Recall the expression for the government’s budget constraint:

Let’s express this relative to nominal GDP: , where is the price level:

A convenient way to rewrite this is:

where:

is the inflation rate.

is the growth rate of real GDP.

is therefore the growth rate of nominal GDP.

Note: this is demonstrated in the appendix to this chapter.

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Debt-to-GDP ratio

The left hand side tells by how much the debt-to-GDP ratio is changing.

It equals zero when the debt-to-GDP ratio is stable.

It increases when:

The primary deficit-to-GDP ratio is greater than zero.

Seigniorage decreases.

The nominal interest rate rises.

Nominal GDP growth is slower:

Per the Solow growth model, if the growth rate of the labor force or the rate of technological change decreases.

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Growth rate of money supply and the debt-to-GDP ratio

What about if the growth rate of the money supply changes?

If the nominal interest rate doesn’t change, increase in growth rate of money supply increases inflation, therefore decreasing debt-to-GDP ratio.

But when money supply grows faster, inflation will rise, hence so will the nominal interest rate (Fisher effect).

So the net effect of an increase in the growth rate of the money supply is ambiguous.

It is difficult to finance budget deficits simply by printing more money because nominal interest rates adjust upward, causing interest payments to also increase.

Example: Germany and its hyperinflation in the 1920s.

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The European debt crisis

Greek government bonds were difficult to sell in 2010 since investors were nervous the country was going to default on their debt.

The ECB controls Greece’s monetary base, so Greece cannot expand monetary base to pay off its debts.

Took politically unpopular steps of decreasing the primary budget deficit with spending cuts and tax increases.

IMF loaned Greece €110 billion, and helped coordinate a €750 billion bailout fund for other Euro nations in danger of default.

Ireland needed a bailout in the fall of 2010 to aid Irish banks that suffered from the real estate bubble collapse.

Irish budget deficit reached 32% of GDP in 2010.

Accepted €85 billion bailout from the IMF and other European nations.

Spain facing similar problems: high unemployment, large budget deficits.

Unclear what the outcome of these debt crises will be.

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Making the Connection

When is fiscal policy sustainable?

We say fiscal policy is sustainable if it can be financed with the debt-to-GDP ratio not rising.

The real interest rate is the nominal interest rate minus the rate of inflation. Then the equation for the government budget constraint becomes:

Assume seigniorage is very small, so the last term disappears. Assume also that the primary budget deficit is zero; then:

In this case, the debt-to-GDP ratio rises or falls according to whether the real interest rate or real GDP growth is higher.

If real GDP growth is higher than the real interest rate, the primary deficit may be greater than zero and still be sustainable.

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United States in 2011

According to the CBO, in 2010 the debt-to-GDP ratio was 62.8%.

During 2011,

Average real interest rate on long-term bonds was 1.2%.

Growth rate of real GDP was 1.8%.

Assuming primary deficit and seigniorage were both zero:

So if the primary budget deficit were zero, the debt-to-GDP ratio would have fallen by 0.4%.

Actually rose to 67.7% because of positive primary budget deficit.

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Can Japan grow its way out of debt?

Japan 2010: government debt reached 215% of GDP.

Since 1990 in Japan:

Economic growth averaged 0.7%

Inflation (GDP deflator) averaged -0.7%

Japanese Ministry of Finance reports Japan pays 1.2% nominal interest on 10-year bonds.

Given this information, was Japanese fiscal policy sustainable?

If not, what would the primary budget deficit have to be to make fiscal policy sustainable?

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Solved Problem

Can Japan grow its way out of debt?

Step 1 Review the chapter material.

Step 2 Determine whether Japanese fiscal policy is sustainable. Japanese real interest rate is Growth rate of Japanese real GDP is 0.7%. Therefore even if Japan had a zero primary budget deficit, its debt-to-GDP ratio would continue to increase.

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Solved Problem

Can Japan grow its way out of debt?

Step 3 Determine the primary deficit necessary to make the debt stable. Equation for government budget constraint:

Assume that seigniorage is insignificant. If the debt is stable, then:

Inserting the figures we know, we obtain:

So the Japanese government would need to run a primary surplus of 2.6% of GDP in order to make the debt sustainable.

Actual Japanese primary deficit in 2010: 8.8%.

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Solved Problem

Understand how fiscal policy affects the economy in the long run.

15.3

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Learning Objective

The budget deficit and crowding out

Recall the national income identity:

In the appendix, we will show that this can be written as:

where:

is the budget deficit.

In order to decrease income taxes by $100 billion, but keep the deficit stable:

Reduce purchases by $100 billion.

Reduce transfer payments by $100 billion.

Increase other taxes by $100 billion.

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The budget deficit and crowding out

If deficits increase, the budget deficit is financed by combination of:

Increased private savings, by cutting private consumption expenditures.

Reduced private investment expenditure, through crowding out.

Net exports, since trade deficits imply borrowing from abroad.

