Fiscal Policy, Deficits, and Debt

Fiscal Policy, Deficits, and Debt Chapter 08

Outline • Fiscal Policy and the AD-AS Model • Built-In Stability • Evaluating Fiscal Policy • Problems, Criticisms, and Complications • The Public Debt

Outline • False Concerns • Substantive Issues • The Long-Run Fiscal Imbalance: Social Security

Fiscal Policy andthe AD-AS Model • Expansionary fiscal policy (used to deal with a recession) • Government spending increases • Tax reductions • Combined government spending increases and tax reductions G up T down G up T down

Recession & cyclical unemployment The government has three options: (1) increases G;(2) reduces T; or (3) does both at the same time. The government can use an expansionary fiscal policy to move the economy out of the recession. A decrease in AD causes a recession. There is deflation (lower P) and a negative GDP gap. Suppose that originally the economy is at Ef,producing Qf at the price Pf. The expansionary fiscal policy would increase AD, shifting it to the right and bringing the economy back to its original equilibrium. P The economy is illustrated by the AD and AS curves below. AS Ef Pf Expansionary fiscal policy Er Pr ADf ADr 10/15/2014 5 Real GDP ($trillions) Qf =$12 Qr =$11

Fiscal Policy andthe AD-AS Model • Contractionary fiscal policy (used to deal with an expansion) • Government spending decreases • Tax increases • Combined government spending decreases and tax increases G down T up G down T up

Demand-pull inflation In reality, the contractionary fiscal policy is designed to stop a further shift, not to restore to a lower price level. In theory, the contractionary fiscal policy would decrease AD, shifting it to the left and bringing the economy back to its original equilibrium. The government has three options: (1) decreases G;(2) raises T; or (3) does both at the same time. The government can use a contractionary fiscal policy to fight inflation. An increase in AD causes an expansion. There is inflation (higher P) and a positive GDP gap. Suppose that originally the economy is at Ef,producing Qf at the price Pf. P The economy is illustrated by the AD and AS curves below. AS Ex Px Contractionary fiscal policy Ef Pf ADx ADf 10/15/2014 7 Real GDP ($trillions) Qx =$13 Qf =$12

Built-In Stability • Automatic or built-in stabilizers T increase budget deficit during a recession TP decrease surplus T increase budget surplus during an expansion TP decrease deficit

Built-In Stability • Automatic or built-in stabilizers • Tax revenues • Transfer payments = negative taxes • Net taxes = tax revenues – transfer payments - subsidies

Built-in stability Built-in stabilizers can only diminish, not eliminate,swings in real GDP.Discretionary fiscal and monetary policies are needed. During a recession, as GDP falls from Q2 to Q1, T1 < Q1, i.e. there exists a budget deficit.The red deficit area is shown. T vary directly with the level of GDP, i.e. at Q1, T are T1; at Q2, T are T2 and at Q3, T are T3. G are fixed and assumed to be independent of the level of GDP, i.e. at Q1, Q2, and Q3, G are the same. During an expansion, as GDP rises from Q2 to Q3, T3 > Q3, i.e. there exists a budget surplus.The green surplus area is shown. G, T T T3 Surplus G (fixed) T2 Deficit T1 10/15/2014 10 Real GDP Q3 Q2 Q1

Built-In Stability -- Taxes During Output Income T C Budget a recession falls falls fall rises deficit During Output Income T C Budget an expansion rises rises rise falls surplus

Built-In Stability • Built-in stability has reduced the severity of U.S. business fluctuations, perhaps by as much as 8 to 10 percent of the change in GDP that otherwise would have occurred.

