Fiscal Policy: Taxes,
Spending, and the Federal
Budget
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Fiscal Policy: Taxes, Spending, and
The Federal Budget
• Almost every year throughout 1980s, and early 1990s, a
best-selling book would be published that predicted
economic disaster for United States and world
• During late 1990s, as federal budget picture improved,
these disaster books quietly disappeared
• Then, in 2002, another flip-flop
– Government was again running a deficit, and more deficits were
projected till the end of the 2000s and beyond
• What caused these flip-flops in the government’s budget?
– And why should we care?
2
Thinking About Spending, Taxes,
and the Budget
• In 1959, federal government’s total outlays were
$92 billion
– Goods and services, transfer payments, and interest on
its debt
• By 2003 total had grown to $2,140 billion, an
increase of more than 2,200%
• Consider national debt—total amount government
owes to the public from past borrowing in years in
which it ran a budget deficit
– In 1959, national debt was $209 billion
• By beginning of 2003, it had grown to $2,936 billion
– Is this our evidence that debt is crushing economy?
3
Thinking About Spending, Taxes,
and the Budget
• From 1959 to 2003 U.S. population grew, labor force grew,
and average worker became more productive
– Why is that important?
• Because spending and debt should be viewed in relation to income
• We automatically recognize this principle when we think
about an individual family or business
• What is true for an individual family is also true for nation
– Budget-related figures such as government outlays, tax revenues,
or government debt should be considered relative to a nation’s
total income—as percentage of GDP
• In 1959, federal government’s total outlays were 19% of
GDP
– In 2003, they were about 20%—reflecting a slight upward drift, but
far from out of control
– Our concerns should be based on, and expressed with, proper
perspective
4
Spending, Taxes, and the Budget:
Some Background
• Our ultimate goal in this chapter is to
understand how fiscal changes have
affected, and continue to affect,
macroeconomy
– Why has national debt decreased in some
years, risen slowly in other years, and risen
very rapidly in still others?
– Although state and local spending also play an
important role in the macroeconomy
• Most significant macroeconomic changes in recent
decades have involved federal government
5
Government Outlays
• Federal government’s outlays—total
amount spent or disbursed by federal
government in all of its activities—can be
divided into three categories
– Government purchases
– Transfer payments
– Interest on national debt
6
Government Purchases
•
Until 1980s, government purchases of goods and services were largest
component of government spending
– To understand how these purchases have changed over time, it’s essential to divide
them into two categories
• Military and non-military
•
•
Federal government uses up only a tiny fraction or our national resources for
non-military purposes
Strongly contradicts a commonly held notion
– Government spending is growing by leaps and bounds because of bloated federal
bureaucracies
•
As a percentage of GDP, non-military government purchases have remained
very low and stable
– Have not contributed to growth in total government outlays
•
What about military purchases?
– Here, we come to an even stronger conclusion
• As a percentage of GDP, military purchases have declined dramatically over past several
decades
• Like non-military purchases, they have not contributed to upward drift in government
outlays
7
Figure 1: Federal Government
Purchases as a Percentage of GDP
8
Government Purchases
• Military purchases were around 10% of GDP in 1959, fell
almost continuously to about 3% in late 1990s, and started
to rise again in early 2000s
• Implications are tremendously important for thinking about
recent past and future of federal government’s role
– Decline in military spending in relation to GDP since early 1960s
has made huge amounts of resources available for other purposes
– Because military spending has little room to fall further and is likely
to rise over next decade, there cannot be any similar freeing up of
resources in coming years
• Resources released from military spending eased many
otherwise tough decisions about resources allocation
– Likelihood of continued increases in military spending will have the
opposite implication
• Government will presented with difficult budget choices
9
Social Security and Other Transfers
• Transfer programs provide cash and in-kind
benefits to people whom federal government
designates as needing help
• Largest category is retirement benefits
– Payments made by Social Security system to retired
people
• Second-largest category of transfers—and
fastest-growing—occurs in health programs
– Social Security system provides health-related benefits
to everyone aged 62 and over through Medicare
• Third and smallest of the three categories of
transfers is income security
– Programs to help poor families
10
Figure 2: Major Federal Transfer
Programs, 2001
11
Social Security and Other Transfers
• Have transfer payments been growing as a fraction of
GDP?
