The Nuts and Bolts of Fiscal Policy

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The Nuts and Bolts of Fiscal Policy
CHAPTER
14
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The Nuts and Bolts of Fiscal Policy

• A History of Fiscal Policy
• Accounting and Budgets
• The Government Budget Constraint
• Taxes
• Borrowing
• Printing Money
• Choosing a Method of Finance

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The Nuts and Bolts of Fiscal Policy

• Formulating and Making Fiscal Policy
• The Budget Process
• Discretionary and Mandatory Spending
• The Importance of Fiscal Regimes
• Social Security and the Long-Term Budget Problem

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History of Fiscal Policy

• As measured by expenditures, the U.S. government
  has increased its role in the economy since World
  War II.
• The increase in the size of the welfare state
  coincided with the fine-tuning objectives of
  Keynesian economists.
• Using fiscal policy to fine-tune became less
  popular in the 1970s.
• In the 1990s Congress passed laws to limit
  government spending.

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Government Spending Over the Past 70 Years
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Budget Deficits and Surpluses

• The budget balance is the difference between
  revenues and expenditures in a year.
• When the balance is negative, there is a budget
  deficit.
• When the balance is positive, there is a budget
  surplus.
• Government debt is the total accumulation of past
  deficits less the total accumulation of past
  surpluses.

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Government Deficit, Surplus, and Debt as a
Percent of GDP
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Accounting and Budgets

• The U.S. government budget is on a cash-flow
  basis, an accounting method that counts revenues
  when they are collected and expenditures when
  they are spent.
• The federal budget is a unified budget, a budget
  that includes all expenditures and revenues
  regardless of their source.
• The on-budget surplus does not count expenditures
  and revenues that are off-budget items
  established by legislation in earlier years.
• Total tax revenues minus all government outlays
  except interest payments is called the primary
  budget balance.

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Budget Balances, Billions of Dollars
1980 1985 1990 1995
2000 Unified Budget -72.7 -212.3 -221.2
-163.9 232.0 On-Budget -73.8
-221.7 -277.8 -226.3 84.0 Off-Budget
-1.1 9.4 56.6
62.4 149.0 Social Security -1.1
9.4 58.2 60.4 145.0 Postal
Service -1.6
2.0 4.0
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Real and Nominal Budget Deficits and Surpluses

• The surplus and debt, stated in nominal terms,
  must be adjusted for inflation to get a true
  measure of its impact.
• Real surplus nominal surplus
  (inflation x debt)
• The larger the inflation rate or the larger the
  debt, the larger the real surplus is relative to
  the nominal surplus.

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Real Deficits and Surpluses(billions of dollars)
1975 1980 1985 1990 1995
2000 Nominal deficit -53 -74 -212
-221 -164 176 or surplus Plus
inflation 54 86 66 142 115
113 x Total debt Government Debt 577 930
1946 3233 5001 5665 Inflation 9.4
9.3 3.4 4.4 2.3
2.0 Equals Real 1 12 -146 -79
-48 289 deficit or surplus
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The Government Budget Constraint

• The three sources of revenue for the government
  (G) are
• Taxes (T)
• Borrowing (B)
• Printing money (M)
• G ? T ?B ?M

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Financing of Government Spending
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Taxes

• On average the government funds 88 of its
  expenditures with tax revenues.
• Tax revenues vary over time because of
• changes in tax laws
• changes in total income earned in the economy
• changes in the distribution of income
• In 2000 and 2001, the government financed all its
  spending with tax revenues and had some left over
  to pay off past debt.

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Borrowing

• The governments use of borrowing to finance
  annual expenditures increased throughout the
  1970s and 1980s.
• In 1984, borrowing covered 25 of the
  governments spending.
• Since 1984, the government has reduced its annual
  borrowing.
• In 1998 the government started running surpluses
  and began to pay off the debt.

