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17.ppt

U.S. Fiscal Policy in the 1990s

Lecture 18

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17.ppt

FEDERAL BUDGET HISTORY

•Taxes have trended up largely to pay for greater entitlements (transfers)•Taxes less transfers were reduced in the 1970s to prepare for baby-boom retirement•The Carter (77-80) and Clinton (92-00) terms saw increased taxes to reduce inherited deficits

FEDERAL TAXES (NIA BASIS)

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% O

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TOTAL TAXES TOTAL TAXES - TRANSFERS PERSONAL TAXES TRANSFERS

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17.ppt

FEDERAL BUDGET HISTORY

•Under Reagan, spending rose to a peak of 25%•Military spending surged •The huge deficits raised interest payments•Other categories were cut

•Military spending is now below pre-WWII %’s•Transfers have surged•Other categories rose in the 1960s

FEDERAL SPENDING (NIA BASIS)

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INTEREST MILITARY TRANSFERS OTHER TOTAL

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17.ppt

FEDERAL BUDGET HISTORY

•Note the similar efforts to close the deficit underCarter and under Clinton, by raising taxes and cutting spending

•Note how unusual a surplus is

•The Federal budget tended to absorb 20% of GDP, with a clear upward trend

FEDERAL BUDGET

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DEFICIT (UNI) TOTAL TAXES (UNI) TOTAL SPENDING (UNI)

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17.ppt

FEDERAL BUDGET HISTORY

•Taxes have trended up largely to pay for greater entitlements (transfers)•Taxes less transfers were reduced in the 1970s to prepare for baby-boom retirement•The Carter (77-80) and Clinton (92-00) terms saw increased taxes to reduce inherited deficits

FEDERAL TAXES (NIA BASIS)

0%

5%

10%

15%

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25%

1980

1982

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% O

F G

DP

TOTAL TAXES TOTAL TAXES - TRANSFERS PERSONAL TAXES TRANSFERS

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17.ppt

FEDERAL BUDGET HISTORY

•Under Reagan, spending rose to a peak of 25%•Military spending surged •The huge deficits raised interest payments•Other categories were cut

•Military spending is now below pre-WWII %’s•Transfers have surged•Other categories rose in the 1960s

FEDERAL SPENDING (NIA BASIS)

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INTEREST MILITARY TRANSFERS OTHER TOTAL

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17.ppt

FEDERAL BUDGET HISTORY

•Note the similar efforts to close the deficit underCarter and under Clinton, by raising taxes and cutting spending

•Note how unusual a surplus is

•The Federal budget tended to absorb 20% of GDP, with a clear upward trend

FEDERAL BUDGET

-10%

-5%

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25%

30%

1980

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% O

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DEFICIT (UNI) TOTAL TAXES (UNI) TOTAL SPENDING (UNI)

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17.ppt

U.S. Fiscal Policy in the 1990sAfter a decade of extreme deficit spending, all three presidential candidates in 1992 promised to move toward a balanced budget in five years

– Ross Perot promised a blend of tax increases and budget cuts– George Bush offered spending cuts but, under pressure from the

Republican Party, promised new tax cuts– Bill Clinton promised higher taxes and spending cuts in existing programs,

but added new spending on education and infrastructure, thereby retaining a deficit

Clinton, the victor, proposed his campaign program in 1993 but Congress rejected it, favoring more aggressive action to balance the budget

– The Democrats controlled Congress, but yielded to public opinion to reject delays in balancing the budget beyond a 5-year plan

In the campaign for the 1994 Congress, the Republicans offered a strict plan they called “The Contract for America”

– This promised budget balance, welfare reform, and select new tax incentives

– They won control of the House and Senate and implemented the basics of their fiscal strategy

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17.ppt

U.S. Fiscal Policy in the 1990sDuring this debate, research groups such as DRI analyzed the impacts

– The exhibits that follow were produced in late 1994 and early 1995– They reveal the expected outcomes, presenting the mainstream

macro-economics position on this debate– The exceptional boom of the late 1990s met and often exceeded

these expectations: – The actual 1995-1998 data and current forecasts through 2002 are

added to a few of the slides to precisely compare results with expectations

Prospects for the Economy through 2002

Slower population growth meansslower labor force growth.

Productivity growth will continue to be hurt by inadequate private investment.

But,Tax changes could boost labor force participation by

second earners and retirees.Welfare reformed to workfare could add over a

million productive employees.Gradual achievement of federal budget balance

would greatly bolster private investment.Capital gains tax cuts would also

boost national growth.

