Lecture PowerPoint Presentation Deficit

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					     ECON2301 - Principles of
        Macroeconomics

         Instructor: Patrick M. Crowley

    Lecture 14 – Public deficits and debts


1
Chapter Outline
   Public Deficits and Debts: Flows
    versus Stocks
   Government Finance: Spending More than Tax Collections
   Evaluating the Rising Public Debt
   Federal Budget Deficits in an Open Economy
   Growing U.S. Government Deficits: Implications for U.S.
    Economic Performance




                                                              2
Public Deficits and Debts:
Flows versus Stocks
   Government Budget Deficit
       Exists if the government spends more
        than it receives in taxes during a given period of time
       Is financed by the selling of government securities
        (bonds)
   The federal deficit is a flow variable, one defined
    for a specific period of time, usually one year.
   If spending equals receipts, the budget is
    balanced.
   If receipts exceed spending, the government is                3
    running a budget surplus.
Public Deficits and Debts:
Flows versus Stocks (cont'd)
   Public Debt
       A stock variable
       The total value of all outstanding government
        securities

   Since 1940, the U.S. federal government has
    operated with a budget surplus in 13 years.
   In all other years, the shortfall of tax revenues
    below expenditures has been financed with
    borrowing.
                                                        4
 Figure 14-1 Federal Budget Deficits and
 Surpluses Since 1940




*Budgeted items not including 2008–2009 financial institutions bailout expenditures.
Source: Office of Management and Budget.
Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP




 *Budgeted items not including 2008–2009 financial institutions bailout expenditures.
 Sources: Economic Report of the President; Economic Indicators, various issues.
Government Finance: Spending More
than Tax Collections (cont'd)
   The resurgence of federal
    government deficits
   Question
       Why has the government’s budget recently slipped
        from a surplus of 2.5% of GDP into a deficit?




                                                           7
Policy Example: Explaining a $109
Billion Deficit Projection Turnaround
   Why was the government’s 2005 deficit projection
    off by $109 billion?
   Federal tax revenues turned out to be more than
    15% higher in 2005.
   Economic growth caused taxable incomes, hence
    revenues, to be much higher than anticipated.




                                                       8
Evaluating the Rising Public Debt
   Gross Public Debt
       All federal government debt irrespective of who owns
        it

   Net Public Debt
       Gross public debt minus all government interagency
        borrowing




                                                               9
Evaluating the Rising
Public Debt (cont'd)
   Some government bonds are held by government
    agencies.
       In this case, the funds are owed from
        one branch of the federal government
        to another.
       To arrive at the net public debt, we subtract
        interagency borrowings from the gross public debt.




                                                             10
Evaluating the Rising
Public Debt (cont'd)
   Tax revenues tend to be stagnant during times of
    slow economic growth.
   Tax revenues grow more quickly when overall
    growth enhances incomes.
   As long as spending exceeds revenues, the budget
    deficit will persist.




                                                       11
Table 14-1 The Federal Deficit, Our Public Debt,
and the Interest We Pay on It
Figure 14-3 Net U.S. Public Debt
as a Percentage of GDP




   Source: U.S. Department of the Treasury.
Net U.S. Public Debt
as a Percentage of GDP
   During World War II, the net public debt grew
    dramatically.
   After the war
       It fell until the 1970s
       Started rising in the 1980s
       Declined once more in the 1990s
       And recently has been increasing again




                                                    14
Evaluating the Rising
Public Debt (cont'd)
   The government must pay interest on the public
    debt outstanding.
   The level of these payments depends on the
    market interest rate.
   Interest payments as a percentage of GDP are
    likely to rise in the future.




                                                     15
Evaluating the Rising
Public Debt (cont'd)
   As more of the public debt is held by foreigners,
    the amount of interest to be paid outside the
    United States increases.
   Foreign residents, businesses and governments
    hold nearly 50% of the net public debt.
   Thus, we do not owe the debt just to ourselves.




                                                        16
Evaluating the Rising
Public Debt (cont'd)
   If the economy is already at full employment,
    then further provision of government goods will
    crowd out some private goods.
   Deficit spending may raise interest rates, which
    in turn will discourage capital formation in the
    private sector.