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Types of Government Securities

• Nonmarketable Securities
• Government bonds that are not traded in secondary
  markets
• Savings bonds, bonds held in accounts such as
  Social Security, and bonds issued to state and
  local governments
• Marketable Securities
• Bonds that the public can buy and sell in
  secondary markets
• Treasury bills, Treasury notes, and Treasury bonds

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Government Securities Outstanding, 2000, (in
billions)
Dollar Percent of Amount
Total Total Interest Bearing Public Debt
5,647 100 Marketable 3,233
57 T-bills 653 12
T-notes 1,829 32 T-bonds
644 11 Inflation-indexed notes
93 2 Federal financing
bank 15 0 Nonmarketable
2,414 43
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Who Holds the Governments Debt?
Total Outstanding Debt, 2000 5.8 trillion -
Debt held by Fed, Social Security, and
other government agencies -2.6
trillion Total Privately Held Debt
3.2 trillion Privately Held Debt
Dollar Amount of Total Depository
Institutions .23 trillion 7.3 U.S.
Savings Bond Holders .19 trillion
5.8 Pension Funds .43 trillion
13.5 Insurance Companies .14 trillion
4.4 Mutual Funds .34 trillion
11 State and Local Governments .26 trillion
8.1 Foreign and International 1.3
trillion 40 Other Investors .3
trillion 10
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Printing Money

• The revenue resulting from printing money is
  called seigniorage.
• The U.S. typically finances less than 1 percent
  of its spending with seigniorage.
• Printing large quantities of money eventually
  leads to inflation.
• Money creation is a major source of revenue for
  some less developed countries.

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Choosing a Method of Finance

• Tax Smoothing
• Maintaining a constant tax rate, rather than
  continually adjusting tax rates to finance
  spending needs
• Reducing the Incentive to Produce
• High tax rates discourage production and work and
  lower potential output
• Crowding Out Investment
• Government borrowing pushes interest rates up
• Political Considerations

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Are Deficits Bad and Surpluses Good?

• In judging whether a country has its fiscal
  affairs in order, economists usually look at the
  size of the deficit relative to GDP.
• Surpluses reduce the demand for funds, resulting
  in lower interest rates and increased investment.
• Most economists favor using the surpluses of the
  late 1990s and 2000s to pay down the debt because
  reversing tax cuts or spending increases are
  difficult if the economy slows.

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Automatic Stabilizers

• Automatic stabilizers are built in government
  spending or taxes when there are fluctuations in
  aggregate income.
• They require no new legislative action and avoid
  the legislative lag.
• When the economy slows, spending on unemployment
  insurance, welfare, and food stamps automatically
  rises, helping to reverse the recession.
• When the economy booms, they work in the opposite
  direction.

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Types of Spending

• Discretionary spending expenditures are
  determined in the annual appropriation process
  and account for one-third of total federal
  government spending.
• Mandatory spending expenditures are authorized by
  permanent laws, such as Social Security and
  Medicare.

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Time Line for Budget Process
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The Congressional Budget Timetable
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Changing the Budget Process to Reduce Budget
Deficits

• The Budget Enforcement Act of 1990 capped
  discretionary spending and established the paygo
  rule for mandatory programs.
• The paygo rule makes Congress fund new spending
  with tax increases or other spending decreases.
• The spending caps and paygo rules were extended
  until 2002 by the Budget Reconciliation Act of
  1998.

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Fiscal Policy Regime

• The fiscal policy regime are the general rules
  that determine the direction of fiscal policy and
  set the framework within which the economy will
  operate.
• In the late 1990s the fiscal policy regime was to
  lower the deficit.
• People expected less government spending,
  interest rates fell, private investment
  increased, and productivity rose.

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Rhetorical Tools Used by Politicians to Discuss
Fiscal Policy

• Talk about levels, not percentages.
• Front load spending, back load taxes.
• Take credit for anything good. Assign blame for
  anything bad.
• Use forecasts that make your policies look good.
• Emphasize the positive aspects of data.

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Social Security

• Social Security is a fiscal issue because it is a
  partially unfunded retirement system.
• In an unfunded retirement system some current
  expenditures come out of current revenue because
  the trust fund is insufficient to cover future
  benefits.
• In a funded retirement system, all current
  payments go into a trust fund from which future
  benefits are paid.

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The Social Security Financial Problem

• When Social Security was founded in 1935, there
  were about 30 workers for each retiree.
• Because of longer life expectancy and the baby
  boom, the number of workers per beneficiary is
  falling and will be below 2 by 2020.
• By 2015, revenues will be less than payments and
  the fund will shrink until it is exhausted in
  2034.

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Workers per Beneficiary
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Aging Populations Around the World
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The Real Problem - A Gap
Potential output after baby-boomers retire
Potential output before baby-boomers retire
AS0
Price Level
1. Potential output shifts to the left..
P0
2. Creating a gap between the quantity of
aggregate supply and quantity of aggregate demand.
AD
Gap
Real output, Income
Y0
Y1
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Social Security Solutions

• Cut benefits
• Increase taxes on workers
• Immigration
• Productivity increases faster than wages