Chapter 15: Government Debt & Budget Deficit

1. Chapter 15: Government Debt & Budget Deficit

2. Deficit & Debt • Federal deficit occurs when government spending (purchases & transfers) exceeds tax receipts • Federal debt is the amount of funds the government must borrow to cover its deficit • Money is owed to government agencies, private individuals and firms, and foreign individuals, companies, and countries

3. Size of Debt • Size of the debt is measured by the debt ratio: government debt as a percentage of the GDP • Debt ratio in U.S. in 1998 = 65, less than Belgium (125), Italy (123), and Japan (93), but more than Australia (40), Finland (59) and U.K. (60)

4. The Debt-GDP Ratio

5. The Debt-GDP Ratio (US)

6. Change in Debt Ratio • Revolutionary War = 45 • Civil War = 40 • WW I = 40 • WW II = 120 • In recent years, the ratio increased from 22 in 1970 to 40 in 1980 to 60 in 1990 and to 65 in 1998

7. Deficit & Debt Projections All variables are expressed as percentage of GDP

8. Deficit & Debt Projections • Receipt shall stay constant at 20% • Spending shall rise from 21% in 2000 to 22% in 2030 to 43% in 2050 • Deficit shall rise from –1% in 2010 to 23% in 2050 • Debt falling to 17% in 2020 shall rise to 93% in 2040 and 206% in 2050

9. Measurement Problem 1 • Calculating deficit in “nominal” value results in an overstatement of the amount of debt required to cover the deficit • Deficit and debt must be expressed in “real” values; i.e. adjusted for inflation

10. Measurement Problem 2 • Unlike private accounting procedures, government debt does not measure the difference between government assets and liabilities • Capital budgeting, that accounts for assets and liabilities, measures changes in capital

11. Measurement Problem 3 • Government debt does not account for Social Security liabilities • Unlike public debt, the government can refuse making Social Security payments if funds are insufficient

12. Measurement Problem 4 • Deficit and debt move pro-cyclically: they fall during a slump and rise during a boom • To solve this problem, the government calculates a “cyclically-adjusted” budget deficit, which the amount of deficit at full employment

13. Traditional View of Debt • A tax cut increases disposable personal income, consumption spending, employment, and income. A higher AD results in higher income and real interest rate as the IS curve shifts to the right. • In the long-run, price level will rise, lowering SRAS to reduce income to its full employment level

14. Ricardian View of Debt: Analysis • Forward-looking consumers may not spend their additional disposable income to cause growth • With a tax cut, people shall expect a future spending cut as the government would not want to run a deficit • Likewise, consumers view debt accumulation as a sign of higher future taxes, thus saving money for that purpose

15. Ricardian View of Debt: Case Study • In early 1992, President Bush reduced the federal income tax withholding requirement to increase disposable income and stimulate growth • Forward-looking consumers expecting larger tax liabilities in April, did not spend the additional income to help the economy grow

16. Ricardian View of Debt: Burden • Parents learning that debt operates as a negative future transfer payment, would not spend as much during their lifetime • Parents save and accumulate assets to pass money on to their children and grand children

17. Position of the FED • A substantial reduction in long-term prospective deficit will significantly lower long-term inflation expectations • Inflationary financed growth results in increased tax revenues and government spending to cause deficit and inflation • Deficit financed growth increases debt with no real income growth, but higher inflation