Answers to Textbook Questions and Problems CHAPTER 19 Government Debt and Budget Deficits Questions for Review 1. What is unusual about U.S. fiscal policy since 1980 is that government debt increased sharply during a period of peace and prosperity. Over the course of U.S. history, the indebtedness of the federal government relative to GDP has varied substantially. Historically, the debt–GDP ratio generally increased sharply during major wars and fell slowly during peacetime. The 1980s and 1990s are the only instance in U.S. history of a large increase in the debt–GDP ratio during peacetime. 2. Many economists project increasing budget deficits and government debt over the next several decades because of changes in the age profile of the population. Life expectancy has steadily increased, and birth rates have fallen. As a result, the elderly are becoming a larger share of the population. As more people become eligible for “entitlements” of Social Security and Medicare, government spending will rise automatically over time. Without changes in tax and expenditure policies, government debt will also rise sharply. 3. Standard measures of the budget deficit are imperfect measures of fiscal policy for at least four reasons. First, they do not correct for the effects of inflation. The measured deficit should equal the change in the government’s real debt, not the change in the nominal debt. Second, such measures do not offset changes in government liabilities with changes in government assets. To measure the government’s overall indebtedness, we should subtract government assets from government debt. Hence, the budget deficit should be measured as the change in debt minus the change in assets. Third, standard measures omit some liabilities altogether, such as the pensions of government workers and accumulated future Social Security benefits. Fourth, they do not correct for the effects of the business cycle. 4. Public saving is the difference between taxes and government purchases, so a debt-financed tax cut reduces public saving by the full amount that taxes fall. The tax cut also increases disposable income. According to the traditional view, since the marginal propensity to consume is between zero and one, both consumption and private saving increase. Because consumption rises, private saving increases by less than the amount of the tax cut. National saving is the sum of public and private saving; because public saving falls by more than private saving increases, national saving falls. 5. According to the Ricardian view, a debt-financed tax cut does not stimulate consumption because it does not raise permanent income—forward-looking consumers understand that government borrowing today means higher taxes in the future. Because the tax cut does not change consumption, households save the extra disposable income to pay for the future tax liability that the tax cut implies: private saving increases by the full amount of the tax cut. This increase in private saving exactly offsets the decrease in public saving associated with the tax cut. Therefore, the tax cut has no effect on national saving. 6. Which view of government debt you hold depends on how you think consumers behave. If you hold the traditional view, then you believe that a debt-financed tax cut stimulates consumer spending and lowers national saving. You might believe this for several reasons. First, consumers may be shortsighted or irrational, so that they think their permanent income has increased even though it has not. Second, consumers may face binding borrowing constraints, so that they are only able to consume their current income. Third, consumers may expect that the implied tax liability will fall on future generations, and these consumers may not care enough about their children to leave them a bequest to offset this tax liability. If you hold the Ricardian view, then you believe that the preceding objections are not important. In particular, you believe that consumers have the foresight to see that government borrowing today implies future taxes to be levied on them or their descendants. Hence, a debt-financed tax cut gives consumers transitory income that eventually will be taken back. As a result, consumers will save the extra income they receive in order to offset that future tax liability. 7. A budget deficit might be good policy for the following reasons. First, it can help stabilize the economy if output is below full employment. Second, it can allow the country to keep tax rates relatively smooth despite fluctuations in government spending (e.g., temporary wars) or in output (namely, in recessions). Third, it can shift a tax burden from current to future generations. For example, some expenditures might benefit future generations, and some economists argue that those generations should bear some of the costs of financing the expenditures. 