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Fiscal Policy

Fiscal Policy. The Government Budget Constraint. The Arithmetic of Deficits and Debt The budget deficit in year t equals:. is the government debt at the end of year t -1. is government spending during year t. is taxes minus transfers during year t. change in the debt.

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Fiscal Policy

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  1. Fiscal Policy

  2. The Government Budget Constraint • The Arithmetic of Deficits and Debt • The budget deficit in year t equals: is the government debt at the end of year t-1. is government spending during year t. is taxes minus transfers during year t.

  3. change in the debt interest payments primary deficit The Government Budget Constraint • The change in government debt during year t is equal to the deficit during year t: • Debt at the end of year t equals:

  4. U.S. Fiscal Deficits

  5. Financing the Deficit

  6. Full Repayment in Year 2 Tax Cuts, Debt Repayment, and Debt Stabilization

  7. Debt Stabilization in Year 2 Tax Cuts, Debt Repayment, and Debt Stabilization

  8. Conclusions • An increase in the deficit today must eventually be offset by a decrease in the deficit in the future (by increasing T or decreasing G). • The longer the government waits or the higher the real interest rate, the higher the eventual increase in taxes. • The legacy of deficits is higher government debt. • To stabilize the debt, the government must run a surplus equal to the interest payments on the existing debt. • To eliminate the debt, the government must run a surplus equal to the interest payments on the existing debt plus repayment of the stock of debt.

  9. The Evolution of the Debt to GDP Ratio • If GDP grows (g increases), the ratio of debt to GDP will grow more slowly (at a rate equal to rg).

  10. U.S. National Debt as % of GDP

  11. The Evolution of the Debt-to-GDP Ratioin OECD Countries • In the 1960s, GDP growth was strong. As a result, rg was negative. OECD Countries were able to decrease their debt ratios. • In the 1970s, rg was again negative due to very low interest rates, leading to a further decrease in the debt ratio.

  12. The Evolution of the Debt-to-GDP Ratioin OECD Countries • In the 1980s, real interest rates increased and growth rates decreased, thus, debt ratios increased rapidly. • 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.

  13. Public Debt (% of GDP)

  14. Taxes

  15. Sources of Tax Revenue in the United States(2004)

  16. Government Spending in the United States(2004)

  17. Foreign Aid from the Rich Countries

  18. Issues in Fiscal Policy • Tax distortions • The danger of high debts

  19. Reducing Tax Distortions • Very high tax rates can lead to high economic distortions. People might work less, and engage in illegal, untaxed activities. • Inflation (seigniorage) also distorts prices and therefore incentives. • Tax smoothing is the idea that it is better to maintain a relatively constant tax rate.

  20. The Dangers of Very High Debt • The higher the ratio of debt to GDP, the larger the potential for catastrophic debt dynamics. • 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.

  21. Public Debt

  22. Surpluses and Aging • Entitlement programs are programs that require the payments of benefits to all who meet the eligibility requirements established by the law.

  23. Surpluses and Aging • Entitlement spending to GDP is projected to increase for these reasons: • Aging • The steadily increasing cost of health care. • Projected entitlement spending would eventually exceed revenues.

  24. Surpluses and Aging • Since 1983, Social Security contributions have exceeded benefits. The Social Security Trust Fund is an account where the surpluses have been accumulating, and now equal 12% of GDP. • The Social Security Trust Fund is expected to reach 20% of GDP in 2020, then to decline and be equal to zero by 2030.

  25. Aging in a Comparative Perspective

  26. Possible Solutions to the Medicare Problem • Cut benefits • Increase taxes on workers • Immigration • Dramatic health care reform • Retirement Accounts • Fully-funded vs. pay-as-you-go schemes • Privatization All of these are controversial!

  27. Fiscal Policy in the short-, medium- and long-run • In the short run: fiscal policy and the IS-LM model (open or closed) – moving the IS curve. • In the medium run: how will different fiscal policies affect employment and the price level. • In the long run: how will fiscal policy affect the investment rate (capital accumulation) and the rate of technological progress: • private and public savings • incentives for R & D.

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