Chapter 14:
Fiscal Policy,
Deficits, and Debt
Fiscal Policy

Fiscal policy consists of deliberate
changes in government spending and tax
collections designed to achieve full
employment, control inflation, and
encourage economic growth.
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Fiscal Policy and
the AD-AS Model
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The Council of Economic Advisors (CEA)
provides advice and assistance on
economic matters to the president.
Discretionary fiscal policy is initiated on
the advise of the CEA and changes to
government spending and taxes are at the
option of the Federal government.
Nondiscretionary fiscal policy are changes
that occur automatically.
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Expansionary Fiscal Policy

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When the economy is in recession,
expansionary fiscal policy may be in order.
Expansionary fiscal policy is an increase
in government spending, a decrease in
taxes, or some combination of the two for
the purpose of increasing aggregate
demand and real output.

If the Federal budget is balanced at the outset,
expansionary fiscal policy will create a
government budget deficit.
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Expansionary Fiscal Policy
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Contractionary Fiscal Policy

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When demand-pull inflation occurs,
contractionary fiscal policy may help to
control it.
Contractionary fiscal policy is a decrease
in government spending, an increase in
taxes, or some combination of the two for
the purpose of decreasing aggregate
demand and halting inflation.

Contractionary fiscal policy may create a
budget surplus.
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Contractionary Fiscal Policy
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Built-In Stability

A built-in stabilizer is anything that
increases the government’s budget deficit
(or reduce its budget surplus) during a
recession and increase its budget surplus
(or reduce its budget deficit) during an
expansion without requiring explicit action
by policymakers.

Examples include personal income taxes,
payroll taxes, corporate income taxes, sales
taxes and excise taxes.
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Built-In Stability
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Taxes reduce spending and aggregate
demand; in addition, reductions in
spending are desirable when the economy
is moving toward inflation, whereas
increases in spending are desirable when
the economy is slumping.
Built in stability has reduced the severity of
business fluctuations in the U.S..
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Evaluating Fiscal Policy
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In evaluating the status of fiscal policy, we
must adjust deficits and surpluses to
eliminate automatic changes in tax
revenues and compare the sizes of the
adjusted budget deficits (or budget
surpluses) to the level of potential GDP.
The standardized budget (or fullemployment budget) is used for this
purpose.
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Evaluating Fiscal Policy

The standardized budget is a measure of
what the Federal budget deficit or surplus
would be with existing tax rates and
government spending programs if the
economy had achieved its full-employment
GDP in the year.

The standardized budget deficit is zero at the
full-employment output level.
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Evaluating Fiscal Policy

If the economy slides into a recession, the
standardized budget deficit is still zero
since government expenditure equals the
tax revenue that would be forthcoming at
the full-employment GDP.
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Evaluating Fiscal Policy

The deficit that arises in a recession is a
cyclical deficit and is not caused by
government discretionary fiscal policy.

A cyclical deficit is a Federal deficit that is
caused by a recession and the consequent
decline in tax revenue.
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Evaluating Fiscal Policy
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If a standardized deficit of zero in one year
is followed by a standardized budget deficit
in the next year, then fiscal policy is
expansionary.
Conversely, if a standardized deficit of zero
in one year is followed by a standardized
budget surplus in the next year, then fiscal
policy is contractionary.
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Problems, Criticisms,
and Complications
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A number of significant problems may
arise in enacting and applying fiscal policy
such as:
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problems of timing
political considerations
future policy reversals
offsetting state and local finance
crowding-out effect
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Problems, Criticisms,
and Complications
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Timing issues include recognition lag,
administrative lag and operational lag.
Political considerations include political
business cycles: the alleged tendency of
presidential administration and Congress to
create macroeconomic instability by
reducing taxes and increasing government
spending before elections and to raise taxes
and reduce expenditures after elections.
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Problems, Criticisms,
and Complications

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Consumption smoothing arises when
taxpayers believe policy is only temporary
and is likely to be reversed in the future.
The fiscal policies of state and local
governments are frequently pro-cyclical;
they worsen rather than correct recession
or inflation.
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Problems, Criticisms,
and Complications

Another potential flaw in fiscal policy is the
crowding-out effect: a decrease in
private investment caused by higher
interest rates that result from the Federal
government’s increased borrowing to
finance deficits (or debt).
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Current Thinking on
Fiscal Policy
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Despite the many complications of fiscal
policy, the current popular view is that
fiscal policy can help “push the economy”
in an intended direction but cannot “finetune it” to a specific outcome.
Monetary policy is considered by many to
be the best month-to-month stabilization
tool for the U.S. economy.
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The Public Debt

The national or public debt is essentially
the total accumulation of the deficits
(minus the surpluses) the Federal
government has incurred through time.

Deficits have emerged because of war
financing, recessions, fiscal policy, and lack of
political will by Congress.
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The Public Debt

The total public debt represents the total
amount of money owed by the Federal
government to the owners of government
securities.

U.S. securities are Treasury bills, Treasury
notes, Treasury bonds, U.S. savings bonds,
and I-bonds issued by the Federal
government to finance expenditures that
exceed tax revenues.
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The Public Debt
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The U.S. and other highly productive
nations can incur and carry a large public
debt more easily than poor nations.
Many economists conclude that the annual
interest charge accruing on the bonds sold
to finance the debt is the primary burden
of the U.S. debt.
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False Concerns

The large U.S. debt does not threaten to
bankrupt the Federal government, leaving
it unable to meet its financial obligations.
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One reason is the public debt is easily
refinanced.
Another reason is the Federal government has
the option to impose new taxes or increase
existing tax rates to finance the debt.
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Substantive Issues
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The distribution of ownership of
government securities is highly uneven,
where ownership of the public debt is
concentrated among wealthier groups.
A large public debt may impair economic
growth if higher taxes for interest
payments on government securities
dampen incentives to bear risk, to
innovate, to invest, and to work.
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Substantive Issues
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External public debt, or the part of the
public debt owned by foreigners, is an
economic burden to Americans.
Another potentially serious problem is that
the financing of the large public debt
transfers a real economic burden to future
generations by passing a smaller stock of
capital goods on to them.
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The Long-Run Fiscal
Imbalance: Social Security

The most significant fiscal issue in the U.S.
is the long-term funding imbalance in the
Social Security and Medicare programs.
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There is a severe long-run shortfall in Social
Security funding because of growing payments
to retiring baby boomers.
The accumulation of monies in the Social
Security trust fund will be greatly inadequate for
paying the retirement benefits to future retirees.
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The Long-Run Fiscal
Imbalance: Social Security

The problem is one of demographics; the
percentage of the American population age
62 and older will rise substantially over the
next several decades.
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The Long-Run Fiscal
Imbalance: Social Security
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To help make Social Security financially
sound, some suggest investing all or part
of the trust fund in corporate stocks and
bonds, since these presumably have
higher returns relative to U.S. securities.
Another option is to increase the payroll
tax immediately and allocate the new
revenues to individual accounts.
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The Long-Run Fiscal
Imbalance: Social Security
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Yet, another idea is to place half the
payroll tax into accounts that individuals
would own, maintain, and bequeath.
New options for reform will likely develop
over time; nevertheless, society will
eventually need to confront the problem of
trillions of dollars of unfunded Social
Security liabilities.
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