Crowding out A reduction in private investment caused by government budget deficits.

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The conventional view: crowding out private investment

Conventional view among economists is that budget deficits crowd out investment.

If government borrows $100 billion, firms and households cannot borrow that same money.

So national savings decreases.

With fewer funds available, the real interest rate rises, causing investment spending to decrease.

Consequence of the lower investment spending: the private capital stock grows less quickly.

So private capital stock will be lower than it otherwise would have been, in the future: lower potential GDP.

Implies significant long-run costs to running persistent budget deficits.

But note that deficits may finance public investments, for example in infrastructure.

Also, short-run benefits (reducing unemployment, etc.)

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Do government deficits raise real interest rates?

Conventional economic view: government budget deficits lead to higher real interest rates.

William Cale and Peter Orszag: 1 percentage point increase in the deficit relative to GDP results in long-term real interest rates 0.25 to 0.35% higher.

Effect of primary budget deficit even greater: 0.40-0.70%.

Studies using debt-to-GDP rather than deficit-to-GDP find smaller effects.

Eric Engen and Glenn Hubbard: 1 percentage point increase in debt relative to GDP raises long-term real interest rates by 0.03%.

CBO estimates gross federal debt held by public will rise from 68% of GDP (2011) to 93% of GDP (2022); this 25% increase would result in real interest rates being 0.75% higher than they would have been.

Most studies give empirical support for the conventional economic view.

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Macro Data

Ricardian equivalence

Some economists believe that private savings will adjust to government deficits, crowding out private expenditures rather than investment.

Ricardian equivalence The theory that forward-looking households fully anticipate the taxes implied by government spending, so that changes in lump-sum taxes have no effect on the economy.

A deficit created by cutting taxes, would lead to reduced consumption today as households save the money received from tax cuts to pay future taxes.

Changes in fiscal policy that impact lifetime disposable income would have affects on consumption today.

Assumes extreme forward looking behavior, both far into one’s own future and into the future of one’s offspring.

Assumes perfect capital-markets such that households can borrow and lend as much as they want at current interest rates.

Application is only to lump-sum taxes.

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Does Ricardian equivalence really hold?

Many economists are skeptical of Ricardian equivalence:

Assumes households are very forward-looking—anticipate and react to changes in taxes perhaps decades in the future.

Assumes households are not credit-constrained—that they can borrow or save as much as they want at current interest rates.

Applies only to lump-sum taxes; (more common) changes in tax rates will affect behavior.

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Explain the fiscal challenges facing the United States.

15.4

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Learning Objective

Projections of federal government revenue/expenditure

The CBO forecasts federal government revenue and expenditure in future years, allowing forecasts of federal budget deficit and path of debt-to-GDP ratio.

Federal revenue and expenditure as a percentage of GDP

Figure 15.6

CBO expects revenue to significantly increase over the coming decades, to almost 30% of GDP by 2087.

CBO forecasts budget surplus to return in 2049.

Substantial uncertainty in these forecasts.

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Many proposals but not much progress on deficit

National Commission on Fiscal Responsibility and Reform made five specific recommendations.

Raise $1.1 trillion in tax revenues by eliminating deductions for mortgage interest, employer healthcare coverage, tax exemptions for municipal bonds, and preferential tax rates for capital gains and dividend income.

Increase the federal government tax on gasoline by 15 cents a gallon.

Increase federal taxes on higher-income households to support Social Security by raising or removing the income cap on Social Security payments.

Cap domestic spending, such as on farm subsidies and defense spending.

Increase the retirement age from 67 to 69 in the future to reduce Social Security expenditures, and increase Medicare premiums significantly.

Commission’s recommendations would reduce but not eliminate the budget deficit, reducing debt accumulated between 2012-2020 from $8 to $4 trillion.

Steps 1 and 2, would allow for lower personal and corporate tax rates, increasing aggregate supply.

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Making the Connection

Many proposals but not much progress on deficit

Ultimately, commission did not receive enough support to bring proposals to Congress for a vote.

Other groups have made other recommendations:

Panel led by Pete Domenici and Alice Rivlin recommended measured to reduce debt accumulation by about $6 trillion through 2020.

Recommended tax code reform, changes to entitlements, and freezes on some types of spending.

“Gang of Six” Democratic and Republican senators failed to reach agreement on deficit-reducing measures in 2011, but renewed attempts in 2012.

By late 2012, the president and Congress had not adopted any of these groups’ recommendations.

Difficult to obtain bipartisan support for action.

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Making the Connection

Will the United States pay off its debt?

CBO projections of future surpluses are based on “temporary” tax cuts and spending increases expiring.

Two scenarios for federal debt as a percentage of GDP, 2012-2087

Figure 15.7

But if instead, current policies are followed (current tax rates, etc.) then the debt-to-GDP ratio is likely to grow quickly.

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How is expenditure projected to change?