                                                       17
Evaluating the Rising
Public Debt (cont'd)
   Crowding-out may place a burden on future
    generations.
       Increased present consumption may crowd out
        investment and reduce the growth of capital goods—
        which could reduce a future generation’s wealth.
       Taxes may have to be increased; imposing higher
        taxes on future generations in order to retire the
        debt.




                                                             18
Evaluating the Rising
Public Debt (cont'd)
   Paying off the public debt in the future
       If the debt becomes larger, each person’s share
        would increase.
       Taxes would be levied, and may not be assessed
        equally.
       A special tax could be levied based on a person’s
        ability to pay.




                                                            19
Evaluating the Rising
Public Debt (cont'd)
   If deficits lead to slower growth rates future generations
    will be poorer.
   Both present and future generations will be economically
    better off if…
       Government expenditures are really investments
       The rate of return on such public investments exceeds the
        interest rate paid on the bonds




                                                                    20
International Example: Where Are Most
Treasury Securities Held Abroad?
   More than $2 trillion in U.S. Treasury securities
    of the $5 trillion in net outstanding debt is held
    outside the United States.
   Japan accounts for more than one-third of all
    foreign holdings of the U.S. net public debt.
   China has dramatically increased its holdings of
    US net public debt over the past year.



                                                         21
Figure 14-4 The Distribution of Foreign
Holdings of U.S. Treasury Securities




                                          22
        International Example: Where Are Most
        Treasury Securities Held Abroad? (cont'd)
   For critical analysis:
       Why might the fact that market interest rates in
        Japan have hovered very close to 0% during the
        2000s help explain relatively large holdings of U.S.
        Treasury securities by residents of that country?




                                                               23
Federal Budget Deficits
in an Open Economy
   Question
       Is there a connection between the U.S. trade deficit
        and the federal government budget deficit?

   We know what a budget deficit is, but a trade
    deficit exists when the value of imports exceeds
    the value of exports.
   Some say it appears that there is a relationship
    between trade and budget deficits; at least there
    is a statistical correlation between the two.

                                                               24
Figure 14-4 The Related U.S. Deficits




Sources: Economic Report of the President; Economic Indicators, various issues;
author’s estimates.
Federal Budget Deficits
in an Open Economy (cont'd)
   As the government borrows funds to finance the
    deficit, and domestic private consumption does
    not decrease, then some of these funds will be
    borrowed from foreigners.
   The interest rate paid on bonds will need to be
    high enough to attract foreign investors.
   If foreigners are using the dollars they hold to
    buy U.S. government bonds, then they will have
    fewer dollars to spend on U.S. exports.
   This shows that a U.S. budget deficit can
    contribute to a trade deficit.                     26
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance
   Which government deficit is the
    true deficit?
       The government may report distorted measures of its
        own budget.
           Government has not adopted a business-like approach to
            tracking its expenditures and receipts.
           Official government ―measures‖ yield lowest possible deficits
            and highest reported surpluses.

   An operating budget includes current outlays for
    on-going expenses, such as salaries and interest
    payments.
   A capital budget, includes expenditures on                              27
    investment items, such as machines, buildings,
    roads, and dams.
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   Capital budgeting theory
       For years, many economists have recommended Congress
        create a capital budget and remove investment outlays from
        the operating budget.
       Opponents point out this would allow
        the government to grow even faster than
        at present.
       For years, many economists have recommended Congress
        create a capital budget and remove investment outlays from
        the operating budget.
       Opponents point out this would allow the government to
        grow even faster than at present.                        28
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
 Even without a distinction drawn between the
  capital and operating budgets, there is a
  discrepancy about the true government deficit
  measure.
 Pick a deficit, any deficit: deficit estimates are
  produced both by
       The Office of Management and Budget
       The Congressional Budget Office

   They have different names
       ―Baseline deficit‖
       ―Policy deficit‖
                                                       29
       ―On-budget deficit‖
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   There is also some disagreement as
    to whether the Social Security surplus should be
    used to reduce current deficit numbers.
   So keep in mind that any one specific deficit
    measure you hear is based on a definition and a
    set of assumptions with which others may
    disagree.