Cyclical & standardized deficits Expansionary fiscal policy actions are taken when eitherthe G line shifts upward or the T line shifts downward.The resulting standardized deficit is caused by the government’s expansionary actions.Actual deficit = standardized deficit + cyclical deficit The diagram shows an economy producing full-employmentoutput Q1, where T = G = $500.Both the actual and standardized (full-employment) budget deficits in year 1 are 0.The government’s fiscal policy is “neutral.” Because both points a and b represent $500, the standardized (full-employment) budget deficit in year 2 is still zero. Fiscal policy is neutral, i.e. no fiscal action istaken by the government. Now suppose that the economy falls into a recession andGDP falls from Q1 to Q2.The government takes no discretionary action, i.e. doesnothing. T falls from $500 to $450 (point c), while G stays the same (point b). A cyclical deficit (bc) occurs. G, T($bil) Cyclicaldeficit T Standardizeddeficit b’ G’ $550 a b G $500 $450 c 10/15/2014 13 Real GDP Q1 Q2

Evaluating Fiscal Policy • Standardized budget • 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 level of GDP. • Cyclical deficit • A federal deficit that is caused by a recession and the consequent decline in tax revenues.

Evaluating Fiscal Policy • Standardized budget • deficits imply expansionary fiscal policy • surpluses imply contractionary fiscal policy • Recent U.S. fiscal policy • Budget deficits (1992 – 1997) • Budget surpluses (1998 – 2001) • Budget deficits (2002 - ?)

Federal deficits (-) and surpluses (+) as percentage of GDP (1992 – 2007)

Problems, Criticisms, and Complications • Problem of timing • Recognition lag is the time between the beginning of recession or inflation and the certain awareness that is actually happening

Problems, Criticisms, and Complications • Problem of timing • Administrative lag occurs between the time when the need for fiscal actions is recognized and the time action is taken

Problems, Criticisms, and Complications • Problem of timing • Operational (Effectiveness) lag – occurs between the time fiscal action is taken and the time that action affects output, unemployment, and the price level.

Problems, Criticisms, and Complications • Problem of timing Recognition lag Administrative lag Operational lag 4 – 6 months 6 months 6 – 12 months Beginning of recession or inflation Aware of recession orinflation Take actions to reduceunemployment or to fight inflation Recession isover or inflation lowered Caught the cold Know that one has a cold Takemedicine(see doctor) To be well again

Problems, Criticisms, and Complications • Political considerations – political business cycle • The alleged tendency of administration and Congress to create macroeconomic instability Before elections After elections Reduces T Raise T Increase G Reduce G to increase AD to decrease AD

Problems, Criticisms, and Complications • Future policy reversals • Tax rate changes that households view as permanent are more likely to alter consumption and AD than tax changes they view as temporary.

Problems, Criticisms, and Complications • Offsetting state and local finance • The fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation. • Why? Most state and local governments face constitutional or other legal requirements to balance their budgets.

Problems, Criticisms, and Complications • Crowding-out effect • A decrease in private investment caused by higher interest rates that result from the federal government’s increased borrowing to finance the budget deficits (or debt). • Small during recessions • Large during expansions

Problems, Criticisms, and Complications • Crowding-out effect Governmentborrows moneyto financebudget deficits. The overall demand formoney increases. Investmentchoked off or“crowded out.” The interest rateincreases.

Problems, Criticisms, and Complications • Current thinking on fiscal policy • Some argue that it is better not to take any fiscal policy actions. • Monetary policy is more superior. • Most economic fluctuations tend to be mild and self-correcting.

Problems, Criticisms, and Complications • Current thinking on fiscal policy • Mainstream economists advocate maintaining a relatively neutral fiscal policy, with a standardized budget deficit or surplus of no more than 2% of potential GDP. • General agreement – proposed fiscal policy should be evaluated for its potential impacts on long-run productivity growth.

The Public Debt • The national (or public) debt • The total amount of money owed by the federal government to the owners of government securities; • Equals to the sum of past government budget deficits less government budget surpluses

The Public Debt • Ownership • U.S. Treasuries (securities) = Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds issued by the U.S. federal government to finance expenditures that exceed tax revenues, i.e. budget deficits.

