Fiscal Policy, Deficits, and Debt
CHAPTER FOURTEEN
FISCAL POLICY, DEFICITS, AND DEBT
CHAPTER OVERVIEW
This chapter looks at government efforts to pursue stabilization of the economy through spending and
taxation, analyzing the effects of fiscal policy through the aggregate demand-aggregate (AD-AS) model.
Built-in stabilizers that automatically adjust government expenditures and tax revenues when the
economy moves through the business cycle phases are examined. The recent use and resurgence of fiscal
policy as a tool are discussed, as are problems, criticism, and complications of fiscal policy.
Budgeting issues are given considerable attention. The concept of the standardized budget is developed
and is used to assess the direction of fiscal policy. Issues of national concern—Federal budget deficits
and the public debt—are the focus of the latter part of this chapter. Recent data on the U.S. budget and
debt are provided as a basis for discussion.
The material on the public debt is designed to dispel two popular misconceptions as to the character and
problems associated with a large public debt: (1) the debt will force the U.S. into bankruptcy; and (2)
the debt imposes a burden on future generations. The debt discussion, however, also entails a look at
substantive economic concerns. Potential problems of a large public debt include greater income
inequality, reduced economic incentives, and crowding out of private investment.
The chapter concludes by examining the impending problems of the Social Security system and policy
options proposed to correct them.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Define and explain the purpose of fiscal policy.
2. Describe the Council of Economic Advisers.
3. Distinguish between discretionary and nondiscretionary fiscal policy.
4. Differentiate between expansionary and contractionary fiscal policy.
5. Recognize the conditions for recommending an expansionary or contractionary fiscal policy.
6. Explain expansionary fiscal policy and its effects on the economy and Federal budget.
7. Explain contractionary fiscal policy and its effects on the economy and Federal budget.
8. Give two examples of how built-in stabilizers help eliminate recession or inflation.
9. Explain the differential impacts of progressive, proportional, and regressive taxes in terms of
stabilization policy.
10. Explain the significance of the standardized (or full-employment) budget concept.
11. Describe recent U.S. fiscal policy actions and the motivation behind them.
12. List three timing problems encountered with fiscal policy.
13. State political problems that limit effective fiscal policy.
14. Identify actions by households, and by state and local governments that can frustrate fiscal policy.
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15. Explain and recognize graphically how crowding out can reduce the effectiveness of fiscal policy.
16. Differentiate between deficit and debt.
17. State the absolute size of the debt and the relative size as a percentage of GDP.
18. Describe the annual interest charges on the debt, who holds the debt, and the impact of inflation on
the debt.
19. Explain why the debt can also be considered public credit.
20. Identify and discuss widely held myths about the public debt.
21. Explain the real or potential effect of the debt on income distribution, economic incentives, fiscal
policy, and private investment.
22. Explain why the surpluses of the early 2000s turned to deficits beginning in 2002.
23. Describe the long-run budgetary problems facing the Social Security system.
24. Define and identify terms and concepts at the end of the chapter.
LECTURE NOTES
I.
Introduction
A. One major function of the government is to stabilize the economy (prevent unemployment or
inflation).
B. Stabilization can be achieved in part by manipulating the public budget—government
spending and tax collections—to increase output and employment or to reduce inflation.
C. This chapter will examine a number of topics.
1. It explores the tools of government fiscal stabilization policy using AD-AS model.
2. Both discretionary and automatic fiscal adjustments are examined.
3. The problems, criticisms, and complications of fiscal policy are addressed.
4. The public debt and its effects on the economy, both real and imagined, are explored.
5. Investigation of the long-run fiscal imbalances in the Social Security system conclude the
chapter.
II.
Fiscal Policy and the AD/AS Model
A. Discretionary fiscal policy refers to the deliberate manipulation of taxes and government
spending by Congress to alter real domestic output and employment, control inflation, and
stimulate economic growth. “Discretionary” means the changes are at the option of the
Federal government.
B. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples
illustrated in Figure 14.1).
1. Expansionary Policy needed: In Figure 14.1, a decline in investment has decreased AD
from AD1 to AD2 so real GDP has fallen and also employment declined. Possible fiscal
policy solutions follow:
a. An increase in government spending (shifts AD back to the right).
b. A decrease in taxes (raises income and consumption; AD shifts right).
c. A combination of increased spending and reduced taxes.
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d. If the budget was initially balanced, expansionary fiscal policy creates a budget
deficit.
2. Contractionary fiscal policy needed: When demand-pull inflation occurs as illustrated by
a shift from AD3 to AD4 in the vertical range of aggregate supply in Figure 14.2. Then
contractionary policy is the remedy:
a. A decrease government spending shifts AD4 back to AD3. Here price level returns
to its preinflationary level P1.
b. An increase in taxes will reduce income and consumption and shift back to AD3.
c. A combined spending decrease and tax increase could have the same effect with the
right combination.
III.
Built-In Stabilizers
A. Built-in stability arises because net taxes (taxes minus transfers and subsidies) change with
GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending
to rise when the economy is slumping and vice versa when the economy is becoming
inflationary. Figure 14.3 illustrates how the built-in stability system behaves.
1. Taxes automatically rise with GDP because incomes rise and tax revenues fall when
GDP falls.
2. Transfers and subsidies rise when GDP falls; when these government payments (welfare,
unemployment, etc.) rise, net tax revenues fall along with GDP.
B. The strength of automatic stabilizers depends on responsiveness of changes in taxes to
changes in GDP: The more progressive the tax system, the greater the economy’s built-in
stability. In Figure 14.3 line T is steepest with a progressive tax system.
C. Automatic stabilizers reduce instability, but do not eliminate economic instability.
IV.
Evaluating Fiscal Policy
A. A balanced standardized (full employment) budget in Year 1 is illustrated in Figure 14.4
because budget revenues equal expenditures when full-employment exists at GDP1.
B. At GDP2 there is unemployment and assume no discretionary government action, so lines G
and T remain as shown.
1. Because of built-in stability, the actual budget deficit will rise with decline of GDP;
therefore, actual budget varies with GDP.
2. The government is not engaging in expansionary policy since the budget is balanced at
the full employment level of output.
3. The standardized budget measures what the Federal budget deficit or surplus would be
with existing taxes and government spending if the economy is at full employment.
4. Actual budget deficit or surplus may differ greatly from full-employment budget deficit
or surplus estimates.
C. Budget deficits may be either standardized or cyclical.
1. Standardized deficits occur when there is a deficit in the full-employment budget as well
as the actual budget.
a. Standardized deficits signal an expansionary fiscal policy.
b. Standardized surpluses indicate contractionary fiscal policy.
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2. Cyclical deficits refer to when the standardized budget is balanced, but the actual budget
is in deficit due to a recession.
D. Global Snapshot 14.1 compares standardized budget deficits for selected countries.
E. Applying the Analysis: Recent U.S. Fiscal Policy
1. Table 14.1 shows the U.S. budget experience from 1990 to 2004.
2. Actual and standardized deficits persisted through most of the 1990s.
3. Personal and corporate tax rate increases in 1993 reduced the standardized deficits.
4. The actual budget moved into surplus in 1998; the standardized in 1999.
5. Projected surpluses encouraged major tax rate reduction enacted in 2001.
a.
Tax rate cuts helped soften the blow of the 2001 recession.
b.
Tax cuts also turned the standardized surplus back into deficit in 2002.
6. Further tax cuts and increased spending have increased the deficit but provided stimulus.
7. Figure 14.5 shows actual and projected surpluses from 1992 to 2012.
V.
Problems, Criticisms and Complications
A. Problems of timing
1. Recognition lag is the elapsed time between the beginning of recession or inflation and
awareness of this occurrence.