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902mit17.ppt

Summary of the Forecast Made in 1994,and the Results as of 1999

‘82-’94 ‘95-’02Fore ‘95-’98 Actual

Unemployment Rate 6.9 5.8 5.1Real GDP Growth (annual) 2.9 2.4 3.4Housing Starts (million) 1.4 1.3 1.5Consumer Price Inflation 3.8 3.4 2.4Productivity Growth 1.3 1.4 1.6Prime Rate 9.4 7.9 8.5

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Adult Population Growth Has Fallen to Approximately 1% Per Year

0102030405060708090

100

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Pop Male(20-64) Pop Female(20-64)Pop Retires Pop Teenagers

population by age group, millions

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Population Growth Rates by Age and Sex

60’s 70’s 80’s 90-94 95-99 2000-05

Males (20 to 64) 1.1 1.9 1.4 1.0 0.9 1.0Female (20 to 64) 1.2 1.8 1.2 0.9 1.0 1.0Retirees (above 65) 2.6 2.4 2.0 1.6 0.8 0.9Teenagers (16 to 19) 3.6 1.5 -1.5 -1.1 2.4 0.9Total 1.6 1.9 1.2 0.9 1.0 1.0

Average Growth Rates BRINNER

13902mit17.ppt

The Labor Force Will Also GrowOnly Slightly Faster Than 1% Per Year

0

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2 .5

3

T o ta l L a b o rF o rc e

6 0 's 7 0 's 8 0 's 9 0 -9 4 9 5 -9 9 2 0 0 0 -2 0 0 5

Average Growth Rates

History Forecast

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Teenage and Female ComponentsWill Exhibit the Fastest Growth

-1

-0 .5

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1

1 .5

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2 .5

(average labor force growth rates, 1995-2002)

Males

Females

Retirees

Teenagers

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The Labor Force Is Rising at a Similar Pace Because the Big Gain From Women Becoming New Earners Appears Past

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M a le (2 0 -6 4 ) F e m a le (2 0 -6 4 ) R e tire s T e e n a g e rs

Labor Force by Age-Sex Group, Millions

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Participation Rates..... for Prime-Age Women Rose to Nearly Match Those of Men..while retirees are less inclined to work.

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M a le s F e m a le s R e tie re s T e e n a g e rs

Percent of each age-sex group participating in the labor force

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The Recent Gains in Productivity Are Not At All Exceptional:

They Reflect Normal Cyclical Boosts andResponses to Capital Formation

The Future Is Likely to Resemble the Recent Past

Unless National Saving and Investment Improve and

More People Want to Work

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Key Contributors to Long-Term Growth

1982-1994 1995-2002

Labor Force 1.5 1.3Capital Stock 2.8 3.1R&D Expenditures 4.3 3.7

Potential GDP 2.35 2.44Productivity 1.13 1.44

Average Growth RatesBRINNER

19902mit17.ppt

Productivity Growth is Always Best in the Opening Years of a Recovery

-5

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1 9 6 1 1 9 6 6 1 9 7 1 1 9 7 6 1 9 8 1 1 9 8 6 1 9 9 1 1 9 9 6-2

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R e a l G D P (le ft s c a le ) P ro d u c tiv ity (r ig h t s c a le )

(percent change) (percent change)

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This Recovery Has Not Been Exceptional in Terms of Productivity Growth

0123456789

1 0

4Q trs .

8Q trs .

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1 6Q trs .

1 9 9 1 :1 R e c e s s io nT ro u g h

Av e ra g e o f L a s tT h re e M o jo rR e c e s s io n s

Cumulative Productivity Growth During Recoveries(Cumulative % Gain at Selected Intervals after a Recession Trough)

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Total Business Capital Stock Growth Has Been Low By Postwar Standards...

0

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Average Growth Rates of Total Nonresidential Capital Stock

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...In Spite of Exceptional Growth in Computer Equipment

0

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6 0 's 7 0 's 8 0 's 9 0 -9 5

Average Growth Rates of Capital Stock in Computers

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Growth in Other Forms of Capital Has Also been Weak in the 1990s

0

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6 0 's 7 0 's 8 0 's 9 0 -9 4

P u b lic In fra s tru c tu re s P riv a te R & D C a p ita l S to c k

(average growth rates)

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Net Investment is Exceptionally Low

Capital Spending as a % of GNP Has Been Declining and More of this Spending is on Short-Lived Equipment

0

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1 0

1 2

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1 9 4 6 1 9 5 1 1 9 5 6 1 9 6 1 1 9 6 6 1 9 7 1 1 9 7 6 1 9 8 1 1 9 8 6 1 9 9 1

Investment Relative to GDP, %

Gross Investment

Net Investment

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902mit17.ppt

WE CAN DO BETTER

Increase capital formation through diligent pursuit of budget balance and lower capital gain taxation .

Motivate, not penalize, work effort through tax changes and workfare.

Support education reform and training.

