Chapter 5 -The Federal Budget
Budget = Tax Revenues Government Expenditure
(over a given period)
Budget = Tax Revenues (Government purchases of goods
and services + Transfer Payments
+ Interest on the National Debt)
Budget Definitions
Budget < 0 -- Budget Deficit
Budget > 0 -- Budget Surplus
Budget = 0 -- Balanced Budget
Realistic Goal -- Balanced Budget
when Y = YN.
The Federal Budget: 2006
(Billions of Dollars)
Government Receipts = $2495.8
Government Expenditure
= $2715.8
Budget
= -$220.0
Source: Economic Indicators,
February 2008
Breakdown of
Government Receipts
Personal Income Taxes = $1053.2
Corporate Profits Taxes = $373.1
Taxes on Production and Imports
= $98.6
Contributions for
Social Insurance = $901.6
Miscellaneous
=
$69.3
Breakdown of
Government Expenditure
Consumption Expenditures (G)
= $812.8
Transfer Payments
= $1576.1
Net Interest Paid
= $277.5
Miscellaneous
= $49.4
The Budget: In Our Notation
Recall variable definitions:
-- T = net taxes
= tax revenues
- (transfer payments
+ interest on the
national debt)
-- G = government purchases of
goods and services
The Budget and
The Size of the Deficit
Budget = T - G
Size of Deficit = G - T
The National Debt
The National Debt -- The total
accumulated stock of debt owed
by the government to its lenders.
Debt2011 = Debt2010 + Deficit2011
National Debt -Realistic Goal
Realistic Goal -- consider the
Debt-Income Ratio =
(National Debt)/(GDP).
For US in 2007 =
($5035.1)/($13843.8) = 0.364
Decomposition of Deficit
Purpose -- break up deficit for
more precise analysis of causes.
Consider the deficit, with the
income tax function for net taxes.
 Deficit = G - (T0 + tY*)
Add and subtract the term tYN
 Deficit = [G - (T0 + tYN)]
+ t(YN - Y*)
The Cyclical Deficit
The Cyclical Deficit = t(YN - Y*) -the deficit that arises when the
economy is not at its natural level.
Sluggish economy (Y* < YN) 
positive cyclical deficit.
Economy with accelerating
inflation (Y* > YN)  negative
cyclical deficit.
More on the Cyclical Deficit
Connected with
Automatic Stabilization -- net tax
revenues change automatically in
directions that work to stabilize the
economy.
Cyclical deficit -- not considered a
special problem. It’s resolved
when Y = YN.
The Structural Deficit
The Structural Deficit =
[G - (T0 + tYN)].
Interpretation -- the deficit that
remains after Y* = YN.
Constitutes a problem, with a need
for special deficit policy.
Realistic Goal (Budget)
-- zero structural deficit.
•Analyzing the Deficit -A Numerical Example
Year Structural + Cyclical = Total
1979
100
-50
50
(Y* > YN)
1982
100
50
150
(Y* < YN)
1995
100
0
100
(Y* = YN)
Main Results From Example
Overstimulated economy can
mask a deficit problem.
Sluggish economies tend to have
larger deficits.
Two step strategy -- deficits
(1) Get Y* = YN.
(2) Take steps to reduce deficit
that remains.
Why are the Debt and
Deficits a Problem?
Hampers the use of fiscal policy.
Getting the benefits without
considering the costs.
Crowding Out Effect -- higher
deficits may increase interest
rates, reducing investment and
possibly net exports.
The Crowding Out Effect
Consider “magic equation”:
S + (T - G) + -NX = I.
Less government saving (T - G) , more
reliance on foreign borrowing (NX) or
lower investment (I).
Particularly damaging if investment
decreases (more later).
The Increased Debt: Burden
on Future Generations
In general, older generations enjoy
benefits from the debt. But
younger generations have to
sacrifice in the future to repay the
debt, maintain interest payments,
or be deprived of new initiatives.
The Crowding Out Effect:
A More Sober Implication
Crowding Out Effect – Expansion of
Federal Deficit and Debt increases
interest rates, lowers investment (and
possibly consumption)
Lower investment retards development
of the capital stock, the economy’s
productive capacity for future
generations.
Maybe Effects of Deficits
and Debt Aren’t so Bad
Riccardian Equivalence -- Given
an increased deficit, older people
correspondingly increase their
saving.
Older generations provide the
means to pay debt and interest.
Riccardian Equivalence -No Crowding Out Effect
Within the macro identity:
S + (T - G) + -NX = I.
Riccardian Equivalence  when
(T - G), S simultaneously 
interest rates and therefore
Investment are unaffected.
Another Reason Why Debt
May Not Be Overly Harmful
The government (in reality) as
producer as well as spender.
Some G is in fact government
investment (e.g. buildings)
Some investment government can
do better than the private sector
(infrastructure).
Reducing a Structural
Deficit = [G - (T0 + tYN)]
Increase Taxes (income or
consumption-based)
Advantages: smaller multiplier,
can focus on higher incomes,
undesirable behavior.
Disadvantages: implicit
permission for government to be
inefficient in its spending.
Reducing a Structural
Deficit = [G - (T0 + tYN)]
Decrease Transfer Payments.
Advantages: smaller multiplier,
largest component of government
expenditure, holds the line on
taxes.
Disadvantages: very painful to the
groups affected (often vulnerable).
Reducing a Structural
Deficit = [G - (T0 + tYN)]
Decrease Government Purchases
of Goods and Services
Advantages: permanence, gives
discipline to government,
encourages (often more efficient)
private sector to replace
government programs.
Disadvantages: largest multiplier,
most painful way.
Reducing a Structural
Deficit = [G - (T0 + tYN)]
All three are contractionary measures,
will reduce Y*.
-- shifts EP curve downward
-- shifts IS curve leftward
Hopefully, i* will decrease (IS-LM), 
I, with its associated benefits.
One more possibility -- can we make
YN? -- Discussed later.
The Clinton Surpluses:
What Happened?
Marginal tax rate increases on
higher incomes, sales tax
increases in 1993.
Holding the line on transfer
payments, government purchases.
Unusually large growth in the
natural level of real GDP (YN).