Chapter 5 The Federal Budget

1
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)

2
Budget Definitions

• Budget lt 0 -- Budget Deficit
• Budget gt 0 -- Budget Surplus
• Budget 0 -- Balanced Budget
• Realistic Goal -- Balanced Budget when Y YN.

3
The Federal Budget 2001 (Billions of Dollars)

• Tax Revenues 1991.0
• Government Expenditure
• 
  1863.9
• Budget 127.1
• Source Economic Indicators, April 2002

4
Breakdown of Tax Revenues

• Personal Income Taxes 1010.1
• Corporate Profits Taxes 186.5
• Indirect Business Taxes 110.9
• Contributions for
• Social Insurance 720.6

5
Breakdown of Government Expenditure

• Consumption Expenditures (G)
• 
  514.1
• Transfer Payments 831.7
• Grants-in-aid to State
• and Local Governments 274.2
• Net Interest Paid 236.4
• Net Subsidies of
• Govt Enterprises 52.4

6
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

7
The Budget and The Size of the
Deficit

• Budget T - G
• Size of Deficit G - T

8
The National Debt

• The National Debt -- The total accumulated stock
  of debt owed by the government to its lenders.
• Expanded by deficits, reduced by surpluses

9
National Debt -- Realistic Goal

• Realistic Goal -- consider the
  Debt-Income Ratio
• (National Debt)/(GDP).
• For US in 2001
• (3320.0)/(10208.1) 0.325

10
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)

11
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 lt YN) ? positive cyclical
  deficit.
• Economy with accelerating inflation (Y gt YN) ?
  negative cyclical deficit.

12
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. Its resolved when Y YN.

13
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.

14
Analyzing the Deficit -- A Numerical
Example

• Year Structural Cyclical Total
• 1979 100 -50 50
• (Y gt YN)
• 1982 100 50 150
• (Y lt YN)
• 1995 100 0
  100
• (Y YN)

15
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.

16
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.

17
The Crowding Out Effect

• Consider macro identity
• 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).

18
The Increased Debt Burden on Future Generations

• Older generations enjoy benefits from the debt.
  But younger generations have to sacrifice in the
  future to repay the debt or at least maintain the
  interest payments.
• Lower investment retards development of the
  capital stock, the economys productive capacity
  for future generations.

19
Maybe Effects of Deficits and Debt Arent so Bad

• Riccardian Equivalence -- Given an increased
  deficit, older people correspondingly increase
  their saving.
• Older generations provide the means to pay debt
  and interest.

20
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.

21
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).

22
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.

23
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).

24
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.

25
Reducing a Structural Deficit G - (T0 tYN)

• All three are contractionary measures, will
  reduce Y.
• -- shifts EP curve downward
• -- shifts IS curve leftward
• Hopefully, i will decrease (IS-LM), ? I?, with
  its associated benefits.
• One more possibility -- can we make YN?? --
  Discussed later.