I. Introduction
A. Objectives
B. Topics to be covered
1. The sources of the deficit
2. The types of deficits
3. Deficits and inflation
4. Are deficits a burden on future generations?
5. Reducing the Deficit
II. The Sources of the Deficit
A. The federal government's budget balance equals revenue minus expenditure.
Budget Balance = REVENUE - EXPENDITURE
1. If revenue exceeds expenditure, there is a budget surplus;
REV > EXPEND
2. if revenue equals expenditure, there is a balanced budget;
REV = EXPEND
3. and if it exceeds revenue, there is a budget deficit.
REV < EXPEND
B. Government debt is the total amount of borrowing the government owes.
1. It is the accumulation of all past deficits.
DEBT = SUM of DEFICITS
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C. The US Federal Budget since 1975
1. In the US, the government deficit was small and falling in the later 1970s,
1. but then rose to a peak of 5.3 percent of GDP in 1983.
2. It then fell but remained large throughout the 1980s and
3. increased with the 1991 recession.
D. The US federal government has four main sources of revenue:
1. Personal income taxes,
2. corporate income taxes,
3. indirect taxes, and
4. social security contributions.
E. In the US, total taxes increased as a fraction of GDP between 1975 and 1981,
1. but then declined until 1986.
2. Since then they have remained more or less steady.
3. Indirect taxes and social security have remained fairly stable and
4. it has been personal income and corporate taxes that have declined the most.
E. US Government expenditures can be divided into three parts:
1. purchases of goods and services,
2. transfer payments, and
3. debt interest payments.
F. In the US, total expenditures decreased between 1975 and 1979,
1. but then increased from 1979 to 1983.
2. They declined slightly until 1989,
3. after which they have again increased.
4. Debt interest payments increased the most;
5. Deficit was beginning to feed on itself
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F. The deficit and the business cycle
1. Deficit tends to:
1. increase as the economy is in a recession and
2. shrink when it is in an expansion.
3. This occurs because:
a. tax revenues fall in a recession while
b. expenditures rise.
c. transfer payments rise
G. Even though the US economy was in a recovery from 1982 to 1989,
1. the deficit remained large, around 3 percent of GDP.
a. This behavior is unusual and perhaps worrisome.
H. The cyclically adjusted deficit is the concept used to control for the tendency of the deficit to change with the business cycle:
1. The cyclically adjusted deficit is the deficit that would occur if the economy were at full employment.
2. If the cyclically adjusted deficit is positive,
a. then the federal government is engaging in expansionary policy.
I. US has a large cyclically adjusted deficit. (Large deficits even at full employment.)
II. The Real Deficit
A. Inflation can distort the measured deficit.
1. The real deficit is "the change in the real value of outstanding government debt."
Real Deficit = DEBT 1995 - DEBT 1994
P 1995 P 1994
2. The actual deficit and the real deficit are the same
a. if there is no inflation.
B. Inflation reduces the real value of the government's debt.
1. But this reduction is not included in the nominal deficit as conventionally measured.
2. If inflation is anticipated, lenders will increase nominal interest rate to offset decline in value of the debt
C. The distinction between the real and nominal deficit is important in practice only when the inflation rate is high,
1. as it was in the 1970s.
2. At that time the real deficit was much less than the nominal deficit.
3. In the 1980s and 1990s the two deficits behaved similarly.
(low rate of inflation)
IV. Deficits and Inflation
A. Introduction
1. Do deficits cause inflation?
A. To finance a deficit, the federal government sells bonds.
1. Can sell to :
a. the public
b. The Fed
1. If the Fed buys the bonds, its payment creates new money.
a. This is called money financing.
3. The purchase of the bonds by any other agent does not affect the money supply and
a. This is called debt financing.
1. Debt financing means that in future years the government must pay interest on the accumulated debt.
2. If the deficit is money financed,
a. the government pays the interest to the Fed,
b. which sends it back to the government.
c. Thus there is no net interest payment due.
B. Money financing the debt causes inflation;
1. debt financing may also cause inflation if
2. the larger interest payments and deficit are eventually money financed.
C. Some economists suggest that debt financing may be more inflationary than money financing
1. because eventually the interest payments on the debt will be money financed.
2. If people expect this to occur,
a. they reduce their demand for money immediately and debt financing immediately creates inflation.
b. Buy more goods
c. Immediately inflationary
3. This idea developed by Thomas Sargent (Univ of Chicago) and Neil Wallace of Minnesota. They called this "unpleasant monetarist arithmetic".
It attacks the central tenet of monetarism - that all inflations are caused by increases in the money supply.
Deficit will cause inflation if people expect that it will eventually be money financed.
D. International evidence
1. International evidence suggests there is a positive correlation between deficits and inflation.
2. A lot of deviations from average relationship.
3. Correlation strongest in Latin America
IV. Are Deficits A Burden on Future Generations?
A. It is common to believe that the deficit burdens future generations.
1. One suggestion is that the deficit harms future generations because they must pay taxes in order to finance the interest payments on the debt.
