TOPIC 4 (supplement)

1. TOPIC 4 (supplement) Debt and Deficits (After Exam)

2. Government Outlays • Government purchases (G) Government spending on currently produced good and service. It includes: Consumption goods (GC) and Investment goods (GI) • Transfer payments (TR) These are payment made to individuals. It includes SS benefits, unemployment insurance benefits, welfare payments, and Medicare Note: Transfers will increase when Y is low (more government transfers occur when economy is in a recession). Define: TR = TR0 - tr Y (TR0 – part of transfers independent of income) (tr is the responsiveness of total transfers to income changes) • Net interest payments (INT) Interests paid on government bonds less the interests received by the government (ex. student loans)

3. Government outlays: Federal, state, and local Source: Abel and Bernanke, chapter 15

4. Government Outlays in Selected OECD CountriesSource: OECD, National Accounts, 2002

5. Tax Revenues (T) • There are four main categories of tax receipts: • Personal taxes: This includes personal income and property taxes • Contributions for social insurance: This includes primarily Social Security taxes. • Indirect business taxes: This includes mainly sale taxes • Corporate taxes: This includes mainly corporate profit taxes • Like transfers, tax receipts are dependent upon income in the economy (Y). When income is low, there is less tax base: • T = T0 + t Y ; where T0 is the part of tax revenues that is independent of income and t (in essence) the marginal tax rate on income.

6. Taxes: Federal, state, and local Source: Abel and Bernanke, chapter 15

7. Government Deficits • Deficit = outlays - tax revenues Deficit = ( G + TR + INT) - T It measures how much the government has to borrow to pay for its total outlays • Primary deficit = (G + TR) - T It measures whether the government can afford its current programs. Separates out interest paid on the stock of government debt • Note: Surpluses are defined as T – (G + TR) If deficits are positive, surpluses are negative. Therefore, given definitions, increasing deficits implies shrinking surpluses.

8. Some Thoughts on Government Deficits Using equations for T and TR above, we can express the primary deficit as: G + (Tr0 - tr Y) – tY = (G + Tr0– T0) – (t+ g) Y (where Y is current period GDP). Notice: Given the tax and transfer programs in the U.S., when Y is high, deficits are low. When Y is low, deficits are high. This should make sense, in recessions, transfers are HIGH and tax receipts are LOW. Holding G fixed implies that deficits should be increasing in recessions! Definitions: • Actual Deficit (as above) = (G + Tr0 – T0) – (t+g) Y • Structural Budget Deficits is the deficit that would exist in the economy that would occur at Y* = (G + Tr0 – T0) – (t+g) Y* • Cyclical Deficits: Actual Deficits - Structural Deficits. Notice: Structural deficits are the deficits that would occur if we are at Y*!

9. More Thoughts and Deficits • In general: Deficits are countercyclical! (They rise when Y falls and fall when Y rises) • Y* is the level of output in the economy that occurs when the labor market clears (we are at N*). • As we will see later in the course, Y does not always equal Y*. This implies that even if the government has a policy (combination of G and T) that would lead to no deficits at Y* (the target level of output for the economy), deficits could still occur (the reason: Y does not always equal Y*). • Predictions: When the economy is strong, deficits should be low (or surpluses should be high) <<Think of the 1990s>> When the economy is weak (in a recession), deficits should be high. <<Think of the growing deficits resulting from the current recession>>

10. Actual and Projected Budget Deficit as a Share of GDP(Source: Congressional Budget Office (CBO))

11. Graphing Deficits When Policy Is Constant (ie, G, T0, Tr0, tr, t fixed) Deficit Even when the structural deficit is close to zero ((G +Tr0 - T0)/(t + tr) = Y*), actual deficits can be large when Y < Y*! Structural Deficit = G +Tr0 - T0 – (t + tr)Y* Y Y* Actual Deficit = G +Tr0 - T0 – (t + tr)Y

12. Graphing Deficits When Policy Changes Deficit What happens to actual and structural deficits when G increases to G’? G’+Tr0-T0 G+Tr0-T0 Structural Deficit = G +Tr0 - T0 – (t + tr)Y* Y Y* Actual Deficit = G +Tr0 - T0 – (t + tr)Y Changing government policy affects both structural and actual deficits!

13. Summary • Deficits move with the business cycle (i.e, as Y moves away from Y*) • This is the nature of our tax and transfer system • Government goal should be to manage STRUCTURAL deficits (realizing that cyclical deficits move as Y moves).

14. Deficits and Public Debt • Budget deficits increase public debt. If the government spends more than it gets in taxes, it has to finance its expenses by issuing debt. • Public debt is a stock variable: It is the total value of government bonds outstanding at any particular time. It reflects past deficits. • A useful measure to consider is: debt/GDP

15. Debt/GDP This ratio increases when: • Primary deficit increases • Interest rate increases • Level of GDP is low (for example because of slow rates of GDP growth)

16. Ratio of Federal debt to GDP Source: Abel and Bernanke, chapter 15

17. Debt Held by the Public as a Share of GDP, 1940 to 2014Source: CBO, January 2004

18. Costs and Benefits of Government Spending Consumption G Governments can provide services that may be inefficiently provided in private sector (i.e., police protection, parks, post office, etc). Investment G Governments can provide investment that is used as an input into other production (i.e., highway and transportation infrastructure, bridges, enforce property rights). Training and Education G (another form of Investment G) Governments can train the work force (i.e., student loan programs, public education, state colleges, etc). Cost to Government Spending????? ---- Diverts resources from private sector! Benefits of Government Spending???? --- Helps increase A in a country (roads, property rights, skilled labor). Provides goods not provided in market place. Must compare the benefits to the costs of government spending!

19. Costs and Benefits of Government Spending Remember (from topic 1): S(household) + S(government) = I + NX For now, assume NX = 0 (in the U.S., it is really small) A fall in S(government) implies that I will fall holding S(household) constant. This implies government deficits can lead to lower investment. Notes: We will prove why investment falls soon (hint: interest rates will adjust) We will also assess whether S(household) is actually constant. Notes: We refer to the fact that I falls from increased deficits as “Crowding Out” Lower I today implies lower K tomorrow. Drawback of higher deficits is that K is low tomorrow (when K is low tomorrow, Y*(tomorrow) will be lower).

20. Public Debt: A Burden on Future Generations Note: when assessing future generations, we need to know what will happen to Y* in the future. (i.e., what happens to A and K in the future). Do current deficits harm future generations? Case for Yes: Higher deficits mean higher consumption G and (through lower T) higher C. Thus higher deficits potentially mean lower S(national). Lower S(national) results in lower I (S = I). Lower I today results in lower K for the next generation. All else equal, higher government deficits today could reduce the earnings potential (Y) of future generations. Case for No: Higher deficits can come from higher investment G (infrastructure, education) that create higher future A. Higher future A could make future generations better off even if future K is lower.