13 Fiscal Policy, Deficits, and Debt McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Objectives • Purposes, Tools, and Limitations of Fiscal Policy • Role of Built-In Stabilizers in Moderating Business Cycles • How the Standardized Budget Reveals the Status of U.S Fiscal Policy • The Size, Composition, and Consequences of the U.S Public Debt 30-2 Fiscal Policy • Council of Economic Advisers (CEA) • Discretionary fiscal policy – Eliminate recessionary or inflationary gap – Countercyclical • Nondiscretionary fiscal policy – Passive or automatic 30-3 Fiscal Policy and the AD-AS Model or AE Model • Expansionary Fiscal Policy – Increased Government Spending – Tax Reductions – Some Combination of the Two – Political considerations • Budget Deficit 30-4 Expansionary Fiscal Policy Recessions Decrease Aggregate Demand Price Level $5 Billion Additional Spending AS Full $20 Billion Increase in Aggregate Demand P1 AD1 AD2 $490 $510 Real Domestic Output, GDP 30-5 Equilibrium Versus Full-Employment GDP Recessionary Expenditure Gap Aggregate Expenditures (billions of dollars) 550 530 510 AE0 AE1 $5 Billion Gap Yields $20 Billion GDP Change Recessionary Expenditure Gap = $5 Billion 490 470 Full Employment 45° 490 510 530 Real GDP (billions of dollars) 30-6 Fiscal Policy and the AD-AS Model • Contractionary Fiscal Policy – Decreased Government Spending – Increased Taxes – Some Combination of the Two • Budget Surplus • Policy Options: G or T? • Political considerations G 11.1 30-7 Contractionary Fiscal Policy Reduce Demand Pull Inflation $5 Billion Initial Decrease In Spending Price Level AS Full $20 Billion Decrease in Aggregate Demand P1 AD4 AD3 $510 $522 Real Domestic Output, GDP 30-8 Equilibrium Versus Full-Employment GDP Inflationary Expenditure Gap AE2 Aggregate Expenditures (billions of dollars) 550 530 AE0 Inflationary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change 510 490 470 Full Employment 45° 490 510 530 Real GDP (billions of dollars) 30-9 Built-In Stability • Automatic stabilizers – Taxes and transfers • Economic importance • Tax progressivity – Progressive tax system – Proportional tax system – Regressive tax system 30-10 Global Perspective LO4 13-19 Budget Deficits and Projections Actual Projected (as of March 2010) Budget Deficit (-) or Surplus, Billions $200 -200 -400 -600 -800 -1000 -1200 -1400 -1600 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Congressional Budget Office, http://www.cbo.gov LO4 13-20 Fiscal Policy Issues Problems, Criticisms, and Complications • Problems of timing – Recognition lag – Administrative lag – Operational lag • Political considerations – Political Business Cycle – Annual balanced budgets – Cyclically balanced budgets • Future policy reversals • Offsetting state and local finance • Crowding-out effect 30-21 Current Thinking on Fiscal Policy • Let the Federal Reserve handle short• • • LO4 term fluctuations Fiscal policy should be evaluated in terms of long-term effects Use tax cuts to enhance work effort, investment, and innovation Use government spending on public capital projects 13-22 The U.S Public Debt • • LO4 $11.9 trillion in 2009 ($9.01 Trillion 2007 and $7.96 Trillion in 2005) • The accumulation of years of federal deficits and surpluses Owed to the holders of U.S securities • Treasury bills • Treasury notes • Treasury bonds • U.S savings bonds 13-23 The U.S Public Debt Debt held outside the Federal government and the Federal Reserve: 57% LO4 Debt held by the Federal government and the Federal Reserve: 43% 13-24 The U.S Public Debt LO4 13-25 Global Perspective Public Sector Debt as Percentage of GDP, 2009 20 40 60 80 100 Italy Japan Greece Belgium France United States France Germany United Kingdom Spain Netherlands Canada Source: Organization for Economic Cooperation and Development, OECD LO4 13-26 The U.S Public Debt • Interest charges on debt • Largest burden of the debt • 1.3% of GDP in 2009 • False Concerns • Bankruptcy • Refinancing • Taxation • Burdening future generations LO4 13-27 Debt and GDP • Substantive issues – Income distribution – Incentives – Foreign-owned public debt • Crowding-out effect revisited – Burden on future generations – Public investment as an offset – Graphically 30-28 Crowding Out A Large Public Debt to Finance Public Investment Will Cause… 16 If Public Spending Spurs More Private Investment Will Increase to ID2 Real Interest Rate (Percent) 14 12 b 10 c a Interest Rate Rise Will Decrease Investment a to b 10 CrowdingOut Effect ID2 ID1 15 20 25 30 35 40 Investment (Billions of Dollars) 30-29 The Leading Indicators Average workweek Initial claims for unemployment insurance New orders for consumer goods Vendor performance New orders for capital goods Building permits for houses Stock prices Money supply Interest-rate spread 10 Consumer expectations Source: The Conference Board 30-30 Social Security, Medicare Shortfalls • More Americans will be receiving benefits • • as they age Social security shortfalls • Income during retirement • Funds will be depleted by 2037 Medicare shortfalls • Medical care during retirement • Funds will be depleted by 2017 13-31 Social Security, Medicare Shortfalls • Possible options “to fix” include: • Increasing the retirement age • Increasing the portion of earnings subject to the social security tax • Disqualifying wealthy individuals • Redirecting low-skilled immigrants to higherskilled, higher paying work • Defined contribution plans owned by individuals 13-32 Key Terms • fiscal policy • Council of Economic Advisers (CEA) • expansionary fiscal policy • budget deficit • contractionary fiscal policy • budget surplus • built-in stabilizer • progressive tax system • proportional tax system • • • • • • • • • regressive tax system standardized budget cyclical deficit political business cycle crowding-out effect public debt U.S securities external public debt public investments 30-33 ... Is the fiscal policy… • Expansionary? • Neutral? • Contractionary? • Use the cyclically adjusted budget to evaluate LO3 13- 13 Government Expenses, G and Tax Revenues, T Evaluating Fiscal Policy... officially began December 2007 and lasted 18 months 13- 18 Global Perspective LO4 13- 19 Budget Deficits and Projections Actual Projected (as of March 2010) Budget Deficit (-) or Surplus, Billions... evaluated in terms of long-term effects Use tax cuts to enhance work effort, investment, and innovation Use government spending on public capital projects 13- 22 The U.S Public Debt • • LO4 $11.9