Copy of AP Macro 27 fiscal policy, deficits, and debt

Fiscal Policy and the AD-AS Model

  • Fiscal policies are discretionary or active
  • Changes in taxes and government spending designed to affect the level of aggregate demand in the economy are called fiscal policy

Expansionary fiscal policy

  • consists of government spending increases, tax reductions, or both, designed to increase aggregate demand and therefore raise real GDP
  • Used in a recession
    • Ex. sharp decline in investment spending
    • The cause of the recession may be that profit expectations on investment projects have dimmed, curtailing investment spending and reducing aggregate demand.
  • If prices are inflexible downward at P1, there is a negative GDP gap of $20b
  • An increase in unemployment accompanies this negative GDP gap because fewer workers are needed to produce the reduced output.
  • the economy depicted is suffering both recession and cyclical unemployment.
  • If the federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit —government spending in excess of tax revenues.

Increased Government Spending

  • Other things equal, a sufficient increase in government spending will shift an economy’s aggregate demand curve to the right, from AD2 to AD1
  • represent a $5 billion increase of government spending as the horizontal distance between AD and the dashed downsloping line immediately to its right.
  • At each price level, the amount of real output that is demanded is now $5 billion greater than that demanded before the expansion of government spending.
  • Through the multiplier effect, the aggregate demand curve shifts to AD1 by the multiplier (4) * the $5 increase in gov spending
  • unemployment falls as firms increase their employment to the full-employment level that existed before the recession.

Tax Reductions

  • a tax cut must be somewhat larger than the proposed increase in government spending if it is to achieve the same amount of rightward shift in the aggregate demand curve because part of a tax reduction increases saving, rather than consumption
  • With an MPC of 0.75, taxes must fall by $6.67 billion for $5 billion of new consumption to be forthcoming because $1.67 billion is saved (not consumed).
    • Necessary change in consumption/MPC=the amount taxes must change
    • This $5 is then subject to spending multiplier
  • The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption and a specific shift in the aggregate demand curve.

Combined Government Spending Increases and Tax Reductions

  • the government might increase its spending by $1.25 billion while reducing taxes by $5 billion. As an exercise, you should explain why this combination will produce the targeted $5 billion initial increase in new spending.
    • $20 negative GDP gap
    • MPC = 0.75, MPS = 0.25
    • Spending multiplier = 4
    • Tax multiplier = -3
    • 5*0.75=$3.75(bil) increase in consumption caused by tax cut
    • $1.25 increase in gov spending + $3.75 increase in consumption from tax cut = $5
    • 1.25*4=$5 (bil) increase in GDP caused by government spending
    • -5*-3=$15 (bil) increase in GDP caused by tax cut
  • recall from the appendix to Chapter 26 that rightward shifts of the aggregate demand curve relate directly to upward shifts of the aggregate expenditures schedule.

Contractionary Fiscal Policy

  • When demand-pull inflation occurs, a restrictive or contractionary fiscal policy may help control it.
  • consists of government spending reductions, tax increases, or both, designed to decrease aggregate demand and therefore lower or eliminate inflation
  • The economy starts at equilibrium at point a
  • Suppose that after going through the multiplier process, a $5 billion initial increase in investment and net export spending shifts the aggregate demand curve to the right by $20 billion, from AD3 to AD4.
  • Given the upsloping AS curve, however, the equilibrium GDP does not rise by the full $20 billion. It only rises by $12 billion, to $522 billion, thereby creating an inflationary GDP gap of $12 billion
  • The upslope of the AS curve means that some of the rightward movement of the AD curve ends up causing demand-pull inflation rather than increased output. As a result, the price level rises from P1 to P2 and the equilibrium moves to point b.
  • Without a government response, the inflationary GDP gap will cause further inflation (as input prices rise in the long run to meet the increase in output prices)
  • When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus —tax revenues in excess of government spending.
  • Ratchet effect
    • While increases in aggregate demand that expand real output beyond the full-employment level tend to ratchet the price level upward, declines in aggregate demand do not seem to push the price level downward.
    • This means that stopping inflation is a matter of halting the rise of the price level, not trying to lower it to the previous level.
    • It also means that the government must take the ratchet effect into account when deciding how big a cut in spending or an increase in taxes it should undertake.

