Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 14

Chapter 14: Deficit Spending and the
Public Debt

 Explain how federal government budget deficits occur
 Define the public debt and understand alternative measures of the public debt
 Evaluate circumstances under which the public debt could be a burden to future generations
 Discuss why the federal budget deficit might be measured incorrectly
 Analyze the macroeconomic effects of government budget deficits
 Describe possible ways to reduce the government budget deficit
14-3

 Government Budget Deficit

Exists if the government spends more than it receives in taxes during a given period of time

Is financed by the selling of government securities (bonds)
14-4

 The federal deficit is a flow variable, one defined for a specific period of time, usually one year.
 If spending equals receipts, the budget is balanced.
 If receipts exceed spending, the government is running a budget surplus.
14-5

 Balanced Budget
 A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time
 Government Budget Surplus

An excess of government revenues over government spending during a given period of time
14-6

 Public Debt

A stock variable

The total value of all outstanding government securities
14-7

 Since 1940, the U.S. federal government has operated with a budget surplus in 13 years.
 In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.
14-8

Figure 14-1
14-9

Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
14-10

 Why was the government’s 2005 deficit projection off by $109 billion?
 Federal tax revenues turned out to be more than
15% higher in 2005.
 Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.
14-11

 Gross Public Debt

All federal government debt irrespective of who owns it
 Net Public Debt

Gross public debt minus all government interagency borrowing
14-12

Evaluating the Rising Public Debt (cont'd)
 Some government bonds are held by government agencies.

In this case, the funds are owed from one branch of the federal government to another.

To arrive at the net public debt, we subtract interagency borrowings from the gross public debt.
14-13

Evaluating the Rising Public Debt (cont'd)
 Tax revenues tend to be stagnant during times of slow economic growth.
 Tax revenues grow more quickly when overall growth enhances incomes.
 As long as spending exceeds revenues, the budget deficit will persist.
14-14

Table 14-1 The Federal Deficit, Our Public
Debt, and the Interest We Pay on It
14-15

Figure 14-3
14-16

Net U.S. Public Debt as a Percentage of GDP
 During World War II, the net public debt grew dramatically.
 After the war

It fell until the 1970s

Started rising in the 1980s

Declined once more in the 1990s

And recently has been increasing again
14-17

Evaluating the Rising Public Debt (cont'd)
 The government must pay interest on the public debt outstanding.

The level of these payments depends on the market interest rate.
 Interest payments as a percentage of GDP are likely to rise in the future.
 As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases.

Foreign residents, businesses and governments hold nearly 50% of the net public debt.

Thus, we do not owe the debt just to ourselves.
14-18

 We will not hold class this Thursday,
April 9.
 Instead, work on your projects:

Macroeconomics in the News, paper due April 16

Teaching project, paper due April 23

Evaluating the Rising Public Debt (cont'd)
 If the economy is already at full employment, then further provision of government goods will crowd out some private goods.
 Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.
 Crowding-out may place a burden on future generations.

Increased present consumption may crowd out investment and reduce the growth of capital goods, which could reduce a future generation’s wealth.

Taxes may have to be increased, imposing higher taxes on future generations in order to retire the debt.
14-20

Evaluating the Rising Public Debt (cont'd)
 Paying off the public debt in the future
 If the debt becomes larger, each person’s share would increase.
 Taxes would be levied, and may not be assessed equally.
 A special tax could be levied based on a person’s ability to pay.
14-21

Evaluating the Rising Public Debt (cont'd)
 Our debt to foreign residents

We do not owe all the debt to ourselves.

