The Government Budget The Federal Budget Deficit

							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)
Budget Definitions

Budget < 0 -- Budget Deficit
Budget > 0 -- Budget Surplus
Budget = 0 -- Balanced Budget

Realistic Goal -- Balanced Budget
 when Y = YN.
The Federal Budget: 2001
(Billions of Dollars)

Tax Revenues =          $1991.0
Government Expenditure =
                       $1863.9
Budget =                 $127.1

Source: Economic Indicators,
 April 2002
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
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
 Gov’t Enterprises      = $52.4
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
The Budget and
The Size of the Deficit

Budget = T - G
Size of Deficit = G - T
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
National Debt --
Realistic Goal

Realistic Goal -- consider the
 Debt-Income Ratio =
       (National Debt)/(GDP).

For US in 2001 =
       ($3320.0)/($10208.1) = 0.325
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*)
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* < YN) 
 positive cyclical deficit.
Economy with accelerating
 inflation (Y* > YN)  negative
 cyclical deficit.
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. It’s resolved
 when Y = YN.
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.
•Analyzing the Deficit --
A Numerical Example

  Year Structural + Cyclical = Total
  1979    100         -50        50
(Y* > YN)
  1982    100          50       150
(Y* < YN)
  1995    100           0       100
(Y* = YN)
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.
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.
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).
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 economy’s productive capacity
 for future generations.
Maybe Effects of Deficits
and Debt Aren’t so Bad

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