Decreased Government Spending

  • what would happen if the government ignored the ratchet effect and attempted to design a spending-reduction policy to eliminate the inflationary GDP gap.
    • Since the $12 billion gap was caused by the $20 billion rightward movement of the aggregate demand curve from AD3 to AD4, the government might naively think that it could solve the problem by causing a $20 billion leftward shift of the aggregate demand curve to move it back to where it originally was
    • ratchet effect implies that the price level is stuck at P2
    • when the government reduces spending by $5 billion to shift the aggregate demand curve back to AD , it will actually cause a recession!
    • new equilibrium will not be at point a. It will be at point d, where real GDP is only $502 billion, $8 billion below the full employment level of $510 billion
    • With the price level downwardly inflexible at P2, the $20 billion leftward shift of the aggregate demand curve causes a full $20 billion decline in real/equilibrium GDP.
    • government has overdone the decrease in government spending, replacing a $12 billion inflationary GDP gap with an $8 billion recessionary GDP gap
  • How to avoid
    • First, the government takes account of the size of the inflationary GDP gap. It is $12 billion. Second, it knows that with the price level fixed, the multiplier will be in full effect. Thus, it knows that any decline in government spending will be multiplied by a factor of 4.
    • Decline spending by $3bil, not $5bil
    • it need not undo the full increase in aggregate demand that caused the inflation in the first place.
  • horizontal distance between AD4 and the dashed downsloping line to its left represents the $3 billion decrease in government spending. Once the multiplier process is complete, this spending cut will shift the aggregate demand curve leftward from AD4 to AD5 . With the price level fixed at P2, the economy will come to equilibrium at point c. The economy will operate at its potential output of $510 billion, and the inflationary GDP gap will be eliminated.

Increased Taxes

  • If MPC=0.75, the government must raise taxes by $4 billion to achieve its fiscal policy objective.
  • Reduces consumption by $3bil
  • After the multiplier process is complete, this initial $3 billion decline in consumption will cause aggregate demand to shift leftward by $12 billion at each price level (multiplier of 4 × $3 billion).
  • With the economy moving to point c, the inflationary GDP gap will be closed and the inflation will be halted.

Combined Government Spending Decreases and Tax Increases

  • determine why a $1.5 billion decline in government spending combined with a $2 billion increase in taxes would shift the aggregate demand curve from AD to AD .
  • explain the three fiscal policy options for fighting inflation by referring to the inflationary-expenditure gap concept developed with the aggregate expenditures model (Figure 25.7 ).
  • recall from the appendix to Chapter 26 that leftward shifts of the aggregate demand curve are associated with downshifts of the aggregate expenditures schedule.

Policy Options: G or T?

  • Economists who believe there are many unmet social and infrastructure needs usually recommend that government spending be increased during recessions. In times of demand-pull inflation, they usually recommend tax increases. Both actions either expand or preserve the size of government.
  • Economists who think that the government is too large and inefficient usually advocate tax cuts during recessions and cuts in government spending during times of demand-pull inflation. Both actions either restrain the growth of government or reduce its size.
  • The point is that discretionary fiscal policy designed to stabilize the economy can be associated with either an expanding government or a contracting government.

Built-In Stability

  • automatic response, or built-in stability, constitutes nondiscretionary (or “passive” or “automatic”) budgetary policy and results from the makeup of most tax systems.
  • we implicitly assumed that the same amount of tax revenue was being collected at each level of GDP. But the actual U.S. tax system is such that net tax revenues vary directly with GDP.
  • Net taxes are tax revenues less transfers and subsidies. From here on, we will use the simpler “taxes” to mean “net taxes.”