Who holds the U.S. public debt? Debt Held by the Federal Government and Federal Reserve (53%) Debt Held Outside The Federal Government and Federal Reserve (47%) Other – Including State and Local Governments U.S. Banks And other Financial Institutions 7% 8% 9% 25% Federal Reserve Foreign Ownership 44% 7% U.S. Government Agencies U.S. Individuals Source: U.S. Treasury

The Public Debt

The Public Debt • International comparisons • Many nations have larger publicly held debts as a percentage of their GDP (page. 184) • Interest charges (2007) • $237 billion (fourth largest item behind social security, national defense, and health care) • Interest payment = 1.7% of GDP

False Concerns • Bankruptcy – the large U.S. public debt does not threaten to bankrupt the federal government. Two reasons: • Refinancing – The public debt is easily financed. The government sell new bonds and use the proceeds to pay off holders of maturing bonds. • Taxation – The government can impose new taxes of increasing tax rates to finance its debt.

False Concerns • Burdening future generations • The U.S. owes a substantial portion of the public debt to itself (75%). While that part is the liability to Americans (as taxpayers), it is also an assets to Americans (as holders of Treasury securities). • Only the repayment of the 25% of the public debt owed to foreigners would negatively impact U.S. purchasing power.

False Concerns • Burdening future generations • Future generations inherit the debt, but also an equal amount of assets in terms of Treasury securities.

Substantive Issues • Income distribution • Payment of interest on the public debt probably increases income inequality. • The lower-income taxpayers pay the higher-income bondholders.

Substantive Issues • Incentives • Large public debt may impair economic growth. • Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work.

Substantive Issues • Foreign-owned public debt • This is an economic burden to Americans. • The U.S. transfer goods & services to foreign lenders.

Substantive Issues • Crowding out revisited • If the amount of current investment crowded-out is extensive, future generations will inherit an economy with a smaller production capacity and, other things equal, a lower standard of living.

Crowding out revisited The public investments, through complementary effects,may shift the ID curve to the right to ID2.The economy moves to point c on ID2. Originally, the economy is at point a on the investmentdemand curve ID1. The economy invests $25 billion at the interest rate of 6%. The government, by financing a large public debt, pushesinterest rate upward to 8%. If the curve ID1 is fixed, the economy moves to point b, investing only $15 billion. i (%) b c Increase ininvestment demand 8% a 6% ID2 ID1 10/15/2014 40 Investment ($billions) $15 $25

The Long-Run Fiscal Imbalance: Social Security • The future funding shortfall • There is a severe long-run shortfall in SS funding because of growing payments to retiring baby boomers. • SS program: ½% of GDP (1950) to 4.2%. • $461 billion SS program is a “pay as you go” plan, from 12.4% SS tax (including 2.9% Medicare tax)

The Long-Run Fiscal Imbalance: Social Security • The future funding shortfall • 2017 – SS retirement revenues will fall below SS retirement benefits. • 2041: SS trust fund will be exhausted. • The problem: aging U.S. population • Number of workers per SS beneficiary: 5:1 (1960); 3:1 (today); 2:1 (2040)

The Long-Run Fiscal Imbalance: Social Security • The future funding shortfall • There is no easy way to restore long-run balance to SS funding. • SS Administration: to bring projected SS revenues and benefits into balance over the next 75 years would require • 13% permanent reduction in SS benefits, • 16% permanent increase in tax revenues, or • some combination of the two

The aging U.S. population

The Long-Run Fiscal Imbalance: Social Security • Public options/suggestions • Increasing the retirement age • Subjecting a larger portion of total earnings to SS tax • Reducing benefits for wealthy retirees

The Long-Run Fiscal Imbalance: Social Security • Public options/suggestions • Boost the trust fund by investing all or part of in in corporate bonds and stocks • Increase the payroll tax immediately by as much as 1.5% and allocate the new revenues to individual accounts • Place half the payroll tax into accounts that individual, not the government, would own, maintain, and bequeath.

See You! Take Care!

Fiscal Policy, Deficits, and Debt