– Yes
– All three categories of transfer programs have grown rapidly in
recent decades
• In recent decades, transfers have been the fastestgrowing part of the federal government outlays and are
currently equal to about 12.5% of GDP
• Growth in transfers relative to GDP was most rapid in
1970s during Nixon administration
• Transfers are sensitive to ups and downs of the economy
– Transfers as a fraction of GDP rise during recessions
• Number of needy recipients rises in a recession
• GDP falls in a recession
12
Figure 3: Federal Transfer
Payments as a Percentage of GDP
13
Figure 4: Federal Government Interest
Payments as a Percentage of GDP
14
Total Government Outlays
• Figure 5 shows total outlays in relation to GDP over past
several decades
• Important things to notice in the figure
– Fluctuations in government outlays over the period
– Upward trend of federal outlays as a percentage of GDP
• Over past several decades, and until early 1990s, federal government
outlays as a percentage of GDP drifted upward
– Main causes were increases in transfer payments and increases in
interest on national debt that exceeded decreases in military spending
– Downward trend in mid and late 1990s
• From 1992 to 2000, federal government spending as a percentage of
GDP fell steadily, although it remained a higher percentage of GDP
than in 1959
– Main causes of decline were
» Sharp decreases in military spending
» More modest decreases in transfer payments relative to GDP during
a long expansion
15
Figure 5: Total Federal Outlays As A
Percentage of GDP
16
Total Government Outlays
• However, Figure 5 also shows the appearance of
a likely new trend
– In early 2000s, due to a rise in military and domestic
security purchases and continued increases in transfer
• Federal government outlays as a percentage of GDP began
rising, and seem likely to continue rising through decade
• These trends in government outlays have
important implications, but they are only half of the
story
• In order to understand their impact on the budget
and the macroeconomy, we must look at the other
side of the budget
– Tax revenue
17
The Personal Income Tax
• Most important source of revenue for federal government
– Also most conspicuous and painful
• Designed to be progressive
– Tax those at the higher end of the income scale at higher rates
than those at the lower end of the scale
– Excuse poorest families from paying any tax at all
• We can see from Table 2 that income tax is designed to be
quite progressive
• But tax system shown in the table does not reflect ways
that people can avoid tax
– Many people have deductions far above standard deduction
• Also, remember that we are looking at federal personal
income tax only
18
Table 2: The 2002 Personal Income
Tax for a Married Couple with Two Children
19
The Social Security Tax
• Applies to wage and salary income only
– Put in place in 1936 to finance Social Security system
created in that year
• Because payroll tax applies only to earnings
below a certain level, it is regressive
• Social Security tax is actually largest tax paid by
many Americans
– Especially those with lower incomes
20
Other Federal Taxes
• Federal government also collects around $300
billion annually from other taxes
• Corporate profits tax is often criticized by
economists because of two important problems
– Only applies to corporations
– Results in double taxation on the portion of corporate
profits that corporations pay to their owners
• Federal government also taxes consumption of
certain products
– Such as gasoline, alcohol, tobacco, and air travel
• Called excise taxes
21
Trends in Federal Tax Revenue
• Federal revenue trended upward from around 18% of GDP
in early 1960s to around 20% in late 1990s
• In early 2000s, federal tax revenues began a projected
downward trend due to long-term reductions in tax rates
• While trends in total federal revenue as a fraction of GDP
have been rather mild, its composition has changed
dramatically
• Why have Social Security taxes grown in importance?
