L8 - Fiscal Policy: Government Debt and Budget Deficits Flashcards
What is the Government budget Deficit?
Government Budget Deficit = Government Spending - Government Revenue
- The amount of new debt a government needs to finance its operations
- so a government will say each fiscal year if they are going to run at a deficit, this accumulates minus any repayments that are made in that period
What are some issues with calculating the budget deficit?
- Inflation
- Capital Assets
- Uncounted Liabilities
- The business cycle
Why is inflation an issue when calculating the budget deficit?
- With the basic calculation, it is calculated on nominal value as inflation hasnt been taken into account
- Correcting the deficit for inflation can make a huge difference, especially when inflation is high. –> means that its cheaper to repay so the real debt is cheaper
Why is Capital Assets an issue when calculating the budget deficit?
•Currently, deficit = change in debt
Better, capital budgeting:
- deficit = (change in debt) – (change in assets)
Example: Suppose the govt sells an office building and uses the proceeds to pay down the debt.
- under current system, deficit would fall
- under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets
Problem with capital budgeting: determining which government expenditures count as capital expenditures
Why is Uncounted Liabilities an issue when calculating the Government Budget Deficit?
•The current measure of the deficit omits important liabilities of the government:
- -future pension payments owed to current govt workers –> the government take an spend that money you loan them until they pay you back as in the form of your pension
- -future Social Security payments
- -contingent liabilities, such as covering federally insured deposits when banks fail
Why is the business cycle an issue when calculating the Government Budget Deficit?
• sometimes the deficit is influenced by other factors than assets and liabilities like the business cycle - in a recession income is low, people are paying less tax, profits are low so corporations are paying less tax so by that its the government is receiving less revenue and has to increase is purchases to stimulate the economy
The deficit varies over the business cycle due to automatic stabilizers (the income tax system).
•These are not measurement errors but do make it harder to judge fiscal policy stance.
- Example: Is an observed increase in the deficit due to a downturn or an expansionary shift in fiscal policy?
•Solution: cyclically adjusted budget deficit (full-employment deficit) based on estimates of what government spending and revenues would be if the economy were at the natural rates of output and unemployment.
Is government debt really a problem under the traditional view?
If we have an expansion in government expenditure, or reduce taxes –. increases the deficit
- Short run: C rises (paying less in taxes), spending rises, Y rises, and unemployment falls
- Long run:
- Y and u return to their natural rates
- closed economy: rise in r and fall in I
- open economy: rise in ε and fall in NX
- (or higher trade deficit)
- Very long run:
- taxes will rises again and to need to reduce debt will fall on future generations, also increase in consumption means that both public and private savings are falling –> higher taxes and lower national savings
- slower growth until the economy reaches a new steady state with lower income per capita
Is government debt really a problem under the Ricardian view?
- Due to David Ricardo (1820), advanced more recently by Robert Barro
- According to Ricardian equivalence, a debt-financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run
- basically ignore the traditional view
What is the logic behind Ricardian Equivalence?
•Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes,
- that is equal—in present value—to the tax cut. ( they know they are going have to pay it back eventually so they discount the future tax cut when spending now)
- The tax cut does not make consumers better off, so they do not increase consumption spending.
- Instead, they save the full tax cut in order to repay the future tax liability. –>
- as they expect higher taxes in the future, as under ricardo people spend based on lifetime income not current income (traditional view) so they increase savings now to compensate for higher taxes in the future –> smooth consumption over time
•Result: Private saving rises by the amount public saving falls, leaving national saving unchanged.
- deficits are not a problem as deficit in the public sector are often by deficits in the private sector
What are some Problems with Ricardian equivalence?
- Myopia: Not all consumers think so far ahead; some see the tax cut as a windfall.
- Borrowing constraints : Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut. –> current income determines current consumption so if people want to consume more and get a tax cut, they will simple spend the tax cut
- Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.
- this is not the case because people leave wills and inheritance for future generation, as they dont want the burden to fall on their children etc, (this was an extension by Robert Barro on the model)
What are some other perspectives on government debt?
Balanced Budget versus optimal Fiscal Policy
•Some politicians have proposed amending the U.S. Constitution to require a balanced federal government budget every year. –> however after looking at the Keynesian Cross, we can see that classical economist were so concerned with balancing the budget they couldnt see the arising problems of the Great Depression
Many economists reject this proposal (dont need such as strict system), arguing that the deficit should be used to:
- stabilize output and employment
- smooth taxes in the face of fluctuating income –> as high taxes decentives working so better to have tax smoothing
- redistribute income across generations, when appropriate –> not an issue for then future generation to repay the taxes as they are reaping the benefits of the prior tax cut