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902mit17.ppt

Budget-Balancing Need Not Be Painful Nor Partisan:Our Earlier Studies of a Concord Coalition Plan for Budget Balance by 2003 Demonstrated that as the Government Shrinks, Interest-Sensitive Sectors Will Rise

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1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3

C a p ita lS p e n d in g

R e s id e n tia lC o n s tr u c t io n

Im p o r ts E x p o r ts

(Real Spending by sector, percent change relative to baseline)

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902mit17.ppt

To Update the Nonpartisan Concord Coalition Work in the Context of Current Policy Debates,

DRI Has Created a Special Simulation :

Our Implementation of a Balanced Budget in 2002 Includes:

Elements in Common with the Republican Contract:– Personal Tax Cuts (Bad Economics; Good Politics?)– 50% Capital Gains Tax Cut (16.5% top rate)– Welfare Reform– Greater Work Incentives (Marriage Penalty Reduced and

Social Security Earnings Limit Raised)– Some Specified Spending Cuts and Transfers to States– But not the Extra-Generous Investment Incentives or

Inflation Indexation of Gains

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902mit17.ppt

DRI Has Created a Special Simulation :

Our Implementation of a Balanced Budget in 2002 Includes:From the Congressional Budget Office Options “Menu:

– 1 Percentage Point Reduction in Social Security Indexation

– Taxation of Above-Average Employer-Paid Health Benefits

– A Wide Range of Other, Reasonable but Tough Options

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902mit17.ppt

The Simulation Reflected the Call for A Much Smaller Economic Role for the Federal Government ;The Results to Date Slightly Exceed Expectations

14%

16%

18%

20%

22%

24%

26%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

SPECIAL SIM BASELINE DATA AS OF 1999

Federal Spending, Including and Excluding Interest, Relative to GDP

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Tax Cuts were planned, but the booming economy and stock market raised taxes relative to GDP!

0.14

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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

TAXES / GNP SPEC. SIM. DATA AS OF 1999

Taxes Relative to Income

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Fiscal Impacts, Including Responsible Economic Feedbacks

($ Billions, Average change from baseline)

1996 1996-2000 2001-2005

Federal Taxes -24 -15 -32Federal SpendingDefense -9 -19 -28Non-defense (excl. Interes -42 -65 -102Net Stimulus (+)/Restraint -28 69 -98Interest Savings -5 -30 -106Federal Deficit 33 99 204Federal Debt (1995 $ per Household)

-280 -1803 -7475

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This Budget Balancing Produces Interest Savings Equal to Program Savings by 2003

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1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5

������������������

������������������ T o ta l D e fic itR e d u c tio n

P ro g ra m & T a xC h a n g e s

In te re s t S a v in g s

(Billions of dollars, changes relative to baseline)

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902mit17.ppt

Aggressive Federal Borrowing Forces High Bond Yields and a Balanced Budget offers a Return to better norms

0

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1 2

0 .0 0 % 0 .5 0 % 1 .0 0 % 1 .5 0 % 2 .0 0 % 2 .5 0 % 3 .0 0 %

Cyclically Adjusted Federal Deficit as a % of GDP

10 Year Bond Yields (Percent)

50’s

60’s 2001-2005

1995-2000

70’s 2001-2005

1995-2000

90’s

80’s

“Special Sim.”

DRI’sBaseline

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17.ppt

0

2

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-3 -2 -1 0 1 2 3 4 5 6

10-Y

ear G

over

nmen

t Bon

d Yi

eld

Federal Deficit as a Percent of GDP

1981

1969 1993

19791983

1996

1960

1980

19981997

The 1995-1998 Bond Rate Declines Match the Expected Impacts

The line is the 1959-96 fitted relationship between yields and deficits

The line is the 1959-96 fitted relationship between yields and deficits

1995

Interest Rates and Budget Deficits:The Numbers Look Like the 50’s & 60s

Market Rates Federal Deficit/GDP Average 10-yr. F.Funds T-bills Actual Cyclically Adj50’s 3.28 2.50 2.00 0.0% 0.3%60’s 4.67 4.18 3.98 0.2% 0.7%70’s 7.50 7.10 6.29 1.7% 1.4%80’s 10.60 9.97 8.82 3.6% 2.8%90-95’s 7.37 5.15 4.95 3.2% 2.4%

Baseline96-2000 7.17 5.27 4.90 2.5% 2.0%2001-2005 7.24 5.25 4.86 2.4% 1.9%

Special Sim. with Balanced Budget in 2002 96-2000 5.64 4.09 3.87 1.2% 0.7%2001-2005 4.39 3.09 2.98 0.0% 0.4%

Actual 95-98 OutcomeAverage 6.15 5.48 5.09 1.0% 0.9%1998 5.26 5.35 4.78 -0.8% -0.1% (Surpluses!)

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Lower Interest Rates Are an Absolutely Logical Impact of Budget Balancing

1. Interest rates are the “price” of national savings; when savings are scarce, rates are high, and when savings are plentiful, rates are low.