2. Administrative lag refers to the time taken to change policy once the problem has been
recognized.
3. Operational lag is the time elapsed between change in policy and its impact on the
economy.
B. Political considerations: Government has other goals besides economic stability, and these
may conflict with stabilization policy.
1. A political business cycle may destabilize the economy: Election years have been
characterized by more expansionary policies regardless of economic conditions, as
politicians attempt to maximize votes rather than pursue macroeconomic stability.
2. If households expect a policy reversal, fiscal policy may be ineffective. Households
given a tax cut to encourage consumption, if they expect the cut to be rescinded, will
save the extra disposable income instead of using it to stimulate total spending.
3. State and local finance policies may offset federal stabilization policies. They are often
procyclical, because balanced-budget requirements cause states and local governments to
raise taxes in a recession or cut spending making the recession possibly worse. In an
inflationary period, they may increase spending or cut taxes as their budgets head for
surplus.
4. The crowding-out effect may be caused by fiscal policy.
a. “Crowding-out” may occur with government deficit spending. It may increase the
interest rate and reduce private spending which weakens or cancels the stimulus of
fiscal policy.
b. Some economists argue that little crowding out will occur during a recession.
c. Economists agree that government deficits should not occur at full employment.
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C. Current thinking on fiscal policy
1. Some economists argue that the economy is self-correcting and fiscal policy is
unnecessary. However,
2. Most economists believe that fiscal policy is an important policy tool for pushing the
economy in a particular direction, but not for “fine tuning” it. Monetary policy is
generally preferred for month-to-month adjustments.
3. In addition to its effects on AD, the productivity (AS) effects of a fiscal policy need to
be considered. The effect of fiscal policy is not simply a matter of how many dollars are
spent (or collected in tax revenue), but also how they are spent (or from whom they are
collected).
a. Lower taxes could increase saving and investment.
b. Lower personal taxes may increase effort, productivity and, therefore, shift aggregate
supply to the right.
c.
VI.
Lower personal taxes may also increase risk-taking and, therefore, shift supply to
the right.
The Public Debt
A. The public debt is the total amount of money owed by the Federal government to owners of
government securities; equal to the sum of past budget deficits less surpluses.
B. The public debt in 2004 was $7.4 trillion. This is a large number. One million seconds ago
was 12 days back. One trillion seconds ago was around 30,000 B.C.
C. Causes of the expansion in debt:
1. National defense and military spending have soared, especially during wartime. During
World Wars I and II, debt grew rapidly.
2. Recessions cause a decline in revenues and growth in government spending on programs
for income maintenance. Such periods included 1974-75, 1980-82, 1990-91, and 2001.
3. Tax cuts are another cause. Tax cuts in the 1980s without equivalent spending cuts led
to increasing debt. The Clinton administration in 1993 is an example of how politically
difficult it is to reduce spending and raise taxes to reduce the deficit. An unpopular
deficit reduction act was passed in that year and many Democrats lost elections later.
D. Ownership of the debt (Figure 14.6)
1. Public debt is held in the form of U.S. securities: Treasury bills, Treasury notes,
Treasury bonds, and U.S. savings bonds.
2. Ownership of the debt is an important question in terms of who the Federal government
is obligated to repay, and has implications for whether U.S. assets remain in the country.
3. The public held 58 percent in 2004; the Federal government 42 percent.
4. Foreign interests hold 26 percent of the U.S. public debt, meaning most of the public
debt is held (and owed) internally.
E. Debt and GDP
1. Comparing the debt to GDP is more meaningful than the absolute level of debt by itself.
Use the example of a family or corporate borrowing. For a prosperous family or firm,
$100,000 worth of debt may be a small fraction of their income; for others, $100,000
worth of debt may mean they’re unable to make payments on the debt. The amount is
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not as important as the amount relative to the ability to pay. Also, most borrowing is
made to purchase physical assets such as buildings, equipment, etc. Another way to
judge government debt is to compare it to an estimate of public assets.
