Eco 301 ch26

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Eco 301 ch26

  1. 1. Fiscal Policy: A Summing Up
  2. 2. Fiscal Policy: A Summing Up <ul><li>In the short run, a fiscal deficit raises interest rates and output. Therefore the impact on investment is ambiguous. </li></ul><ul><li>In the medium run, only r rises, so I falls. </li></ul><ul><li>In the long run, lower investment implies a lower capital stock and lower growth. </li></ul><ul><ul><li>However, the S-R increase in output can have long term social consequences. </li></ul></ul>
  3. 3. The Government Budget Constraint <ul><li>The Arithmetic of Deficits and Debt </li></ul><ul><ul><li>The budget deficit in year t equals: </li></ul></ul>26-1 is the interest payments on government debt at the end of year t -1. In words: The budget deficit equals spending including interest payments on the debt, minus taxes net of transfers. is government spending during year t . is taxes minus transfers during year t .
  4. 4. Fiscal Policy: A Summing Up <ul><li>Notice the difference between deficit and debt </li></ul><ul><ul><li>Debt is what the government owes. It is a stock, the accumulation of past deficits. </li></ul></ul><ul><ul><li>Deficit is the difference between government outlays and tax revenue. It is a flow, the change in the level of debt. </li></ul></ul>
  5. 5. The Government Budget Constraint <ul><li>The government budget constraint states that the change in government debt during year t is equal to the deficit during year t : </li></ul><ul><li>Debt at the end of year t equals: </li></ul>change in the debt interest payments Primary deficit
  6. 6. Current Versus Future Taxes <ul><li>Suppose a government moves from a balanced budget to a deficit by cutting taxes in period 1 by an amount of 1bn. </li></ul><ul><ul><li>Taxes go back to normal in period 2,unless debt has to be repaid. </li></ul></ul><ul><li>This means that B 1 = 1bn. </li></ul><ul><li>How and when should it repay its debt? </li></ul><ul><ul><li>Notice that if B>0, the debt keeps accumulating even if T=G because of interest payments on the debt. </li></ul></ul>
  7. 7. Current Versus Future Taxes <ul><li>Full Repayment of the debt in year 2: </li></ul>Replacing B 2 =0bn and B 1 =1bn , and rearranging: In words, to repay the debt fully in year 2, the government must run a primary surplus equal to (1+ r )bn.
  8. 8. Full Repayment in Year 2 <ul><li>Tax Cuts, Debt Repayment, and Debt Stabilization </li></ul>(a) If debt is fully repaid during year 2, the decrease in taxes of 1 in year 1 requires an increase in taxes equal to (1+ r ) in year 2.
  9. 9. Full Repayment in Year 2 <ul><li>Suppose the government borrows $1 in 2011. </li></ul><ul><li>In 2012 the debt will be $1(1+r). In 2013, $1(1+r) 2 . In 2014, $1(1+r) 3 . In year 2015, it will be $1(1+r) 4 . </li></ul><ul><li>Debt at the end of year t is given by: </li></ul><ul><li>Debt at the end of year t  1 is given by: </li></ul>
  10. 10. Full Repayment in Year t <ul><li>Debt at the end of year t  1 is given by: </li></ul><ul><li>In year t, when the debt is repaid, the budget constraint is: </li></ul><ul><li>Debt at the end of year t equals zero: </li></ul>which implies that the necessary surplus in year t to repay the debt must be:
  11. 11. Full Repayment in Year 5 <ul><li>Tax Cuts, Debt Repayment, and Debt Stabilization </li></ul>(b) If debt is fully repaid during year 5, the decrease in taxes of 1 in year 1 requires an increase in taxes equal to (1+ r ) 4 during year 4. Notice taxes go back to “normal” level of zero in year 2, and then rise in year t to pay the debt.
  12. 12. Debt Stabilization in Year 2 <ul><li>Tax Cuts, Debt Repayment, and Debt Stabilization </li></ul>(c) The government doesn’t want to repay the debt. It just wants to keep it constant. If debt is stabilized from year 2 on, then taxes must be permanently higher by r from year 2 on.