Automatic or Built-In Stabilizers

  • A built-in stabilizer is anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers
  • Government expenditures G are fixed and assumed to be independent of the level of GDP. Congress decides on a particular level of spending, but it does not determine the magnitude of tax revenues. Instead, it establishes tax rates, and the tax revenues then vary directly with the level of GDP that the economy achieves.
  • Line T represents that direct relationship between tax revenues and GDP

Economic Importance

  • tax revenues automatically increase as GDP rises during prosperity, and since taxes reduce household and business spending, they restrain the economic expansion. That is, as the economy moves toward a higher GDP, tax revenues automatically rise and move the budget from deficit toward surplus.
  • the high and perhaps inflationary income level GDP3 automatically generates a contractionary budget surplus.
  • as GDP falls during recession, tax revenues automatically decline, increasing spending by households and businesses and thus cushioning the economic contraction. With a falling GDP, tax receipts decline and move the government’s budget from surplus toward deficit.
  • the low level of income GDP1 will automatically yield an expansionary budget deficit.

Tax Progressivity

  • The size of the automatic budget deficits or surpluses—and therefore built-in stability—depends on the responsiveness of tax revenues to changes in GDP (slope of T).
  • If tax revenues change sharply as GDP changes, the slope of line T in the figure will be steep. If tax revenues change very little when GDP changes, the slope will be gentle and built-in stability will be low.
  • steepness of T in Figure 27.3 depends on the tax system itself
    • In a progressive tax system (steepest tax line T), the average tax rate (= tax revenue/GDP) rises with GDP. In a proportional tax system , the average tax rate remains constant as GDP rises. In a regressive tax system , the average tax rate falls as GDP rises
    • tax revenues will rise with GDP under both the progressive and the proportional tax systems, and they may rise, fall, or stay the same under a regressive tax system.
    • The more progressive the tax system, the greater the economy’s built-in stability
  • built-in stability provided by the U.S. tax system has reduced the severity of business fluctuations, perhaps by as much as 8 to 10 percent of the change in GDP that otherwise would have occurred
  • In recession-year 2009, for example, revenues from the individual income tax fell by a staggering 22 percent. This decline helped keep household spending and real GDP from falling even more than they did.
  • built-in stabilizers can only dampen, not counteract, swings in real FIGURE 27.3 Built-in stability. Discretionary fiscal policy (changes in tax rates and expenditures) or monetary policy (central bank–caused changes in interest rates) therefore may be needed to try to counter a recession or inflation of any appreciable magnitude.

Evaluating How Expansionary or Contractionary Fiscal Policy Is Determined

  • How can we determine whether a government’s discretionary fiscal policy is expansionary, neutral, or contractionary?
  • We cannot simply examine the actual budget deficits or surpluses that take place under the current policy because they will necessarily include the automatic changes in tax revenues that accompany every change in GDP
  • in evaluating the status of fiscal policy, we must adjust deficits and surpluses to eliminate automatic changes in tax revenues and also compare the sizes of the adjusted budget deficits and surpluses to the level of potential GDP.

