Chapter 12 The Government Budget the Public Debt

Key Questions • What difference does it make if the government runs a surplus or deficit? • What will be the long-run consequence of allowing the post-2001 deficits to continue? • Will a persistent government budget deficit cause the public debt to explode without limit? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 2

Fiscal Policy, Growth, and Economic Welfare • Recall: We argued that an increase in the national saving rate is likely to stimulate economic growth. – NS can be increased by fiscal policy via higher taxes or lower spending. • The Rate of Time preference is the extra amount a consumer would be willing to pay to be able to obtain a given quantity of consumption goods now rather than a year from now. – The U. S. saves too little if the rate at which individuals discount future consumption is less than the rate of return on private investment. • Should fiscal policy be used to increase NS or should nothing be done? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3

Figure 12 -1 Two Alternative Paths of Consumption per Person Copyright © 2009 Pearson

Government Budget Deficit, NS, and Growth • Recall: National Saving is the sum of private and government saving: NS = S + (T – G) • Recall: The magic equation: NS = I + NX – If NS Either I or NX must fall • The only way I can be maintained if NS falls is if the fall in NS is completely offset by a decline in foreign investment or increase in foreign borrowing. • This is possible in a small open economy. • In a large open economy, if NS must cause both a decline in I and NX. • To stimulate growth via higher investment spending, NS must be raised either through higher private saving or higher government saving. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5

Government Investment vs. Consumption • The ultimate aim of policies to boost NS is to increase the ratio of investment to real GDP. • Two Types of Investment – Private investment on machines and structures – Government investment, for instance, on education and highways • Government investment generates a future return consisting of the benefits to future generations created by the investment. • Government consumption provides only current benefits. • Is government debt harmful? – The true burden of government debt depends on the extent to which government debt is used to finance government investment or consumption. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6

Measuring Government Debt • One measure of indebtedness is the ratio of nominal federal debt to nominal GDP: D/PY – The government deficit = G – T = ∆D – The growth rate of D/PY = d – (p + y) • • Stability in indebtedness requires that the growth rate of D/PY equals zero d = p + y The Allowable Deficit that keeps the debt-GDP ratio constant is: d. D = (p + y)D – Implication: The debt-GDP ratio remains constant if the deficit equals the outstanding debt times the growth rate of nominal GDP. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7

International Perspective: The Debt-GDP Ratio: How Does the United States Compare? Copyright © 2009

When Is There Too Much Government Debt? • There is a limit to the size of government debt since the government must pay interest on the debt held by the public. – The government can meet its interest bill forever by issuing more bonds without increasing the debt-GDP ratio only if the economy’s real growth rate of output equals or exceeds its real interest rate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9

Figure 12 -2 The Ratio of U. S. Government Debt to GDP, 1790– 2008 Sources: Historical Statistics of the United States Millennial Edition and Economic Report of the President 2008. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10

Figure 12 -3 Federal Government Revenues and Expenditures as a Percent of Natural GDP, 1960– 2008 Sources: Bureau of Economic Analysis NIPA Tables and Congressional Budget Office. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 11

Figure 12 -4 Components of Federal Government Expenditures as a Percent of Natural GDP, 1960– 2007 Source: Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12

Supply Side Economics • Supply Side Economics, embraced by the Reagan administration, posits that high tax rates stifle individual initiative and saving. – – – Income tax reduce the after-tax reward to work and saving. An increase in the after-tax reward to work and saving creates a significant increase in the amount of work and saving. The resulting increase in work and saving is enough to boost tax revenue as compared to before the tax cuts. • Empirical problems with supply side economics: – – – After Reagan’s tax cuts in 1981, the labor force participation grew more slowly. The personal saving rate fell after rising in rising during 1977 -81. Productivity growth grew only moderately, and not nearly as quickly as after the tax hikes of 1993. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13

Figure 12 -5 The Laffer Curve Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Barro-Ricardo Equivalence Theorem • In 1974, Robert Barro argued that changes in taxes would not affect output because tax cuts are balanced by an increase in saving rate rather than an increase in consumption. – Tax cuts financed by deficit spending require higher future tax payments to meet the interest on the public debt, so people will save for those future obligations. • Criticisms – Decision horizons are often quite short. – 1981 tax cuts did not see an increase in saving. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15

The Social Security Debate • The Social Security system is the basic source of retirement benefits for U. S. households. – The “Pay-As-You-Go” system works by collecting taxes from workers and uses those taxes to pay benefits to retired people and their spouses. • Surplus taxes are put into the Social Security trust fund and invested in government bonds. • Problem: Because of the growing number of retirees and increased longevity, the Social Security system will run continuous deficits after 2018 and will run out of money after 2046. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16

Social Security Solvency Solutions • Is there even a problem? – The projections of future benefits payments and tax receipts are based on very conservative estimates. • • Population may be growing faster than assumed. Immigration is assumed to be fixed. Wage growth is assumed to be very slow. Inflation may also be highly variable. • A few possible solutions to the problem: – Raise the ceiling on wages subject to the payroll tax. – Increase the retirement age from 67 to 70. – Increase payroll taxes by 0. 5%. • Should Social Security funds be invested in the stock market? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 17

Figure 12 -6 Social Security Outlays, Revenues, and the Trust Fund, 1985– 2085 (1

Figure 12 -6 Social Security Outlays, Revenues, and the Trust Fund, 1985– 2085 (2 of 2) Source: Congressional Budget Office. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 19

Figure 12 -6 Social Security Outlays, Revenues, and the Trust Fund, 1985– 2085 Source: Congressional Budget Office. Details in Appendix C-4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 20