  13. 13. Conclusions <ul><li>From the preceding arithmetic of deficits and debt we can draw these conclusions: </li></ul><ul><ul><li>If government spending is unchanged, a decrease in taxes must eventually be offset by an increase in taxes in the future. </li></ul></ul><ul><ul><li>The longer the government waits to increase taxes or the higher the real interest rate, the higher the eventual increase in taxes. </li></ul></ul>
  14. 14. Conclusions <ul><li>From the preceding arithmetic of deficits and debt we can draw these conclusions: </li></ul><ul><ul><li>The legacy of past deficits is higher government debt. </li></ul></ul><ul><ul><li>To stabilize the debt, the government must eliminate the deficit. </li></ul></ul><ul><ul><li>To eliminate the deficit, the government must run a surplus equal to the interest payments on the existing debt. </li></ul></ul><ul><ul><ul><li>I.e., raise taxes or cut spending. </li></ul></ul></ul>
  15. 15. The Arithmetic of the Debt to GDP Ratio <ul><li>The debt-to-GDP ratio , or debt ratio gives the evolution of the ratio of debt to GDP. </li></ul>Divide 26.3 by Y t Notice that Then
  16. 16. The Arithmetic of the Debt to GDP Ratio <ul><li>The debt-to-GDP ratio , or debt ratio gives the evolution of the ratio of debt to GDP. </li></ul>It turns out that So we can simplify And reorganize
  17. 17. The Evolution of the Debt to GDP Ratio <ul><li>The change in the debt ratio over time is the difference between the real interest rate and the growth rate of GDP times the initial debt ratio, plus the ratio of the primary deficit to GDP. </li></ul><ul><li>If G=T and B grows at a rate r . But if GDP grows ( g increases), the ratio of debt to GDP will grow more slowly (at a rate equal to r  g ). </li></ul>
  18. 18. The Evolution of the Debt-to-GDP Ratio in OECD Countries <ul><li>We can use the equation above as a useful guide to the evolution of the debt-to-GDP ratio over the last four decades in the OECD countries. The debt to GDP ratio will be larger: </li></ul><ul><ul><li>the higher the real interest rate </li></ul></ul><ul><ul><li>the lower the growth rate of output, </li></ul></ul><ul><ul><li>the higher the initial debt ratio, </li></ul></ul><ul><ul><li>The higher the ratio of the primary deficit to GDP. </li></ul></ul>
  19. 19. The Evolution of the Debt-to-GDP Ratio in OECD Countries <ul><li>In the 1960s, GDP growth was strong. As a result, r  g was negative. Countries were able to decrease their debt ratios without having to run large primary surpluses. </li></ul><ul><li>In the 1970s, r  g was again negative due to very low interest rates, leading to a further decrease in the debt ratio. </li></ul>
  20. 20. The Evolution of the Debt-to-GDP Ratio in OECD Countries <ul><li>In the 1980s, real interest rates increased and growth rates decreased, thus, debt ratios increased rapidly. </li></ul><ul><li>Throughout the 1990s, interest rates remained high and growth rates low. However, most countries ran primary surpluses sufficient to imply a steady decline in their debt ratios. </li></ul>
  21. 21. Four Issues in Fiscal Policy <ul><li>The idea of Ricardian Equivalence , further developed by Robert Barro, and also known as the Ricardo-Barro proposition , is the argument that, once the government budget constraint is taken into account, neither deficit nor debt has an effect on economic activity. </li></ul><ul><ul><li>Consumers do not change their consumption in respond to a tax cut if the present value of after-tax labor income is unaffected. The effect of lower taxes today is cancelled out by higher taxes tomorrow. </li></ul></ul>26-2 1
  22. 22. Deficits, Output Stabilization, and the Cyclically Adjusted Deficit <ul><li>Although protracted budget deficits have adverse effects, they can be used for stabilization. </li></ul><ul><li>This implies that deficits during recessions should be offset by surpluses during booms. </li></ul><ul><li>The deficit that exists when output is at the natural level of output is called the cyclically adjusted deficit </li></ul><ul><ul><li>Other terms used are midcycle deficit , standardized employment deficit , structural deficit , or full-employment deficit . </li></ul></ul>2
  23. 23. Deficits, Output Stabilization, and the Cyclically Adjusted Deficit <ul><li>A reliable rule of thumb is that a 1% decrease in output leads automatically to an increase in the deficit of 0.5% of GDP. </li></ul><ul><li>If output is, say 5% below its natural level, the deficit as a ratio of GDP will therefore be about 2.5% larger than it would be if output was at the natural level of output. </li></ul><ul><ul><li>G>T encourages economic activity. </li></ul></ul><ul><li>This effect of the deficit on economic activity has been called the automatic stabilizer . </li></ul>
  24. 24. Wars and Deficits <ul><li>The economic burden of a war affects consumers and firms differently depending on how the war is paid for. </li></ul><ul><li>If the government relies more on deficit financing and less on tax increases, the decrease in consumption will be smaller and the decrease in investment will be larger. </li></ul><ul><ul><li>If the government relies less on deficit financing and more on tax increases, the decrease in consumption will be larger and the decrease in investment will be smaller. </li></ul></ul>3