Cyclically Adjusted Budget

  • measures what the federal budget deficit or surplus would have been under existing tax rates and government spending levels if the economy had achieved its full-employment level of GDP (its potential output)
  • In full employment year 1, government expenditures of $500 billion equal tax revenues of $500 billion, as indicated by the intersection of lines G and T at point a
  • cyclically adjusted budget deficit in year 1 is zero—government expenditures equal the tax revenues forthcoming at the full-employment output GDP1
  • cyclically adjusted deficit as a percentage of potential GDP is also zero. The government’s fiscal policy is neutral.
  • suppose that a recession occurs and GDP falls from GDP1 to GDP2,
  • A $50 billion budget deficit (represented by distance bc) arises; tax revenues fall to 450 and gov spending is still 500
    • Caused by the recession, not discretionary fiscal actions
    • Fiscal policy is still neutral
  • Because both b and a represent $500 billion, the cyclically adjusted budget deficit in year 2 is zero, as is this deficit as a percentage of potential GDP. Since the cyclically adjusted deficits are zero in both years, we know that government did not change its discretionary fiscal policy, even though a recession occurred and an actual deficit of $50 billion resulted.
  • Figure b
    • real output declined from full-employment GDP3 in year 3 to GDP4 in year 4
    • government responded to the recession by reducing tax rates in year 4, as represented by the downward shift of the tax line from T1 to T2.
    • compare position e on line G with position h on line T2. The $25 billion of tax revenues by which e exceeds h is the cyclically adjusted budget deficit for year 4. As a percentage of potential GDP, the cyclically adjusted budget deficit has increased from zero in year 3 (before the tax-rate cut) to some positive percent [= ($25 billion/GDP3) × 100] in year 4.
    • cyclically adjusted budget deficit/potential GDP
    • This increase in the relative size of the full-employment deficit between the two years reveals that the new fiscal policy is expansionary.

Recent and Projected U.S. Fiscal Policy

  • adjusted deficits are generally smaller than the actual deficits. This is because the actual deficits include cyclical deficits, whereas the cyclically adjusted deficits eliminate them.
  • Only cyclically adjusted surpluses and deficits as percentages of potential GDP (column 3) provide the information needed to assess discretionary fiscal policy and determine whether it is expansionary, contractionary, or neutral
  • Annual actual (not cyclically adjusted) budget deficits are also in percentages of GDP

Fiscal Policy from 2000 to 2007

  • 2000
    • fiscal policy was contractionary that year (cyclically adjusted surplus)
    • Because the economy was fully employed and corporate profits were strong, tax revenues poured into the federal government and exceeded government expenditures.
    • not all was well in 2000. Specifically, the so-called dot-com stock market bubble burst that year
  • 2001
    • the economy slid into a recession. Congress and the Bush administration responded by cutting taxes by $44b in 2001 scheduling an additional $52 billion of cuts for 2002
    • These stimulus policies helped boost the economy and offset the recession as well as cushion the economic blow delivered by the September 11, 2001, terrorist attacks
  • 2002
    • Congress passed further tax cuts totaling $122 billion over two years and extended unemployment benefits.
    • Fiscal policy had definitely turned expansionary. Nevertheless, the economy remained sluggish through 2002 and into 2003.
  • 2003
    • Congress again cut taxes, this time by a much larger $350 billion over several years. Specifically, the tax legislation accelerated the reduction of marginal tax rates already scheduled for future years and slashed tax rates on income from dividends and capital gains. It also increased tax breaks for families and small businesses.
    • economy strengthened and both real output and employment grew between 2003 and 2007
  • 2007
    • full employment had been restored, although a −1.3 percent cyclically adjusted budget deficit still remained

