Global Economics and You, part V:
Deficits & Debt
How do we pay for government spending?
–
–
Taxes
Deficit spending (take a loan from the future)
Deficit = G – T
(annual; a flow)
Debt = Add up the Deficits (cumulative; a stock)
Indebtedness of the world’s governments
Country
Gov Debt
(% of GDP)
Country
Gov Debt
(% of GDP)
Japan
173
U.K.
59
Italy
113
Netherlands
55
Greece
101
Norway
46
Belgium
92
Sweden
45
U.S.A.
73
Spain
44
France
73
Finland
40
Portugal
71
Ireland
33
Germany
65
Korea
33
Canada
63
Denmark
28
Austria
63
Australia
14
Ratio of U.S. govt debt to GDP
1.2
1.0
WW2
0.8
0.6
Revolutionary
War
Civil War
Iraq
War
WW1
0.4
0.2
0.0
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
The U.S. experience with Debt
1980s - 1990s
– debt-GDP ratio: 25.5% in 1980, 48.9% in 1993
– due to Reagan tax cuts, increases in defense
spending & entitlements
1990s - 2000
– $290b deficit in 1992, $236b surplus in 2000
– debt-GDP ratio fell to 32.5% in 2000
– due to rapid growth, stock market boom, tax hikes
The U.S. experience in recent years
Early 2000s
– the return of huge deficits, due to Bush tax cuts,
2001 recession, Medicare expansion, Iraq war
The 2008-2009 recession
– fall in tax revenues
– huge spending increases (bailouts of financial
institutions and auto industry, stimulus package)
Federal Debt and Deficit
•Surplus in 4 of last 25 years.
Fiscal Year
2004
2002
2000
1998
GWBush
1996
1994
Clinton
1992
1988
Bush
1986
1984
Reagan
1990
$500
$400
$300
$200
$100
$$(100)
$(200)
$(300)
$(400)
$(500)
1982
$ in billions
Surplus or Deficit
Troubling long-term fiscal outlook
• The U.S. population is aging.
• Health care costs are rising.
• Spending on entitlements like Social Security and
Medicare is growing.
• Deficits and the debt are projected to significantly
increase…
Percent of U.S. population age 65+
Percent of 23
pop.
actual
projected
20
17
14
11
8
2050
2040
2030
2020
2010
2000
1990
1980
1970
1960
1950
5
U.S. government spending on Medicare and Social
Security
Percent of 8
GDP
6
4
2
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
0
CBO projected U.S. federal govt debt in two scenarios
300
Percent of GDP
250
200
pessimistic
scenario
150
100
50
0
2005
optimistic scenario
2010
2015
2020
2025
2030
2035
2040
2045
2050
Is the govt debt really a problem?
Consider a tax cut with corresponding
increase in the government debt.
Two viewpoints:
1. Traditional view
2. Ricardian view
The traditional view
• Yes, the Debt matters – in the long run
• Short run:  Consumption,  Unemployment
• Long run:
– Consumption and Unemployment back at their
natural rates
– But  Real interest rates,  Investment
Crowding out private investment
The Ricardian view
• No, debt is not a problem
• As argued by David Ricardo (1820)
and Robert Barro (2010)
• According to Ricardian equivalence,
a debt-financed tax cut has no effect on
consumption, national saving, the real interest
rate, investment, net exports, or real GDP,
even in the short run.
The logic of Ricardian Equivalence
• Consumers are forward-looking—a debt-financed tax
cut today has to be paid for with a future tax increase.
• The tax cut does not make us better off, so we do not
increase consumption.
Instead, we save the full tax cut to repay the future tax
liability.
• Result: Private saving rises by the amount public
saving falls, leaving national saving unchanged.
•People increase saving in anticipation of future tax
increases.
•This causes a reduction in private sector spending that
is exactly equal to the increase in government
spending.
•Deficit spending is not stimulative. It has no effect
whatsoever.
•This implies fiscal policy is useless at best.
•Activist policy cannot work!
Problems with Ricardian Equivalence
• Myopia: Not all consumers think so far ahead,
some see the tax cut as a windfall.
• Borrowing constraints: Some consumers cannot
borrow enough to achieve their optimal consumption,
so they spend a tax cut.
• Future generations: If consumers expect that the
burden of repaying a tax cut will fall on future
generations, then a tax cut now makes them feel better
off, so they increase spending.
Evidence against Ricardian Equivalence?
1980s:
Reagan tax cuts increased deficit.
National saving fell, real interest rate rose
1992:
Income tax withholding reduced to stimulate economy.
– This delayed taxes but didn’t make consumers better off.
– Almost half of consumers increased consumption.
The Laffer Curve
Evidence against Ricardian Equivalence?
• Proponents of R.E. argue the Reagan tax cuts did not
provide a fair test of R.E.
– Consumers may have expected the debt to be
repaid with future spending cuts instead of future
tax hikes.
– Private saving may have fallen for reasons other
than the tax cut, such as optimism about the
economy.
• Because the data is subject to different
interpretations, both views of govt debt survive.
OTHER PERSPECTIVES:
Balanced budgets vs. optimal fiscal policy
• A balanced federal budget every year?
• Economists reject this proposal, arguing deficit
should be used to:
– stabilize output & employment
– smooth taxes in the face of fluctuating income
– redistribute income across generations when
appropriate
OTHER PERSPECTIVES:
Debt and politics
“Fiscal policy is not made by angels…”
– Greg Mankiw, p.487
• Trust policymakers with deficit spending?