2. Scarcity, thus rates, reflect both demand and supply. Budget balancing improves both, creating a double downward pressure on interest rates.

3. Obviously, if the federal government is borrowing less, the demand for savings is lower by definition. The drive toward a balanced budget reduces the annual borrowing (the deficit) and the accumulated borrowing (the debt). The demand for savings is lower, hence rates must be lower too.

4. If taxes have not been raised to reduce the federal deficit, then private sector saving (supply) will be unchanged, or higher to the extent that gross income is higher and thus supports more saving.

5. The Federal Reserve should be expected to expand the supply of funds, without creating any additional inflationary pressure. First, short-term credit stimulus is needed to offset fiscal restraint so as to keep unemployment from rising. Second, the investment and other genuine supply side stimulants allow the Fed to target more rapid real growth in the economy. Higher real growth in the nation’s supply potential justifies greater liquidity without fear of extra inflation.

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The DRI Special Simulation Assumed the Federal Reserve Added Only As Much

Extra Liquidity As Was Consistent with No Change from the Baseline Inflation Rates

The greater liquidity added in the special simulation..

– offsets the restraint from fiscal policy,– and reflects the more rapid growth in the

supply side of the economy.In addition, we created alternative scenarios in which the Federal Reserve took no action to boost liquidity.

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902mit17.ppt

Economic Performance with Alternative Federal Reserve Responses

to New Spending and Tax PolicyChanges Relative to Baseline

Federal FundsInterest Rate

UnemploymentRate

CPI InflationRate

2002 96-2002 2002 96-2002 2002 96-2002

If Federal ReserveDoes Not BoostBank Reserves

-.69 -.44 0.4 0.4 -0.5 -0.2

If Fed. Reserve addsBank Reserves,Targeting BaselineInflation Rate

-1.70 -1.20 -0.4 -0.1 0.1 0.1

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Once Again, the Analysis Confirms This Budget-Balancing Need Not Be Painful: As the Government Shrinks, Interest-Sensitive Sectors Will Rise

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C a p ita lS p e n d in g

R e s id e n tia lC o n s tru c tio n

Im p o rts E x p o rts

(Real Spending by sector, percent change relative to baseline)

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Summary of Sectoral Impacts(% Difference from Baseline)

GDP and Sectors 1996 1996-2000 2001-2005------- ------------- --------------

Real GDP -0.1 0.5 2.2Consumer Goods 0.0 - 0.1 0.1Capital Spending 0.1 3.1 7.1Residential Construction 1.8 5.1 6.7Federal Purchases -4.1 -6.5 -7.8Exports 0.1 1.6 5.2

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The Estimated Potential For More Workersand Higher National Income

Impact of the Labor Force Expansion Assumptions on Economic Performance(comparing the special sim with labor force changes to the special sim without)

1996 2000 2005Assumed Gain in Full-Time Equivalent Workers due to:

Welfare Reform 150,000 1 million 1.5 millionLower Marriage Penalty 200,000 400,000 500,000Higher Earnings Limit 200,000 300,000 400,000

Total 550,000 1.7 million 2.4 million

Economic Feedback of More Workers and HoursReal GDP Gain ($Billion, 1987 Prices) $6 $27 $75Cumulative Percentage Gain 0.1% 0.5% 1.1%

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Estimated Supply-Side Benefitsof Our Implementation of Balanced Budget in 2002

Average Annual Growth RatesBaseline Budget Proposals Improvements

95-2000 2000-05 95-2000 2000-05 95-2000 2000-05Labor Force 1.39 1.25 1.64 1.33 0.25 0.08Fixed Investment 4.62 4.13 5.6 4.52 0.99 0.39Bus Cap Stk 3.15 2.67 3.55 3.37 0.40 0.70Ind R&D Spend 4.49 2.76 5.84 2.98 1.35 0.22R&D Capital Stock 2.58 2.52 2.92 2.92 0.34 0.40Potential GDP 2.48 2.25 2.73 2.55 0.25 0.30Output per Hour 1.49 1.28 1.51 1.5 0.01 0.22

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Achieved Benefits of the Implementation of a Balanced Budget by 1997 BRINNER

44902mit17.ppt

Private Investment Gains When the Federal Deficit Shrinks

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1993 1994 1995 1996 1997 1998 1999

GD

P %

Federal DeficitPlant & EquipmentHousing

WE CAN DO BETTER

Diligent pursuit of budget balance can boost real growth rates significantly, adding 2% to national output by 2002 .

Eliminating the deficit need not cause a recession if the Federal Reserve provides moderately greater liquidity.

A virtuous cycle of lower interest rates and lower federal debts ease the challenge of balancing the budget.

Welfare reform and tax changes can motivate more citizens to work, contributing to their prosperity and the nation’s.

Education reform and training efforts can boost productivity of workers who might otherwise face stagnating living standards.

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902mit17.ppt