Fiscal Policy during and after the Great Recession

  • 2007
    • a crisis in the market for mortgage loans flared up. Later in 2007, that crisis spread rapidly to other financial markets
    • As credit markets began to freeze, general pessimism spread beyond the financial markets to the overall economy.
    • Businesses and households retrenched on their borrowing and spending, and in December 2007, the economy entered the great recession
  • 2008
    • Congress acted rapidly to pass an economic stimulus package. This law provided a total of $152 billion in stimulus, with some of it coming as tax breaks for businesses, but most of it delivered as checks of up to $600 each to taxpayers, veterans, and Social Security recipients.
    • increase in the cyclically adjusted budget reveals that fiscal policy in 2008 was expansionary
    • the government hoped that those receiving checks would spend the money and thus boost consumption and aggregate demand. But households instead saved substantial parts of the money from the checks or used some of the money to pay down credit card loans
  • 2009
    • Obama administration and Congress enacted the American Recovery and Reinvestment Act of 2009
    • gigantic $787 billion program—coming on top of a $700 billion rescue package for financial institutions—consisted of low- and middle-income tax rebates, plus large increases in expenditures on infrastructure, education, and health care.
    • The idea was to flood the economy with additional spending to try to boost aggregate demand and get people back to work.
    • Rather than sending out lump-sum stimulus checks as in 2008, the new tax rebates showed up as small increases in workers’ monthly payroll checks
    • With smaller amounts per month rather than a single large check, the government hoped that people would spend the bulk of their enhanced income—rather than save it as they had done with the one-time-only, lump-sum checks received in 2008
    • Recession officially ended in the summer but economy didn’t rebound fast
    • Unemployment remained elevated and tax collections were low due to a stagnant economy. As a result, policymakers decided to continue with large amounts of fiscal stimulus
    • while the intensity of fiscal stimulus was gradually diminishing, it remained substantially stimulatory

Past and Projected Budget Deficits and Surpluses

  • In recession year 2009, the federal budget deficit reached $1,413 billion, mainly but not totally due to reduced tax revenues from lower income and record amounts of stimulus spending. The CBO projects high deficits for several years to come.
  • But projected deficits and surpluses are subject to large and frequent changes, as government alters its fiscal policy and GDP growth accelerates or slows.
  • The budget surpluses of 1998 through 2001 were the first budget surpluses since 1969. Deficits reemerged after the 2001 recession and then ballooned massively with the Great Recession of 2007–2009. Deficits are projected to remain high for many years to come, though not nearly as high as in the years immediately following the Great Recession. Source: Congressional Budget Office, www.cbo.gov

Problems, Criticisms, and Complications of Implementing Fiscal Policy

Problems of Timing

  • Recognition lag
    • the time between the beginning of recession or inflation and the certain awareness that it is actually happening
    • economy does not move smoothly through the business cycle
    • Several slow months will have to happen in succession before people can conclude with any confidence that the good times are over and a recession has begun.
    • several high-inflation months must come in sequence before people can confidently conclude that inflation has moved to a higher level.
    • the economy is often 4 to 6 months into a recession or inflation before the situation is clearly discernible in the relevant statistics.
    • Due to this recognition lag, the economic downslide or the inflation may become more serious than it would have if the situation had been identified and acted on sooner.
  • Administrative lag
    • lag between the time the need for fiscal action is recognized and the time action is taken
    • Following the terrorist attacks of September 11, 2001, the U.S. Congress was stalemated for 5 months before passing a compromise economic stimulus law in March 2002.
    • (In contrast, the Federal Reserve began lowering interest rates the week after the attacks.)
  • Operational lag
    • lag between the time fiscal action is taken and the time that action affects output, employment, or the price level.
    • changes in tax rates can be put into effect relatively quickly once new laws are passed
    • But government spending on public works—new dams, interstate highways, and so on—requires long planning periods and even longer periods of construction
    • Not ideal for offsetting short (6-12 months) periods of recession
    • Consequently, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool

Political Considerations

  • Politicians want a strong economy at election time so they get reelected
    • They may favor large tax cuts under the guise of expansionary fiscal policy even though that policy is economically inappropriate.
    • They may rationalize increased government spending on popular items such as farm subsidies, health care, highways, education, and homeland security.
  • And then after the election, they may try to use contractionary fiscal policy to dampen the excessive aggregate demand that they caused with their pre election stimulus
  • elected officials may cause so-called political business cycles
    • swings in overall economic activity and real GDP resulting from election-motivated fiscal policy, rather than from inherent instability in the private sector
    • difficult to document and prove, but there is little doubt that political considerations weigh heavily in the formulation of fiscal policy

Future Policy Reversals

  • Fiscal policy may fail to achieve its intended objectives if households expect future reversals of policy
  • If taxpayers believe a tax reduction is temporary, they may save a large portion of their tax cut now to maintain their future consumption levels
    • Not increasing present consumption and AD as much as simple model suggests
  • If taxpayers think a tax increase is temporary, they may reduce their saving to pay the tax while maintaining their present consumption
    • not reduce current consumption and AD as much as policy makers intended
  • tax-rate changes that households view as permanent are more likely to alter consumption and aggregate demand than tax changes they view as temporary.