  25. 25. Reducing Tax Distortions <ul><li>Very high tax rates can lead to very high economic distortions. People will work less, and engage in illegal, untaxed activities. </li></ul><ul><li>Tax smoothing is the idea that it is better to maintain a relatively constant tax rate, to smooth taxes. </li></ul><ul><li>Tax smoothing implies large deficits when government spending is high and small surpluses the rest of the time. </li></ul>
  26. 26. The Dangers of Very High Debt <ul><li>The higher the ratio of debt to GDP, the larger the potential for catastrophic debt dynamics. </li></ul><ul><li>Expectations of higher and higher debt give a hint that a problem may arise, which will lead to the emergence of the problem, thereby validating the initial expectations. </li></ul>4
  27. 27. The Dangers of Very High Debt <ul><li>Suppose G=T and r>g. B/Y rises over time. </li></ul><ul><ul><li>Eventually, rB could get so large that government goes bankrupt. </li></ul></ul><ul><ul><li>Fearing this, lenders require a higher r. This raises rB. </li></ul></ul><ul><ul><li>A self-fulfilling prophesy arises. </li></ul></ul><ul><li>Debt repudiation consists of canceling the debt, in part or in full. </li></ul>
  28. 28. The U.S. Budget <ul><li>The government uses its own accounting system to present and discuss the budget in Congress. </li></ul><ul><li>An alternative and more economically meaningful accounting system is provided in the national income and product accounts (NIPA). </li></ul><ul><li>The two systems differ in how they treat assets and government investment. </li></ul>26-3
  29. 29. 20.1 Revenues 0.7 Inflation components 1.7 Real interest payments (3) 2.4 Net interest payments (2) 3.9 Primary surplus (1) (+ sign: surplus) 8.1 Transfers (note: here, part of G; in the book, a part of T) 1.7 Nondefense 0.5 Other spending 2.6 Grants to state/local governments 2.2 Inflation adjusted surplus: (1) minus (3) 1.5 Official surplus: (1) minus (2) 31.0 Memo item. Debt to GDP ratio 3.3 Defense 7.0 Social insurance contributions 16.2 Expenditures, excluding interest payments 5.0 Consumption expenditures 1.0 2.0 10.0 Table 25-2 U.S. Federal Budget Revenues and Expenditures, Fiscal Year 2001 (Percent of GDP) Source: Survey of Current Business, December 2001. Tables 3-2 and 3-7. Indirect taxes Corporate profit taxes Personal taxes
  30. 30. The U.S. Budget <ul><li>Gross debt is the sum of the federal government’s financial liabilities. At the end of 2001, gross debt was $5.6 trillion, or 55% of GDP. </li></ul><ul><li>Net debt is the debt held by the public. At the end of 2001, net debt was $3.1 trillion, or 31% of GDP. The remaining $2.5 trillion was held by government agencies. </li></ul>
  31. 31. The U.S. Budget <ul><li>In 2001, the primary surplus was 3.9% of GDP, and nominal interest payments on the public debt were 2.4%. Therefore, the official surplus was 3.9%  2.4% = 1.5%. </li></ul><ul><li>Real interest payments were 1.7% of GDP. Therefore, the correct measure of the surplus was 3.9%  1.7% = 2.2%. </li></ul>
  32. 32. The U.S. Budget <ul><li>The budget has gone into deficit because: </li></ul><ul><ul><li>Tax cuts and slower U.S. economy, leading to lower tax revenues. </li></ul></ul><ul><ul><li>Increased government spending since September 11, 2001. </li></ul></ul><ul><li>Many economists believe that larger surpluses would be desirable. The U.S. private saving rate is 16.5% of GDP, or 4.5% below the average for OECD countries. Higher surpluses mean higher public saving. </li></ul>
  33. 33. Surpluses and the Aging of America <ul><li>Entitlement programs are programs that require the payments of benefits to all who meet the eligibility requirements established by the law. </li></ul>17.0 16.0 10.0 7.0 Total 2060 3.0 7.0 7.0 Source: “The Economic and Budget Outlook, Fiscal Years 1998-2060.” Congressional Budget Office, January 1999. Table 2-5. 2.0 3.0 5.0 2010 Medicaid Medicare Social Security Projected Spending on Social Security, Medicare, and Medicaid, 1998-2060 (Percent of GDP) Table 26-3 3.0 1.0 6.0 2.0 7.0 4.0 2040 1998
  34. 34. Surpluses and the Aging of America <ul><li>Entitlement spending to GDP is projected to increase for these reasons: </li></ul><ul><ul><li>The Aging of America: The old age dependency ratio—the ratio of the population 65 years old or more to the population between 20 and 64 years old—is projected to increase from about 20% in 1998 to above 40% in 2060. </li></ul></ul><ul><ul><li>The steadily increasing cost of health care. </li></ul></ul><ul><li>Even if all expenditures other than transfers were eliminated, projected entitlement spending would still exceed revenues. </li></ul>
  35. 35. Surpluses and the Aging of America <ul><li>Since 1983, Social Security contributions have exceeded benefits. The Social Security Trust Fund is an account where the surpluses have been accumulating, and was equal to 12% of GDP in 2001, before the US government budget moved into deficit. </li></ul>

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