– Social Security system operates on a pay-as-you-go principle
• Taxes people who are working now in order to pay benefits to those
who worked earlier and are now retired
– For past several decades, system benefited from two favorable
demographic factors
• Relatively small number of retirees
• Large number of taxpayers
22
Figure 6: Federal Government
Revenue As A Percentage of GDP
23
Trends in Federal Tax Revenue
• But now some demographic trends are working
against the system
– Improved health is allowing people to spend a larger
fraction of their lives in retirement
• At the same time, baby boomers will begin retiring en masse in
late 2000s
– Means greater numbers of people drawing benefits
– These increased benefits will be funded by a smaller
number of working taxpayers
• As a result of these trends, government has been raising Social
Security tax rates
– Not just to keep the system solvent, but to go further
» Building up reserves for retiring baby boomers
24
Trends in Federal Tax Revenue
• Ultimately, however, keeping social security
reserves in a separate account is important
for psychological and political reasons
– Making retirees and future retirees feel
confident that money is being held for them
– But focus on keeping trust fund solvent has had
a side-effect
• Caused government to continually raise regressive
payroll tax rate over past few decades
– Rather than rely on the progressive personal income tax to
fund the system
25
The Federal Budget and the National
Debt
• Budget Surplus = Tax Revenue – Outlays
• Budget Deficit = Outlays – Tax Revenue
• Even though world has changed much
since 1980s, reasons for the deficits of early
2000s seem like a repeat of history
– A recession
– Increased military spending
– Sizeable, multi-year tax cut
26
Figure 7(a): The Federal Budget Deficit
or Surplus as a Percentage of GDP
27
Figure 7(b): The Federal Budget Deficit
or Surplus as a Percentage of GDP
28
The National Debt
• Need to address some common confusion among three
related, but very different, terms
– Federal deficit
– Federal surplus
– National debt
• Federal deficit and surplus are flow variables
– Measure difference between government spending and tax
revenue over a given period, usually a year
– National debt, by contrast, is a stock variable
• Measures total amount that federal government owes at a given point
in time
• Relationship between these terms
– Each year government runs a deficit, it must borrow funds to
finance it, adding to national debt
29
The National Debt
• Can measure national debt as total value of
government bonds held by public
– Deficits—which add to the public’s holdings of
government bonds—add to national debt
– Surplus—which decrease the public’s bond holdings—
subtract from national debt
• Since cumulative total of government’s deficits
has been greater than its surpluses
– National debt has grown over past several decades
• Rise and fall in national debt also explains another
trend
– Rise and fall in interest payments the government must
make to those who hold government bonds
30
Figure 8: Federal Debt as a
Percentage of GDP
31
How Economic Fluctuations Affect
the Federal Budget
• Economic fluctuations affect both transfer payments and tax revenues
– In a recession, because transfers rise and tax revenue falls, federal
budget deficit increases (or surplus decreases)
• An expansion has the opposite effects on federal budget
– Because transfers decrease and tax revenue rises, budget deficit
decreases (or surplus increases)
• Because business cycle has systematic effects on spending and
revenue, economists find it useful to divide deficit into two components
– Cyclical deficit
• Part of federal budget deficit that varies with business cycle
– Structural deficit
• Part of federal budget deficit that is independent of business cycle
• Cyclical changes in the budget are not a cause for concern, because
they average out to about zero, as output fluctuates above and below
potential output
– Thus, cyclical deficit should not contribute to a long-run rise in national
debt
32
How the Budget Affects Economic
Fluctuations
• Budget changes that occur automatically during expansions and
recessions have an important impact
– Help to make economic fluctuations milder than they would otherwise be
• Changes in cyclical deficit make multiplier smaller, and thus act as an
automatic stabilizer
– Many features of federal tax and transfer systems act as automatic
stabilizers
• As economy goes into a recession, these features help to reduce decline in
consumption spending
– Also cause cyclical deficit to rise
• As economy goes into an expansion, these features help to reduce rise in
consumption spending
– Also cause cyclical deficit to fall
• Immediately raises a question
– If automatic changes in budget help to stabilize economy, can government
purposely change its spending or tax policy to make economy even more
stable?
33
Countercyclical Fiscal Policy
• When government uses fiscal policy to keep
economy closer to potential GDP in shortrun, it is engaging in countercyclical fiscal
policy
• In 1960s and 1970s, many economists and
government officials believed that
countercyclical fiscal policy could be an
effective tool to counteract business cycle
– Today, however, economists tend to be more
skeptical
• Why?