Offsetting State and Local Finance

  • fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation
  • Unlike the federal government, most state and local governments face constitutional or other legal requirements to balance their budgets.
  • Like households and private businesses, state and local governments increase their expenditures during prosperity and cut them during recession.
  • During the Great Depression of the 1930s, most of the increase in federal spending was offset by decreases in state and local spending
  • During and immediately following the recession of 2001, many state and local governments had to offset the decline in tax revenues from citizens by raising tax rates, imposing new taxes, and reducing spending.
  • Therefore, the $787 billion fiscal package of 2009 made a special effort to reduce this problem by giving substantial aid dollars to state governments
    • the states did not have to increase taxes and reduce expenditure by as much as otherwise

Crowding-Out Effect

  • An expansionary fiscal policy (deficit spending) may increase the interest rate and reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy.
  • The rising interest rate might also potentially crowd out interest-sensitive consumption spending (such as purchasing automobiles on credit), but the crowding out effect focuses on investment.
  • whenever the government borrows money (as it must if it is deficit spending), it increases the overall demand for money
    • If the monetary authorities are holding the money supply constant, this increase in demand will raise the price paid for borrowing money: the interest rate.
  • crowding out is likely to be less of a problem when the economy is in recession because investment demand tends to be weak
    • Because output purchases slow during recessions, most businesses end up with substantial excess capacity and less incentive add capacity
    • Even if deficit spending does increase the interest rate, the effect on investment may be fully offset by the improved investment prospects that businesses expect from the fiscal stimulus.
  • when the economy is operating at or near full capacity, investment demand is likely to be quite strong so that crowding out will probably be a much more serious problem
    • factories will be running at or near full capacity and firms will have high investment demand because:
    • First, equipment running at full capacity wears out fast, so firms will be investing substantial amounts just to replace machinery and equipment that wears out and depreciates.
    • Second, the economy is likely to be growing overall so that firms will be heavily investing to add to their production capacity to take advantage of the greater anticipated demand for their outputs.

Current Thinking on Fiscal Policy

  • some economists argue that it is better not to engage in fiscal policy at all.
    • Believe in superiority of monetary policy (changes in interest rates engineered by the Federal Reserve) as a stabilizing device or believe that most economic fluctuations tend to be mild and self-correcting.
  • But the current popular view is that fiscal policy can help push the economy in a particular direction but cannot fine-tune it to a precise macroeconomic outcome
  • Mainstream economists generally agree that monetary policy is the best month-to-month stabilization tool for the U.S. economy
    • If monetary policy is doing its job, the government should maintain a relatively neutral fiscal policy, with a cyclically adjusted budget deficit or surplus of no more than 2 percent of potential GDP.
    • Use major discretionary fiscal policy if recession threatens to be deep and long lasting, as in 2008 and 2009, or where a substantial reduction in aggregate demand might help the Federal Reserve to quell a major bout of inflation
  • economists agree that any proposed fiscal policy should be evaluated for its potential positive and negative impacts on long-run productivity growth
    • Countercyclical fiscal policy should be shaped to strengthen, or at least not impede, the growth of long run aggregate supply
    • a tax cut might be structured to enhance work effort, strengthen investment, and encourage innovation.
    • an increase in government spending might center on preplanned projects for public capital (highways, mass transit, ports, airports) which complement private investment

The U.S. Public Debt

  • U.S. national debt, or public debt , is essentially the accumulation of all past federal deficits and surpluses
  • In 2015, the total public debt was $18.2 trillion—$10.7 trillion held by the public, excluding the Federal Reserve; and $7.5 trillion held by federal agencies and the Federal Reserve. Between 2007 and 2009, the total public debt expanded by a huge $2.9 trillion.
  • U.S. Treasury defines “the public” to include the Federal Reserve. But because the Federal Reserve is the nation’s central bank, economists view it as essentially part of the federal government and not part of the public.