This figure shows projections for major categories of expenditures over the coming decades, assuming current policies continue.

Composition of federal government expenditure, 1972-2042

Figure 15.8

Increases in costs for Medicare and Medicaid, and debt payments, will result in large increases in federal expenditures under current policies.

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Policy options

Future budget deficits and a rising debt-to-GDP ratio will crowd out private investment spending, resulting in a smaller capital stock, and hence lower per-capita income.

So what options does the federal government have in order to avoid this?

Some ideas:

Seigniorage

Increase taxes on wage and capital income

Reduce primary expenditures, like education and science, or infrastructure projects

Reduce entitlements like Medicare, Medicaid, and Social Security

We will examine the consequences of each of these ideas.

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Could the federal government rely on seigniorage?

CBO forecasts assume current fiscal deficits are financed by selling Treasury bonds.

What if it just “inflated away” the problem?

Seigniorage alone would not be able to finance deficits in a responsible way.

Increased growth in the money supply would also increase nominal interest rates through the Fisher effect.

Nominal interest payments would have to rise to compensate.

Increase the budget deficit further.

Inflation and risk of hyperinflation.

Monetizing deficits runs the risk of causing hyperinflation.

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Increased taxes on wages and capital income?

Increased taxes on labor would reduce after-tax income.

Lower opportunity cost of leisure, leads to reduced supply of labor.

Potential GDP would fall.

Increasing payroll taxes.

Social Security taxes are only paid on income up to a cap.

Raising the cap could raise revenue.

Increased taxes on capital income, dividends, capital gains, or corporate income tax would reduce the after-tax return to capital.

Households will save less, and investment and the capital stock will decline.

Potential GDP would decrease.

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What about reducing primary expenditures?

Another option is to cut expenditure on education, science, and technology.

Education expenditure allows for human capital accumulation.

Cuts here would reduce future productivity, total factor productivity growth, and potential GDP.

Alternatively, the government could reduce expenditures on government capital goods, like roads and bridges.

But such expenditures make private businesses more profitable.

Research by Christophe Kamps of the European Central Bank: government and private capital investments are about equally productive.

Could also reduce spending on national defense.

Difficult to evaluate cost of reduced national security.

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What about reducing transfer payments?

To maintain promised expenditure on the elderly and poor, the federal government would have to take actions likely to reduce potential GDP.

Adjusting policy to reduce expenditures via transfer payments forces those groups to bear the cost of adjusting fiscal policy.

One study found when transfer payments increase by 1 percentage point of GDP, private investment declines by 1.3 percentage points of GDP.

Increased taxes on labor of 1 percentage point of GDP to pay for transfer payments further reduced investment by 0.7 percentage points of GDP.

CBO forecasts transfer payments will rise from 10.4% in 2012 to 18.3% of GDP in 2042, a 15.4 percentage point increase.

Raising taxes to pay for this increase would significantly reduce equilibrium investment, capital-labor ratio, labor productivity, and the standard of living.

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Summary of policy changes

There is no “magic bullet” for solving our fiscal problems; every option has negative consequences.

Likely that some combination of these will need to be enacted.

The effects of potential changes to fiscal policy

Table 15.1

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Answering the key question

“How can the United States solve its long-run fiscal problem?”

If current policies continue, by 2020 the CBO forecasts there will be rapid increases in federal government expenditure and revenue.

Revenue smaller, resulting in debt-to-GDP ratio rising to unsustainable levels.

Policymakers will be faced with difficult choices regarding tax increases and expenditure cuts.

Each of these is likely to lower potential GDP.

Balancing equity and efficiency will be part of the process of arriving at a sustainable fiscal policy.

Cutting any one category of expenditure will not be sufficient to solve the problem.

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Appendix: Derive the conditions for a sustainable fiscal policy.

15.A

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Learning Objective

Showing conditions for a sustainable fiscal policy

Begin with the expression for the budget constraint, relative to nominal GDP:

Subtract the seigniorage to the left hand side, leaving:

Now so we have:

Grouping terms:

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Appendix

Showing conditions for a sustainable fiscal policy

Multiply and divide the second term by last period’s nominal GDP:

The term in large parentheses is the inverse of 1 plus the growth rate of nominal GDP; this in turn equals the growth rate of real GDP plus the inflation rate. So:

The ratio in parentheses is approximately ; so

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Appendix

Showing conditions for a sustainable fiscal policy

Distributing the second term partially, we have:

Now subtract the second term to the right hand side:

Rewriting:

Or, because of the Fisher effect:

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Appendix

Appendix: Derive the equation showing the relationship between budget deficits and private expenditure.

15.B

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Learning Objective

Budget deficits and private expenditures

Begin with the national income identity:

Add transfer payments to each side, and subtracting taxes from each side:

Move consumption expenditures to the left side:

Recall that private savings is:

Private savings is the left side of our previous equation

Solve for the government’s budget deficit:

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Appendix