• They argue :
– policymakers neglect true costs of their spending since
burden falls on future taxpayers
– since future taxpayers cannot vote, their interests are
ignored
OTHER PERSPECTIVES:
Fiscal effects on monetary policy
– Printing money?
– Inflation
– Not too popular in most countries
Taxes: the price to live in a civilized society
"I like paying taxes. With them I buy civilization."
Justice Oliver Wendell Holmes
Dueling tax plans
From the 2008
campaign
Current Law
McCain’s
Plan
Obama’s
Plan
Highest Income
Tax Rate
35%
35%
41%
Capital Gains
15
15
20
Dividends
15
15
20
Income &
Payroll Tax
combined
35
35
43-45
Estate tax
45
15
45
Corporate Tax
35
25
35
"Let me try to put each tax plan into a single number.
Suppose you earn a dollar today and decide to invest it for your kids.
How much, as a result, will he leave his kids in T years?
The answer depends on four tax rates.
First, combined income and payroll tax on the dollar earned.
Second, the corporate tax rate while the money is invested in a firm.
Third, the dividend and capital gains rate as you receive that return.
Fourth, the estate tax when you leave what has accumulated to my kids.
Let
t1 be the combined income and payroll tax rate,
t2 be the corporate tax rate,
t3 be the dividend and capital gains tax rate, and
t4 be the estate tax rate.
And let r be the before-tax rate of return on corporate capital.
Then one dollar you earn today will yield yourkids:
(1-t1){[1+r(1-t2)(1-t3)]^T}(1-t4).
Assume
 r to be 10 percent and
 remaining life expectancy T to be 35 years.
If there were no taxes, so t1=t2=t3=t4=0, then $1 earned today would yield my kids $28.
That is simply the miracle of compounding.
Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15.
• In this case, a dollar earned today yields my kids $4.81.
• Even under the low-tax McCain plan, the incentive to work is cut by 83 percent
compared to the situation without taxes.
Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45.
• In this case, a dollar earned today yields my kids $1.85.
• Obama's proposed tax hikes reduce my incentive to work by 62 percent compared
to the McCain plan and by 93 percent compared to the no-tax scenario.
• In a sense, putting the various pieces of the tax system together, I would be facing a
marginal tax rate of 93 percent.
The bottom line:
• If you are trying to induce me to do some work for you, there is a good chance I
will turn you down.
The Economics of Taxation
Taxes on Economic “Flows”
• Most taxes are levied
on measurable
economic flows.
• For example, a profits,
or net income, tax is
levied on the annual
profits earned by
corporations.
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Proportional, Progressive,
and Regressive Taxes
• A proportional tax is a tax
whose burden is the same
proportion of income for all
households.
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Proportional, Progressive,
and Regressive Taxes
• A progressive tax is a tax whose
burden, expressed as a percentage
of income, increases as income
increases.
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Proportional, Progressive,
and Regressive Taxes
• A regressive tax is a tax whose burden,
expressed as a percentage of income, falls as
income increases.
– Excise taxes (taxes on goods) are regressive.
– The retail sales tax is also regressive.
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Proportional, Progressive,
and Regressive Taxes
The Burden of a Hypothetical 5% Sales Tax Imposed on Three Households with
Different Incomes
HOUSEHOLD
INCOME
SAVING
RATE, %
SAVING
CONSUMPTION
5% TAX ON
CONSUMPTION
TAX
AS A %
OF INCOME
A
$ 10,000
20
$ 2,000
$ 8,000
$ 400
4.0
B
20,000
40
8,000
12,000
600
3.0
C
50,000
50
25,000
25,000
1,250
2.5
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Marginal versus Average Tax Rates
• The average tax rate is the total amount of
tax you pay divided by your total income.
• The marginal tax rate is the tax rate you pay
on any additional income you earn.
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Marginal versus Average Tax Rates
• Marginal tax rates influence
behavior. Decisions about
how much to work and how
much to invest depends in
part on the after-tax return.
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Tax Equity
• One theory of fairness is called the
benefits-received principle, which
holds that taxpayers should
contribute to government (in the
form of taxes) in proportion to the
benefits that they receive from
public expenditures.
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Tax Equity
• Another theory of fairness is called
the ability-to-pay principle, which
holds that citizens should bear tax
burdens in line with their ability to
pay taxes.
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What is the “Best” Tax Base?
• The three leading candidates
for best tax base are:
– Consumption
– Income
– Wealth
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Consumption as the Best Tax Base
• If we want to redistribute
well-being, the tax base
should be consumption
because consumption is the
best measure of well-being.
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Income as the Best Tax Base
• Supporters of the use of income as the tax
base argue that your ability to pay is your
ability to command resources.
• It is your income that enables you to save or
consume, and it is income that should be
taxed regardless of its sources and uses.
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Wealth as the Best Tax Base
• Supporters of the use of
wealth as the tax base argue
that the real power to
command resources comes
not from income but from
accumulated wealth.
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Tax Incidence: Who Pays?
• Tax incidence refers to the ultimate
distribution of a tax’s burden.
• Tax shifting occurs when households can alter
their behavior and do something to avoid
paying the tax.
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Measuring Excess Burdens
• A tax that alters economic
decisions imposes a burden
that exceeds the amount of
taxes collected.
•
An excise tax that raises the price of
a good above marginal cost drives
some consumers to buy lessdesirable substitutes, reducing
consumer surplus.
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