Ownership

  • The total public debt represents the total amount of money owed by the federal government to the holders of U.S. government securities
    • financial instruments issued by the federal government to borrow money to finance expenditures that exceed tax revenues.
  • U.S. government securities (loan instruments) are of four types:
    • Treasury bills (short-term securities), Treasury notes (medium-term securities), Treasury bonds (long-term securities), and U.S. savings bonds (long-term, nonmarketable bonds).
    • Bills
    • Notes
    • Bonds
    • Savings bonds
    • BiNBoS
  • The federal agencies hold U.S. government securities as risk-free assets that they can cash in as needed to make future payments.
  • “the public” in the pie chart consists of individuals here and abroad, state and local governments, and U.S. financial institutions.
  • Foreigners held about 34 percent of the total U.S. public debt in 2015, meaning that most of the U.S. public debt is held internally and not externally
  • Of the $6.1 trillion of debt held by foreigners, China held 20 percent, Japan held 18 percent, Page 556 and oil-exporting nations held 5 percent.

Debt and GDP

  • A wealthy, highly productive nation can incur and carry a large public debt much more easily than a poor nation can.
  • Federal debt held by the public, excluding the Federal Reserve, as a percentage of GDP is more meaningful
  • the percentage rose dramatically starting in 2008 because of massive annual budget deficits.

International Comparisons

  • the public debt as a percentage of real GDP in the United States is neither particularly high nor low relative to such debt percentages in other advanced industrial nations.

Interest Charges

  • The primary burden of the debt is the annual interest charge accruing on the bonds sold to finance the debt.
  • In 2015 interest on the total public debt was $400 billion. Although this amount is sizable in absolute terms, it was only 2.2 percent of GDP for 2015. So, the federal government had to collect taxes equal to 2.2 percent of GDP to service the total public debt.
  • This percentage was unchanged from 2000 despite the much higher total public debt because of the low interest rates kept by the Federal Reserve to help end the great recession

False Concerns

Bankruptcy

  • refinancing and taxation are why the federal government can’t go bankrupt from the public debt

Refinancing

  • As long as the U.S. public debt is viewed by lenders as manageable and sustainable, the public debt is easily refinanced
  • As portions of the debt come due on maturing Treasury bills, notes, and bonds each month, the government does not cut expenditures or raise taxes to provide the funds required.
    • it refinances the debt by selling new bonds and using the proceeds to pay holders of the maturing bonds.
    • new bonds are in strong demand because lenders can obtain a market-determined interest return with no risk of default by the federal government.
  • refinancing could become an issue with a high enough debt-to-GDP ratio (Greece)
    • High and rising ratios in the United States might raise fears that the U.S. government might be unable to pay back loans as they come due.
    • with the present U.S. debt-to-GDP ratio and the prospects of long-term economic growth, this is a false concern for the United States.

Taxation

  • A tax increase (imposing new taxes or increasing existing tax rates) is a government option for gaining sufficient revenue to pay interest and principal on the public debt.
  • Such tax hikes may be politically unpopular and may weaken incentives to work and invest
  • private households and corporations cannot tax the public so they can go bankrupt