2. Figure 14.7 reveals that as a percentage of GDP, Federal debt held by the public is
increasing, but lower than it was in the 1990s.
3. International comparisons show that other nations have relative public debts as great or
greater than that of the U.S. when compared to their GDPs. See Global Snapshot 14.2.
4. Interest charges as a percentage of GDP (1.4 percent in 2004) represent the primary
burden of the debt today.
F. False concerns about the public debt include several popular misconceptions:
1. Can the federal government go bankrupt? There are reasons why it cannot.
a. The government does not need to raise taxes to pay back the debt, and it can borrow
more (i.e. sell new bonds) to refinance bonds when they mature. Corporations use
similar methods—they almost always have outstanding debt.
b. The government has the power to tax, which businesses and individuals do not have
when they are in debt.
2. Does the debt impose a burden on future generations? In 2004 the per capita public debt
in the U.S. was $25,200. But the public debt is a public credit—your grandmother may
own the bonds on which taxpayers are paying interest. Some day you may inherit those
bonds that are assets to those who have them. The true burden is borne by those who pay
taxes or loan government money today to finance government spending. If the spending
is for productive purposes, it will enhance future earning power and the size of the debt
relative to future GDP and population could actually decline. Borrowing allows growth
to occur when it is invested in productive capital.
G. Substantive issues do exist.
1. Repayment of the debt affects income distribution. If working taxpayers will be paying
interest to the mainly wealthier groups who hold the bonds, this probably increases
income inequality.
2. Since interest must be paid out of government revenues, a large debt and high interest
can increase tax burden and may decrease incentives to work, save, and invest for
taxpayers.
3. A higher proportion of the debt is owed to foreigners (about 26 percent) than in the past,
and this can increase the burden since payments leave the country. But Americans also
own foreign bonds and this offsets the concern.
4. Some economists believe that public borrowing crowds out private investment, but the
extent of this effect is not clear (see Figure 14.8).
5. There are some positive aspects of borrowing even with crowding out.
a. If borrowing is for public investment that causes the economy to grow more in the
future, the burden on future generations will be less than if the government had not
borrowed for this purpose.
b. Public investment makes private investment more attractive. For example, new
federal buildings generate private business; good highways help private shipping,
etc.
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VII.
The Long-Run Fiscal Imbalance: Social Security
A. There is an impending long-run shortfall in Social Security funding.
1. It is a “pay-as-you-go” system, meaning that current revenues are used to pay current
retirees (instead of paying from funds accumulated over time).
2. The Social Security retirement program has grown from less than one-half of one percent
of GDP in 1950 to 4.4 percent of GDP today, and is expected to reach 6.5 percent by
2035.
3. Despite efforts to build a trust fund, in 2017 Social Security revenues will fall below
payouts to retirees.
4. In 2041 the trust fund will be exhausted and benefits will exceed revenues by an
estimated 37 percent, with that figure rising to 56 percent annually in 2075.
B. Demographic changes are creating the problem.
1. Baby boomers are entering retirement age and living longer, meaning that there will be
more recipients receiving payouts for longer periods of time.
2. The ratio of the number of workers contributing to the system for each recipient has
declined from 5:1 in 1960 to 3:1 today. By 2040 the ratio will be only 2:1. (Figure 14.9)
C. Numerous solutions have been suggested.
1. Reduce benefits by reducing direct payments, taxing benefits, and/or increasing the age
at which workers are eligible to receive benefits (already part of the system)
2. Increase revenues by raising payroll taxes.
3. Increase the trust fund by setting aside more of current system revenues, or by investing
trust fund monies in corporate stocks and bonds.
4. Allow workers to invest half of their payroll taxes in approved stock and bond funds –
sometimes referred to as “privatizing” Social Security.
D. There are many possible solutions, and the political process may well result in a combination
of the many policies proposed.
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