– Because counter-cyclical fiscal policy is plagued with
several problems
34
Timing Problems
• Takes many months or even longer for most
fiscal changes to be enacted
– Even if all goes smoothly
• But in most cases, it will not go smoothly
• Fed, by contrast, can increase or decrease
money supply on very day it decides that
change is necessary
35
Irreversibility
• To be effective, countercyclical fiscal policy must
be reversible
– Many temporary tax changes become permanent as
well
• Public is never happy to see a tax cut reversed
• Government is often reluctant to reverse a tax hike that has
provided additional revenue for government programs
• Reversing monetary policy, while not painless, is
easier to do
– Moreover, public and Congress have largely accepted
Fed’s role in stabilizing the economy
– Expect that interest rate will be adjusted as condition of
economy changes
36
The Fed’s Reaction
• Even if government attempted to stabilize
economy with fiscal policy, it could usually not do
so very effectively
– Because Fed would not allow it
– Fed views most changes in fiscal policy just as it views
other changes in aggregate expenditure
• As a change to be neutralized
– As long as Fed remains free to set its own course, and
sees its goal as stabilizing the economy at full
employment with low inflation
• There is generally no opportunity—and no need—for
countercyclical fiscal policy
37
The Effects of Fiscal Changes in the
Long-Run
• Fiscal changes have important effects on economy over
long-run
• Important conclusions about fiscal policy in classical model
– Government’s tax transfer policies can influence rate of labor force
participation
– Government’s tax policies can directly influence rate of investment
spending on new capital and R&D
– Government’s budget deficit can influence investment spending as
well
• And, from this chapter, you’ve learned the following
– Budget deficits add to national debt
• But what are consequences of adding to national debt?
38
The National Debt
• On a billboard in midtown Manhattan, a giant
clock-like digital display tracks U.S. national debt
and how it changes each minute
• National debt clock was one of several public
relations campaigns that spread fear among
American public
• Economists do have concerns about national debt
– But they are very different from concerns suggested by
national debt clock or other similar gimmicks
39
Mythical Concerns About the
National Debt
• What bothers many people about a growing national debt is belief that
one day we will have to pay it all back
– But although we might choose to repay national debt, we do not have to
• Ever
– How could a government keep borrowing funds without ever paying them
back?
• Surely, no business could behave that way
• But actually, many successful business do behave that way, and
continue to prosper
• Of course, this does not mean that any size debt would be prudent
– Debt and interest payments have meaning only in relation to income
• All of these observations apply to federal government as well
– As long as nation’s total income is rising, government can safely take on
more debt
40
Mythical Concerns About the
National Debt
• Federal government could pay back national debt
– By running budget surpluses for many years
• How large could annual deficits be without making
national debt a looming danger?
• As long as total national income grows at least as
fast as interest payments on debt
– Ratio of interest payments to income will not grow
– In that case, we could continue to pay interest without
increasing average tax rate on U.S. citizens
41
A National Debt That Is Growing Too
Rapidly
• Important minimal guideline for responsible
government is that debt should grow no faster
than nominal GDP
• Important implications
– To prevent a long-term disaster after too-rapid growth in
the debt, we do not have to run budget surpluses
– Even a temporary violation of the guideline is costly
• How can tax burden be brought back down after a
temporary violation of the guideline?