                                                       30
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   Question
       How do higher deficits affect the economy in the short run?

   Answers
       If the economy is below full-employment, the deficit can
        close the recessionary gap.
       If the economy is already at full-employment, the deficit
        can create an inflationary gap.




                                                                      31
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   In the long run, higher government budget
    deficits have no effect on equilibrium real
    GDP.
   Ultimately, spending in excess of receipts
    redistributes a larger share of real GDP to
    government-provided goods and services.




                                                  32
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   Thus, if the government operates with higher
    deficits over an extended period
       The ultimate result is a shrinkage in the share of
        privately produced goods and services
       By continually spending more than it collects, the
        government takes up a larger portion of economic
        activity.




                                                             33
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   How could the government reduce all its red ink?
       Increasing taxes for everyone
       Taxing only the rich
       Reducing expenditures
       Whittling away at entitlements




                                                       34
Policy Example: How Rich Taxpayers Avoid
Part of a Tax-Rate Increase
   Many have proposed raising taxes on the highest-
    income earners.
   Just like everyone else high-income individuals
    respond to incentives.
   The richest tax payers could use deferred
    compensation plans.
   These individuals would shift income earned in
    current years to future years.



                                                       35
Policy Example:
How Rich Taxpayers Avoid Part
of a Tax-Rate Increase (cont'd)
   Government estimates show increasing the top
    bracket from 35% to 39.6% would reduce total
    taxable income by at least 4%.
   Projections show the increase would give the
    highest income taxpayers a greater incentive to
    incorporate and pay lower corporate-profit tax
    rates.
   Thus, raising the income tax rate by 4.6
    percentage points would result in less than a
    4.6% increase in government tax collections
                                                      36
Policy Example: A Short-Run Deficit Boosting
Stimulus is Set to Give Way to Deficit-Fighting Tax
Increases

   In early 2008, Congress passed the Economic
    Stimulus Act in response to declining GDP
    growth rate.
   This law provided for $45 billion in government
    spending and authorized tax ―rebates‖ aimed at
    stimulating consumptions pending and
    preventing a short-run recessionary gap from
    expanding.
Policy Example: A Short-Run Deficit Boosting Stimulus is Set
to Give Way to Deficit-Fighting Tax Increases (cont'd)


   However, worries over an increasing budget
    deficit prompted Congress to authorize a
    significant personal income tax increase at the
    end of 2010.
   This rate will raise the overall U.S. personal
    income tax burden by 25%.
   Higher tax rates could reduce long-run aggregate
    supply and dampen future real GDP growth.
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   In considering how expenditures might be
    reduced, it is important to look at entitlements.
 These are federal government payments that are
  legislated obligations and cannot be reduced or
  eliminated.
 Entitlements

       Guaranteed benefits under a government program
        such as Social Security, Medicare, or Medicaid

   Noncontrollable Expenditures
       Government spending that changes automatically
        without action by Congress
                                                         39
Figure 14-5 Components of Federal Expenditures
as Percentages of Total Federal Spending




  Source: Office of Management and Budget.
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
   Entitlements are the largest component of the
    U.S. federal budget.
   To make a significant cut in expenditures,
    entitlement programs would have to be revised.
   Question
       What are the political costs of reducing entitlement
        payments for Social Security, Medicare, and
        Medicaid?


                                                               41
Issues and Applications: Budget Deficit Rules
Made to Be Broken?
   Under the Stability and Growth Pact each EU
    member nation agreed on net public debt and annual
    budget deficit percentages.
   Net public debt as a percentage of GDP should be no
    higher than 60%, with the annual budget deficit no
    higher than 3% of GDP.
   Some EU nations satisfied the 60% constraint on net
    public debt as a proportion of GDP.
   Most EU countries satisfied the 3% limitation on the
    ratio of the budget deficit to GDP – but several have
    failed to do so in recent years (Germany, France,       42

    Italy in 2004.
Summary
   Federal government budget deficits
   The public debt
   How the public debt might prove a burden to future
    generations
   Why the federal budget deficit might be incorrectly
    measured
   The macroeconomic effects of government budget deficits
   Possible ways to reduce the government budget deficit




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