Fiscal Policy / Taxes / Public
Finance / Deficits and Debt
• Public finance – government’s taxing and
spending policies
• Fiscal policy – changing of taxes and spending
to affect the level of output in the economy.
– In general:
• Expansionary : G > T (government spending is greater
than tax revenue collected)
• Contractionary: G < T
Historically
• Pre 1930s: Sound Finance – government budget
should always be balanced except in wartime.
– So argue to finance government spending with taxes.
This makes it harder to increase government spending
– encourages more fiscal responsibility?
• Ricardian equivalence theorem – deficits do not
affect level of output in economy b/c people
increase savings to pay future tax increases to pay
for the deficit.
– Ricardo felt that there was no difference in financing
gov’t spending by selling bonds or raising taxes.
Historically
• Depression – 1930s
– Give up principle of sound finance
• Use gov’t spending to stimulate the economy
• Gov’t work programs (Fed Emergency Relief Program, Works
Progress Administration)
• Keynes - Functional Finance – governments
should make spending and taxing decisions on
the basis of their effect on the economy, not
based on principle of balanced budgets.
– If spending too low, run a deficit / if spending too
high, run a surplus
Macro Model Assumptions
• Assumptions about Macro multiplier model that
can lead to problems with fiscal policy:
– Financing deficit doesn’t have offsetting effects
• Crowding out – sell bonds to finance deficit, raise interest
rates, discourage consumption and investment – increased
gov’t spending can “crowd out” private spending
– Gov’t knows what situation is
• Lag time before we know what is going on (can be halfway
into a recession before we know it)
– Gov’t knows potential income level
• Not easy to define - disagreements
Macro Model Assumptions
– Gov’t is flexible in changing spending and taxes
• Takes a lot of time for changes to pass through
Congress, Senate, President
• Budget planning process takes years
– Size of debt doesn’t matter
• Is a large national debt a problem – this is a
complicated issue (we will get to later)
– Fiscal policy doesn’t negatively affect other gov’t
goals
• Goals often conflict
Countercyclical vs. Procyclical
• Countercylclical Fiscal Policy
– Offset changes due to business cycle fluctuations
(during recession - increase spending / expansion
– decrease spending)
• Procyclical Fiscal Policy – changes in spending
and taxes that increase the cyclical
fluctuations (State constitutions requiring
balanced budgets)
Automatic Stabilizers
• We have built fiscal policy into institutions
• Automatic stabilizer – a gov’t policy or program
that counteracts business cycle (countercyclical)
– Unemployment insurance / Welfare system
• When economy is slowing down, unemployment rate rises,
unemployment insurance helps offset the decrease in
income…government spending is automatically increased.
– Tax system
• When economy expands people pay higher taxes – partially
offsets increase in income
Taxes
• Past 25 years – tax policy has dominated econonomic policy.
– “no other issue clearly defines the differences between
the two major political parties”
• Taxes are government policies that directly affect all citizens
• 2.2 trillion in taxes in 2005
– Magnitude suggests that taxes have an important effect on
the economy
– Alters the incentives associated with decisions – thus
affecting actions people and businesses take
• Distorts good economic choices?
Taxes
• We have a “progressive tax system” – rate you pay increases
as you make more money…”ability to pay” principle
• Reagan – large cut in 1981, then the Tax Reform Act of 1986
(removed deductions and loopholes and decreased tax rates)
– Supply-side economics: cut taxes and tax revenue will go
up because economy will expand by more
– Just increasing the debt and postponing taxes?
– NY Times article illustrates the debate
• Rates on high income raised in 1990 and 1993 to REDUCE
BUDGET DEFICITS
TAXES
• George W. Bush
– Tax Cuts in 2001 – phased-in tax cuts in both
income tax and estate tax (most expire in 2011)
– 2003 – reduced taxation of dividends and capital
gains – increase incentive to invest
– 2004 – Fed tax revenue / GDP = 16%, lowest in 45
years
– 2005 – advisory panel report to overhaul the tax
system completely
Deficits and Surpluses
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Flow concepts
2002 - 2008 – large budget deficits
1998 – 2001 – budget surpluses
Long-run – surpluses are good because they
provide additional saving
• Short-run – whether we should have a deficit
or surplus depends if we are above or below
potential income
Deficits and Surpluses
• How does the government finance a deficit?
– Selling bonds to individuals and to the central
bank
– Can also print money – can cause serious inflation
problems (this is usually a last resort)
Debt
• Accumulated deficits – accumulated surpluses
• Stock measure
• NOTE: inflation can make size of debt smaller
(if you owe $100, but there is 4% inflation, the
$100 you owe is now only $96 in real value)
Debt Management
• Treasury Department continually refinances
its bonds that are coming due by selling new
bonds
– If there is a surplus, gov’t can retire some of the
bonds.
• Debt must be judged relative to Assets
– Assets – workforce, resources, factories, housing,
foreign assets, etc.
– Deficits and increasing debt may not be all that
bad if the spending is increasing assets
Government Debt is Different than
Individual Debt
• Government is ongoing (never has to pay back
its debt)
• Government can pay off a debt by creating
money
• 75% of government debt is internal debt
(owed to other governmental agencies and US
citizens)
– Paying interest is a redistribution among citizens
of the country
Debt Burden
• Measure debt relative to GDP – measures
government ability to pay off a debt
• debt service – interest rate on debt times total
debt (amount of interest paid each year)
– 2006 gov’t paid $227 billion in interest
Social Security
• Social Security System began with passage of
Federal Insurance Contribution Act (FICA) in 1935
– Employees and firms pay taxes, and in return
employees get a pension after they retire
– Pay as you go system
– Designed to supplement private-sector pensions
– 1960s 40% workers covered by private pensions
– Today, only 16% of workers covered by private pensions
– Replaced with “defined-contribution” plans – 401(k)
– Potential crisis – average worker (6% contributions for 35 years)
will spend plan’s savings in 8.5 years
Social Security – Crisis?
• Currently Social Security system is running a
large surplus.
– However, eventually, Social Security will be
required to pay out an amount far greater than its
revenue
• 1983 created the Social Security Trust Fund –
holds bonds
• Current estimates – surpluses will continue
until around 2020. By 2040 Social Security
trust fund will be used up.
Medicare – Crisis?
• More so than Social Security
• Recent changes will greatly increase costs in a
few decades
• 2030 – 60 or 65 % of government budget will
be spent on Social Security and Medicare
Solutions?
• Real output per worker increases (so you are producing
enough output for you plus people who are retired)
• Current consumption comes from current output
• Productivity growth
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Privatizing Social Security?
Increase taxes on workers?
Cut benefits once baby boomers retire?
Make social security available only to those who need
it?
• Increase retirement age to 72? Its now 65-68.
NEXT TIME
• Lets talk about Economic plans of presidential
candidates
– Obama
– Clinton
– McCain
• HMWK: Write a two page essay discussing the
differences between the three, end with
which plan you think is best for the economy.
– Economy, Taxes, Health Care, Immigration
• All these can be economic issues!
Presentations (Optional)
• Present one candidates economic proposals
• Power point (10-15 minutes)
• I’ll drop 1 hmwk and 1 quiz grade and give you
extra 5% points on test grade if you do a
presentation.
• Can have teams up to 3 people.
• E-mail me powerpoint and then you can use
my computer