– Raise growth rate of nominal GDP above growth rate of
the debt for some time
– Lower growth rate of debt below growth rate of nominal
GDP for some time
42
A National Debt That Is Growing Too
Rapidly
• But these solutions are costly to society
– Consider
• Raising growth rate of nominal GDP
• Slowing down growth rate of debt below growth rate of nominal GDP
• A debt that rises too fast—faster than nominal GDP—for
some period of time will impose an opportunity cost in the
future
– Cost will be either a permanently higher tax burden, a period of
inflation, or a temporary period of reduced government outlays or
higher taxes relative to GDP
• This is not just theoretical, as U.S. experience during
1970s and 1980s demonstrates
– Fortunately, 1990s was a period of prolonged expansion and
reduced military purchases
• Opportunity cost of lower deficits was not as painful as it might
otherwise have been
43
A Debt Approaching the National
Credit Limit
• If debt were to rise too rapidly relative to GDP, for
too long
– There is a theoretical danger of reaching nation’s credit
limit
• Amount of debt that would make lenders worry about
government’s ability to continue paying interest
• While this is a theoretically sound danger of a
rapidly-rising debt
– Doubtful United States has been anywhere near that
limit during recent decades
44
Failing to Account for Future
Obligations
• Many students reading this book are getting financial help
from parents to pay costs of college
– Planning for this obligation may have begun very early—perhaps
even before you knew what college was
• Federal government is in an analogous situation
– It has effectively promised to provide Medicare and social security
payments to millions of people at some time in the future
• Of course, trying to project total federal revenues and
outlays over the next 75 years, 50 years, or even 15 years
would be guesswork at best
• This uncertainty over future projections has led to
divergent views about policy
• These divergent views formed part of background for
controversy over Bush tax cuts
45
Using the Theory: The Bush Tax
Cuts of 2001 and 2003
• In 2001, Bush administration cut taxes over
ten years by $1.35 trillion, and in 2003, by
another $350 billion
• Much of debate over tax reductions had to
do with distribution
– Whether cuts were apportioned fairly among
different income groups
– But they also raised two important
macroeconomic issues that we’ve discussed in
this chapter
46
The Short Run: Countercyclical
Fiscal Policy?
• Tax cuts of 2001 and 2003 seem like perfect
examples of well-timed countercyclical fiscal
policy
– Does this show that countercyclical fiscal policy works?
• Not really, because a closer look suggests that neither tax cut
was really designed for that purpose
– Tax cut of June 2001 had actually been proposed more than 18
months earlier by presidential candidate Bush as a long-run policy
measure, to promote growth in potential output
– Fact that tax reduction was enacted during a recession was a
stroke of luck—not a example of well-timed short-run fiscal policy
• Remember that countercyclical fiscal policy
requires that changes in taxes be reversible when
economic conditions change
47
The Short Run: Countercyclical
Fiscal Policy?
• As so often happens in macroeconomic debates,
however, politics took over
• In between these two cuts, however, Bush
administration proposed a smaller, $60 billion tax
cut
– If there was ever an opportunity to showcase
effectiveness of countercyclical fiscal policy, this was it
– But tax bill was debated for a full six months in House
and Senate, and was not signed by President until
March, 2002
48
The Long Run: The Tax Cuts and
the National Debt
• Table 3 shows two different projections of budget deficits
and national debt
• Judging by OMB’s numbers, it appears that the
administration’s fiscal policy is an example of a temporary
violation of the guideline for responsible government
– Debt is rising faster than GDP through 2006, and then stabilizing
and descending
• What do these numbers tell us?
– Certainly not a debt disaster
– But a fiscal policy with future costs
• Where does this rise in debt come from?
– Some of the early rise comes from cyclical deficits
– But continued deficits in 2006 and beyond—when the economy is
assumed to have recovered—are mostly structural deficits
49
Table 3: Projected Budget Deficits
and the Rising National Debt
50
The Long Run: The Tax Cuts and
the National Debt
• Look at lower half of Table 3
– Shows numbers put out by Democratic Caucus of
House Budget Committee in a press release, within
days of OMB documents release
– Shows a more sharply rising deficit, and what looks like
a long-run violation of guideline for responsible
government
– Note that Democratic Caucus projects 10 years forward
instead of five
– But that only accounts for part of dramatic difference in
the fiscal story each side tells
• What accounts for the rest?
51
Figure 9: Countercyclical Fiscal
Policy
52
The Long Run: The Tax Cuts and
The National Debt
• The answer is
– Assumptions behind the numbers
• Using Democratic numbers, virtually all of the rise in the
debt can be attributed to tax cuts of some form
– Either original cuts in 2001 and 2003,
– Or expected extensions and further reductions Administration has
discussed
• Based on either set of numbers, we are entering a period
of rising debt that will entail the kinds of future costs we’ve
discussed in the chapter
• Ultimately, our conclusions about any economic policy
must compare costs with benefits
53