2. This ignores the fact that the future generations also receive the interest payments.
3. Hence in the aggregate interest payments do not hurt future generations.
4. Redistribution effects:
a. Some US debt bought by foreigners (e.g. Japanese investors)
5. Crowding out may hurt future generations
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B. Crowding out is "the tendency for an increase in government purchases of goods and services to bring a decrease in investment."
1. This harms future generations since they will inherit a smaller capital stock and hence be able to produce less output.
C. Crowding out does not occur if:
1. there is unemployment or
Spending may increase employment and output
2. if the deficit results from the government's purchase of capital where
a. the return equals or exceeds the return on private capital.
b. Government may buy infrastructure, or investment in human capital
D. Crowding out does occur if:
1. there is full employment or
2. if the deficit arises because the government buys consumption goods or capital goods where
a. the return on the capital goods is less than that on private investment.
E. Crowding out reduces investment if
1. it raises the real interest rate (r).
2. This happens if:
a. government borrowing to finance the deficit increases the demand for loans and
b. does not change the supply.
3. In US with big deficits , real interest rates at an all time high
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F. Ricardian equivalence suggests that the deficit per se does not crowd out investment
1. Idea first advanced by David Ricardo. More recently by Robert Barro of Harvard.
1. Deficit does not raise the real interest rate (r)
2. because deficit financing is essentially the same as tax financing:
1. Deficits simply defer taxes;
2. people, recognizing this, increase their saving in order to pay the higher future taxes.
3. Thus the supply of loans shifts by the same amount as the demand,
a. so the real interest rate (r) does not change.
G. If the future taxes are going to be imposed on a future generation,
1. Ricardian equivalence requires that the current generation save
a. so it can pass along a bequest to the future generation that
b. enables the future generation to pay the tax.
H. While the assumptions of Ricardian equivalence seem strong, there is a surprising amount of empirical evidence in its support.
I. Note:
1. Ricardian equivalence says that government spending will crowd out investment but
2. it makes no difference how the spending is financed.
VI. Reducing the Deficit
A. To eliminate the deficit it is necessary to:
1. either reduce expenditure and/or
2. raise revenue.
B. Reducing Expenditure
1. Some components of government expenditure, such as education and health care, have a tendency to increase more rapidly than real GDP (Y).
2. Only by privatizing these activities can increase in government expenditures be avoided.
C. Many European governments are privatizing a number of government-owned manufacturing operations by selling these operations to the private sector.
D. The "peace dividend" from a reduction in defense spending due to the end of the cold war may provide temporary help in reducing the US deficit.
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A. There are four proposals to help reduce US government expenditure:
1. cutting revenue to force spending cuts,
2. a line-item veto,
3. the Budget Enforcement Act, and
4. the balanced budget amendment.
B. Cutting Revenue to force spending cuts
1. Was strategy of Reagan administration
2. implicitly assumes that Congress spends all the revenue it obtains;
1. therefore the only way to reduce spending is by limiting the revenue Congress acquires.
C. Line item veto
1.If the President wants to reduce expenditures on specific items,
1. a line-item veto would allow the President to veto specific portions of expenditure bills rather than the entire bill.
D. The Budget Enforcement Act of 1990 contains:
1. spending caps and
2. pay-as-you-go rules
3. designed to prevent new programs from increasing the deficit.
E. A balanced budget amendment
1. BB Ammendment would amend the Constitution to require that the federal government balance its budget,
1. thereby eliminating the deficit.
2. Advocated by James Buchanan and Milton Friedman
3. Would give congress an excuse for cutting expenses
4. Difficult or impossible to frame such a law.
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A. A tax rate is the "percentage rate of tax levied on a particular activity;'
B. the tax base is the "activity on which the tax rate is levied."
C. Total tax revenue equals the tax rate times the tax base.
Tax Rev. = Tax rate * Tax base
D. To increase tax revenues,:
1. some economists suggest that tax rates be increased
2. while others suggest that tax rates be decreased.
E. The Laffer curve is the relationship between:
1. tax rates and
2. tax revenues.
Tax rev = fn (tax rate)
3. This relationship demonstrates that as tax rates increase,:
a. initially tax revenues rise,
b. reach a maximum and then
c. decline.
F. Economists argue about where we are on Laffer curve for different taxable commodities.
1. For some highly taxed items, total tax revenues might increase if tax rates were lowered.
2. But for personal income tax probably higher rates would increase revenues.
G. More revenues might be collected by:
1. reforming the tax system and
2. taxing new items.
VI. Summary of the Lecture
Key Concepts
1. Balanced budget
2. Budget balance
3. Budget deficit
4. Budget surplus
5. Cyclically adjusted deficit
6. Debt financing
7. Government debt
8. Laffer curve
9. Line-item veto
10. Money financing
11. Real deficit
12. Tax base
13. Tax rate
Questions for review
1. How does debt financing of a deficit lead to rapidly increasing interest payments?
2. How can a government deficit be a burden on future generations.
3. Why do some economists argue that taxes and government debt are equivalent to each other and so the deficit doesn't matter?
4. Why do some economists think that government revenues can be increased by cutting tax rates?