Burdening Future Generations

  • In 2015 public debt per capita was $56,368
  • The United States owes a substantial portion of the public debt to itself (US citizens and institutions).
    • Although that part of the public debt is a liability to Americans (as taxpayers), it is simultaneously an asset to Americans (as holders of Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds).
  • To eliminate the American-owned part of the public debt would require a gigantic transfer payment from Americans to Americans.
    • Taxpayers would pay higher taxes, and holders of the debt would receive an equal amount for their U.S. government securities.
    • Purchasing power in the United States would not change. Only the repayment of the 34 percent of the public debt owned by foreigners would negatively impact U.S. purchasing power.
  • The economic cost of the Second World War consisted of the civilian goods society had to forgo in shifting scarce resources to war goods production (recall production possibilities analysis). the decision to finance military purchases through the sale of government bonds did not shift the economic burden of the war to future generations.
  • The next generation inherited the debt from the war but also an equal amount of government bonds that would pay them cash in future years. It also inherited the enormous benefits from the victory.

Substantive Issues (valid concerns for public debt)

Income Distribution

  • The distribution of ownership of government securities is highly uneven.
  • In general, the ownership of the public debt is concentrated among wealthier groups, who own a large percentage of all stocks and bonds.
  • Because the overall federal tax system is only slightly progressive, payment of interest on the public debt mildly increases income inequality.
    • Income is transferred from people who, on average, have lower incomes to the higher-income bondholders.

Incentives

  • The current public debt necessitates annual interest payments of $400 billion.
  • With no increase in the size of the debt, that interest charge must be paid out of tax revenues. Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work.
  • a large public debt may indirectly impair economic growth and therefore impose a burden of reduced output (and income) on future generations.

Foreign-Owned Public Debt

  • The 34 percent of the U.S. debt held by citizens and institutions of foreign countries is an economic burden to Americans
  • In return for the benefits derived from the borrowed funds, the United States transfers goods and services to foreign lenders.
  • Of course, Americans also own debt issued by foreign governments, so payment of principal and interest by those governments transfers some of their goods and services to Americans.

Crowding-Out Effect Revisited

  • A potentially more serious problem is the financing (and continual refinancing) of the large public debt, which can transfer a real economic burden to future generations by passing on to them a smaller stock of capital goods
  • crowding-out effect: the idea that public borrowing drives up real interest rates, which reduces private investment spending
  • the need to continuously finance a large public debt may be more troublesome. At times, that financing requires borrowing large amounts of money when the economy is near or at its full-employment output (not at recession when it’s a smaller problem).
    • Because this usually is when private demand is strong, any increase in interest rates caused by the borrowing necessary to refinance the debt may result in a substantial decline in investment spending.
    • If the amount of current investment crowded out is extensive, future generations will inherit an economy with a smaller production capacity and, other things equal, a lower standard of living.

A Graphical Look at Crowding Out

  • Let’s first consider curve ID1
    • Suppose that government borrowing increases the real interest rate from 6 percent to 10 percent. Investment spending will then fall from $25 billion to $15 billion, as shown by the economy’s move from a to b.
    • the financing of the debt will compete with the financing of private investment projects and crowd out $10 billion of private investment.
    • the stock of private capital handed down to future generations will be $10 billion less than it would have been without the need to finance the public debt.

Public Investments and Public-Private Complementarities

  • two factors could partly or fully offset the net economic burden shifted to future generations

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    1. Part of the government spending enabled by the public debt is for public investment outlays and “human capital”
    • Like private expenditures on machinery and equipment, those public investments increase the economy’s future production capacity
    • That greater stock of public capital may offset the diminished stock of private capital resulting from the crowding-out effect, leaving overall production capacity unimpaired.

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    1. public-private complementarities: Some public and private investments are complementary
    • the public investment financed through debt could spur some private-sector investment by increasing its expected rate of return.
    • For example, a federal building in a city may encourage private investment in the form of nearby office buildings, shops, and restaurants.
    • Through its complementary effect, the spending on public capital may shift the private investment demand curve to the right, as from ID1 to ID2
    • In the case shown as the move from a to c in Figure 27.8 , investment remains at $25 billion even though interest rate increases from 6 to 10 %

  • an increase in investment demand may counter the decline in investment that would otherwise result from the higher interest rate.