Fiscal policy • Focus

– Spending• distinguish between purchases and spending or outlays or expenditures

– Tax revenues• distinguish between tax rates and tax revenues• let t = tax rate, Y = income,• then tax revenue is T = tY

– Government debt

• Today’s topics: effect of deficit, debt, countercyclical policy, structural deficit, automatic stabilizers, rules versus discretion

29_02

Apr. 1Jan. 1, 1999 Jan. 1, 2001July 1 Oct. 1 Jan. 1, 2000 Apr. 1 July 1 Oct. 1

Fiscal year 2000

Supplementary budget orchanges in economy mayaffect actual spending.

Congress debates,modifies, andpasses budget.

President submitsbudget to Congressin early February.

Fiscal year is over;spending and taxesare tabulated.

Federal budget summary (billions of dollars)

Fiscal year 1998 versus 1995Tax revenues 1721.4 1351.8Expenditures 1651.4 1515.7 Defense 270.4 272.1 Interest 243.4 232.2 Soc. Sec. 379.2 335.8 Medicare 192.8 159.9Surplus 70.0 - 163.9

Deficit versus debt

• When the government runs a deficit, it increases its debt

• When the government runs a surplus, it reduces its debt

• surplus (‘98) = debt (end ‘97) - debt (end ‘98)• 70 = 3771.1 - 3701.1

• Government borrows by issuing bonds– and retires these bonds when in has a surplus

A graph of the deficit and the debt29_03

1950

3,000

3,500

BILLIONS OF DOLLARS

Debt

Deficit

1995

2,500

2,000

1,500

1,000

500

0

-5001955 1960 1965 1970 1975 1980 1985 1990

Debt as a share of GDP

• Debt/GDP can stay constant or even fall when there is a budget deficit

• Example– 5% growth of GDP– then ratio stays constant if

• Debt/GDP = Debt(1.05)/GDP(1.05)

• thus $3.7 trillion times (.05) = $185 billion deficit

• Debt/GDP ratio falls with balanced budget

29_04

1950

High after WWII

19951955 1960 1965 1970 1975 1980 1985 1990

PERCENT

OF GDP

60

50

40

30

20

10

0

Steady decline with small deficits, some surpluses

Big deficitsstart

Post-WWII bottom

Late 1980splateau

Deficitsareback

80

70

Ratio just starting to decline

Long run effect of deficits or surpluses

• The long run effect of a lower deficit or higher surplus are those of a lower the share of G in GDP---use SAM– real interest rate lower– I/Y higher, leading to higher potential growth

• Short run negative effects can be mitigated by being gradual, being credible, and letting Fed join in (but this is an old issue, now...

The question is how to “use” the “projected” surplus

• Recent shift from deficit to surplus

• Leave it? Cut taxes? Increase spending?

• The social security problem– As baby boom generation retires, benefits will

grow relative to payroll tax revenues– Will need to reduce benefits or increase taxes– Some suggest privatizing part of social security

Countercyclical fiscal policy

• Argues that increasing government spending or reducing taxes during a recession would mitigate the recession– Suggested by Keynes in 1930s (Keynesian

policy)

• Rationale now for “fiscal stimulus” package in Japan

• Discretionary versus automatic

Use of countercyclical fiscal policy (G) to bring the economy back to potential

29_05

REAL GDP

INFLATION

PA

ADI with increase in government purchases

Old ADI

Potential GDP

REAL GDP

INFLATION

PA

ADI with decrease in government purchases

Old ADI

Potential GDP

Use of countercyclical fiscal policy (taxes) to bring economy back to potential

29_06

REAL GDP

INFLATION

PA

ADI with tax cut

Old ADI

Potential GDP

REAL GDP

INFLATION

PA

ADI with tax increase

Old ADI

Potential GDP

Case of good timing in using fiscal policy to hasten the return of real GDP

back to potential GDP29_08

REAL GDP

INFLATION

PA

Potential GDP

ADI without stimulus

Path of economy without a fiscal stimulus

Path of economy with a fiscal stimulus

Old ADI

ADI with stimulus

29_07

2000

BILLIONS OF DOLLARS

2001 2002 2003 2004 2005 YEAR

Path of real GDP without fiscal stimulus

Path of real GDP with fiscal stimulus

Potential GDP

Effect of fiscal policy on the path of real GDP: good and bad timing

29_09

2000

BILLIONS OF DOLLARS

2001 2002 2003 2004 2005 YEAR

Potential GDP

Path of real GDP without fiscal stimulus

Path of real GDP with a fiscal stimulus that came too late

Effect of the economy on the budget deficit

• Budget deficit is cyclical– Deficit rises in recessions– Deficit falls during recoveries and expansions

• To see the reason look at tax revenues and expenditures

Government tax revenues depend on the state of the economy

• when real GDP grows more rapidly, tax revenues rise faster – more people working, higher incomes– people move into higher tax brackets

• when real GDP grows more slowly, tax revenues rise less rapidly – fewer people working, lower incomes– people may move into lower tax brackets

Expenditures also depend on the economy

• When real GDP grows less rapidly or falls, as in a recession, expenditures grow more rapidly – unemployment compensation rises– welfare payments go up– more people retire, increasing social security

payments

• When real GDP grows more rapidly, as in a recovery, expenditures grow less rapidly

Net effect of real GDP on deficit

• deficit = government spending - tax revenue• thus in a recession the deficit will rise, and in a recovery

the deficit will fall

• Y implies D – government spending and tax revenues

• Y implies D– government spending and tax revenues

• Explains why “rosy scenarios” make the deficit look smaller

A NEW GRAPH to show the effect of real GDP on the deficit

29_11

0

BUDGET DEFICIT

REAL GDPCBA

Deficit

Surplus

When real GDP falls, the deficit increases.

When real GDP rises, the deficit falls.

The budget is balanced here.

The structural deficit

• The structural deficit is the deficit that would exist if real GDP = potential GDP

• Also called full employment deficit

• Purpose is to take out (control for) the effects of economic fluctuations in real GDP on the deficit

• Changing structural deficit requires – change in tax laws, size of government,...

Graphical illustration of the structural deficit

29_12

0

BUDGET DEFICIT

REAL GDP

Structural deficit

Actual deficit

Potential GDP

Real GDP is less than potential GDP, as in 1991.

At this point real GDP would equal potential GDP.

Automatic stabilizers

• The tendency for tax revenues to fall and government spending to rise in recessions can have a stabilizing effect on the economy– the changes offset decline in demand during

recession (as with countercyclical policies)

• these changes are “automatic”– occur without executive or legal action– hence fewer lags, timing is better, overall effects can

be very large

Automatic changes in revenues and expenditures due to recession (FY 1991)

29_01 BILLIONS OF DOLLARS

Proposed

Tax Revenue

1,400

1,054

Proposed Actual Proposed

270

Expenditures Deficit

1,200

1,000

800

600

400

200

0

63

Actual

1,324

1,2331,170

Actual

Rules versus discretion debate in fiscal policy

• Problems with discretion are mainly lags• recognition, implementation, impact

• Rules automatic stabilizers• Johnson surcharge (1968)• Bush stimulus package (1992)• Clinton stimulus package (1993)• Kennedy tax cut (1964)• Reagan tax cut (1981-82)

END OF

LECTURE