Future U.S. residents will be taxed to repay principal and interest.
 Portions of U.S. incomes will be transferred abroad.
14-22

Evaluating the Rising Public Debt (cont'd)
 If deficits lead to slower growth rates future generations will be poorer.
 Both present and future generations will be economically better off if…

Government expenditures are really investments
 The rate of return on such public investments exceeds the interest rate paid on the bonds
14-23

International Example: Where Are Most
Treasury Securities Held Abroad?
 More than $2 trillion in U.S. Treasury securities of the $5 trillion in net outstanding debt is held outside the United States.
 Japan accounts for more than one-third of all foreign holdings of the U.S. net public debt.
14-24

Figure 14-4 The Distribution of Foreign
Holdings of U.S. Treasury Securities
14-25

International Example: Where Are Most
Treasury Securities Held Abroad? (cont'd)
 For critical analysis:

Why might the fact that market interest rates in Japan have hovered very close to 0% during the 2000s help explain relatively large holdings of U.S. Treasury securities by residents of that country?
14-26

 Question: Is there a connection between the
U.S. trade deficit and the federal government budget deficit?
 A trade deficit exists when the value of imports exceeds the value of exports.
 Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.
14-27

Figure 14-5
14-28

Federal Budget Deficits in an
Open Economy (cont'd)
 If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports.
 This means that a U.S. budget deficit can contribute to a trade deficit.
14-29

Growing U.S. Government Deficits:
Implications for U.S. Economic Performance
 Which government deficit is the true deficit?

The government may report distorted measures of its own budget.
• Government has not adopted a business-like approach to tracking its expenditures and receipts.
• Official government “measures” yield lowest possible deficits and highest reported surpluses.
14-30

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 An operating budget includes current outlays for on-going expenses, such as salaries and interest payments.
 A capital budget , includes expenditures on investment items, such as machines, buildings, roads and dams.
14-31

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Question
 How do higher deficits affect the economy in the short run?
 Answers:

If the economy is below full-employment, the deficit can close the recessionary gap.
 If the economy is already at full-employment, the deficit can create an inflationary gap.
14-32

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 In the long run, higher government budget deficits have no effect on equilibrium real GDP.
 Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.
14-33

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Thus, if the government operates with higher deficits over an extended period:

The ultimate result is a shrinkage in the share of privately produced goods and services

By continually spending more than it collects, the government takes up a larger portion of economic activity.
14-34

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 How could the government reduce all its red ink?

Increasing taxes for everyone

Taxing only the rich

Reducing expenditures

Whittling away at entitlements
14-35

Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase
 Some estimates show increasing the top bracket from
35% to 39.6% would reduce total taxable income by at least 4%.
 Such projections show this increase as giving the highest income taxpayers a greater incentive to incorporate and pay lower corporate-profit tax rates.
 Thus, raising the income tax rate by 4.6% would result in less than a 4.6% increase in government tax collections – but an increase, not a decrease, as some suggest.
14-36

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 In considering how expenditures might be reduced, it is important to look at entitlements , the federal government payments that are legislated obligations and cannot be reduced or eliminated.
 What are some of these entitlements?
14-37

Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending
14-38

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Entitlements are the largest component of the
U.S. federal budget.
 To make a significant cut in expenditures, entitlement programs would have to be revised.
14-39

Growing U.S. Government Deficits: Implications for
U.S. Economic Performance (cont'd)
 Question

What are the political costs of reducing entitlement payments for Social Security,
Medicare, and Medicaid???
14-40

Summary of Learning Objectives
 Federal government budget deficits
 Whenever the flow of government expenditures exceeds the flow of government revenues a budget deficit occurs.
 The public debt

Total value of all government bonds outstanding
 The federal budget deficit is a flow, whereas accumulated deficits are a stock, called the public debt.
14-41

Summary of Learning Objectives (cont'd)
 How the public debt might prove a burden to future generations
 Higher taxes will reduce private consumption.

Crowding out might reduce economic growth.
 Why the federal budget deficit might be incorrectly measured

No distinction between capital expenses and operating expenses

Each estimate is based on a set of assumptions.
14-42

Summary of Learning Objectives (cont'd)
 The macroeconomic effects of government budget deficits
 Because higher government deficits are caused by increased government spending or tax cuts, they contribute to a short-run rise in total planned expenditures and aggregate demand.

In the long run, increased deficits only redistribute resources from the private sector to the public sector.
14-43

Summary of Learning Objectives (cont'd)
 Possible ways to reduce the government budget deficit:

Increase taxes

Reduce expenditures by revising the terms of entitlement programs
14-44

Read Chapter 15 & also read the end-of-chapter Problems: 15-2,
15-4, 15-6, 15-8, 15-13, 15-14 &
15-15, on pp. 389-391.