Chapter 5 -- The Federal Budget

Budget = Tax Revenues - Government Expenditure (over a given period)

Budget = Tax Revenues - (Government purchases of goods and services + Transfer Payments + Interest on the National Debt)

Budget Definitions

Budget < 0 -- Budget DeficitBudget > 0 -- Budget SurplusBudget = 0 -- Balanced Budget

Realistic Goal -- Balanced Budget when Y = YN.

The Federal Budget: 2006 (Billions of Dollars)

Government Receipts = $2495.8Government Expenditure = $2715.8Budget = -$220.0

Source: Economic Indicators, February 2008

Breakdown of Government Receipts

Personal Income Taxes = $1053.2Corporate Profits Taxes = $373.1Taxes on Production and Imports

= $98.6Contributions for

Social Insurance = $901.6Miscellaneous = $69.3

Breakdown of Government ExpenditureConsumption Expenditures (G)

= $812.8Transfer Payments = $1576.1Net Interest Paid = $277.5Miscellaneous = $49.4

The Budget: In Our Notation

Recall variable definitions:

-- T = net taxes

= tax revenues

- (transfer payments

+ interest on the

national debt)

-- G = government purchases of

goods and services

The Budget and The Size of the Deficit

Budget = T - GSize of Deficit = G - T

The National Debt

The National Debt -- The total accumulated stock of debt owed by the government to its lenders.

Debt2011 = Debt2010 + Deficit2011

National Debt -- Realistic Goal

Realistic Goal -- consider the Debt-Income Ratio =

(National Debt)/(GDP).

For US in 2007 = ($5035.1)/($13843.8) = 0.364

Decomposition of Deficit

Purpose -- break up deficit for more precise analysis of causes.

Consider the deficit, with the income tax function for net taxes.

Deficit = G - (T0 + tY*)

Add and subtract the term tYN

Deficit = [G - (T0 + tYN)]

+ t(YN - Y*)

The Cyclical Deficit

The Cyclical Deficit = t(YN - Y*) -- the deficit that arises when the economy is not at its natural level.

Sluggish economy (Y* < YN) positive cyclical deficit.

Economy with accelerating inflation (Y* > YN) negative cyclical deficit.

More on the Cyclical Deficit

Connected with Automatic Stabilization -- net tax revenues change automatically in directions that work to stabilize the economy.

Cyclical deficit -- not considered a special problem. It’s resolved when Y = YN.

The Structural Deficit

The Structural Deficit =

[G - (T0 + tYN)].

Interpretation -- the deficit that remains after Y* = YN.

Constitutes a problem, with a need for special deficit policy.

Realistic Goal (Budget)

-- zero structural deficit.

•Analyzing the Deficit -- A Numerical Example

Year Structural + Cyclical = Total

1979 100 -50 50

(Y* > YN)

1982 100 50 150

(Y* < YN)

1995 100 0 100

(Y* = YN)

Main Results From Example

Overstimulated economy can mask a deficit problem.

Sluggish economies tend to have larger deficits.

Two step strategy -- deficits

(1) Get Y* = YN.

(2) Take steps to reduce deficit

that remains.

Why are the Debt and Deficits a Problem?

Hampers the use of fiscal policy.Getting the benefits without

considering the costs.Crowding Out Effect -- higher

deficits may increase interest rates, reducing investment and possibly net exports.

The Crowding Out Effect

Consider “magic equation”:

S + (T - G) + -NX = I.Less government saving (T - G) , more

reliance on foreign borrowing (NX) or lower investment (I).

Particularly damaging if investment decreases (more later).

The Increased Debt: Burden on Future Generations

In general, older generations enjoy benefits from the debt. But younger generations have to sacrifice in the future to repay the debt, maintain interest payments, or be deprived of new initiatives.

The Crowding Out Effect:A More Sober Implication

Crowding Out Effect – Expansion of Federal Deficit and Debt increases interest rates, lowers investment (and possibly consumption)

Lower investment retards development of the capital stock, the economy’s productive capacity for future generations.

Maybe Effects of Deficits and Debt Aren’t so Bad

Riccardian Equivalence -- Given an increased deficit, older people correspondingly increase their saving.

Older generations provide the means to pay debt and interest.

Riccardian Equivalence -- No Crowding Out Effect

Within the macro identity:

S + (T - G) + -NX = I.Riccardian Equivalence when (T

- G), S simultaneously interest rates and therefore Investment are unaffected.

Another Reason Why Debt May Not Be Overly Harmful

The government (in reality) as producer as well as spender.

Some G is in fact government investment (e.g. buildings)

Some investment government can do better than the private sector (infrastructure).

Reducing a Structural Deficit = [G - (T0 + tYN)]

Increase Taxes (income or consumption-based)

Advantages: smaller multiplier, can focus on higher incomes, undesirable behavior.

Disadvantages: implicit permission for government to be inefficient in its spending.

Reducing a Structural Deficit = [G - (T0 + tYN)]

Decrease Transfer Payments.Advantages: smaller multiplier,

largest component of government expenditure, holds the line on taxes.

Disadvantages: very painful to the groups affected (often vulnerable).

Reducing a Structural Deficit = [G - (T0 + tYN)]

Decrease Government Purchases of Goods and Services

Advantages: permanence, gives discipline to government, encourages (often more efficient) private sector to replace government programs.

Disadvantages: largest multiplier, most painful way.

Reducing a Structural Deficit = [G - (T0 + tYN)]

All three are contractionary measures, will reduce Y*.

-- shifts EP curve downward

-- shifts IS curve leftwardHopefully, i* will decrease (IS-LM), I,

with its associated benefits.One more possibility -- can we make

YN? -- Discussed later.

The Clinton Surpluses: What Happened?

Marginal tax rate increases on higher incomes, sales tax increases in 1993.

Holding the line on transfer payments, government purchases.

Unusually large growth in the natural level of real GDP (YN).