8. The level of government debt might affect the government’s incentives regarding money creation because the government debt is specified in nominal terms. A higher price level reduces the real value of the government’s debt. Hence, a high level of debt might encourage the government to print money in order to raise the price level and reduce the real value of its debt. Problems and Applications 1. The budget deficit is defined as government purchases minus government revenues. Selling the Liberty Bell to Taco Bell would raise revenue for the U.S. government and, hence, reduce the deficit. A smaller budget deficit would lead the government to borrow less, and as a result the measured national debt would fall. If the United States adopted capital budgeting, the net national debt would be defined as the assets of the government (its schools, armies, parks, and so forth) minus the liabilities of the government (principally outstanding public debt). By selling the Liberty Bell the government would be reducing its assets by the value of the Liberty Bell and reducing its liabilities by its purchase price. Assuming Taco Bell paid a fair price, these reductions would be the same amount and the net national debt would be unchanged. Before you worry too much about the Taco Liberty Bell, you might want to notice that this ad appeared on April Fools Day. 2. Here is one possible letter: Dear Senator: In my previous letter, I assumed that a tax cut financed by government borrowing would stimulate consumer spending. Many economists make this assumption because it seems sensible that if people had more current income, then they would consume more. As a result of this increase in consumption, national saving would fall. Ricardian economists argue that the seemingly sensible assumption that I made is incorrect. Although a debt-financed tax cut would increase current disposable income, it would also imply that at some point in the future, the government must raise taxes to pay off the debt and accumulated interest. As a result, the tax cut would merely give consumers a transitory increase in income that would eventually be taken back. If consumers understand this, then they would know that their permanent, or lifetime, resources had not changed. Hence, the tax cut would have no effect on consumption, and households would save all of their extra disposable income to pay for the future tax liability. Because there would be no effect on consumption, there would also be no effect on national saving. If national saving did not change, then as pointed out by the prominent economist you heard from yesterday, the budget deficit would not have the effects I listed. In particular, output, employment, foreign debt, and interest rates would be unaffected in both the short run and the long run. The tax cut would have no effect on economic well-being. There are several reasons the Ricardian argument may fail. First, consumers might not be rational and forward-looking: they may not fully comprehend that the current tax cut means a future tax increase. Second, some people may face constraints on their borrowing: in essence, the tax cut would give these taxpayers a loan that they are unable to obtain now. Third, consumers may expect the implied future taxes to fall not on them, but on future generations whose consumption they do not care about. Your committee must decide how you think consumers would behave in response to this debtfinanced tax cut. In particular, would they consume more, or not? Your faithful servant, CBO Economist. 3. a. The tax on the workers will reduce their disposable income. When their disposable income falls, they will reduce consumption by an amount that depends on their marginal propensity to consume and will reduce savings by the remaining amount. When the elderly receive the temporary benefit, they will increase their consumption by an amount that depends on their marginal propensity to consume. Since elderly people will tend to have a larger marginal propensity to consume than working people, the net effect on the economy is an increase in consumption. b. The answer to part (a) does depend on whether generations are altruistically linked. If generations are altruistically linked, then the elderly may not feel any better off because of the Social Security benefit, since the tax and benefit increase has no effect on a typical family’s permanent income; it simply transfers resources from one generation of the family to another. If the elderly do not want to take advantage of this opportunity to consume at their children’s expense, they may try to offset the effect of the tax increase on the young by giving them a gift or leaving a bequest. To the extent that this takes place, it mitigates the impact of the tax change on consumption and saving. 4. A rule requiring a cyclically adjusted balanced budget has the potential to overcome, at least partially, the first two objections to a balanced-budget rule that were raised in this chapter. First, this rule allows the government to run countercyclical fiscal policy in order to stabilize the economy. That is, the government can run deficits during recessions, when taxes automatically fall and expenditures automatically rise. These automatic stabilizers affect the deficit but not the cyclically adjusted deficit. Second, this rule allows the government to smooth tax rates across years when income is especially low or high—it is not necessary to raise tax rates in recessions or to cut them in booms. On the other hand, this rule only partially overcomes these two objections, since the government can only run a deficit of a certain size, which might not be big enough. Also, a cyclically adjusted balanced budget does not allow the government to smooth tax rates across years when expenditure is especially high or low, as in times of war or peace. (We might take account of this by allowing an exemption from the balanced budget rule in special circumstances such as war.) This rule does not allow the government to overcome the third objection raised in the chapter, since the government cannot shift the burden of expenditure from one generation to another when this is warranted. Finally, a serious problem with a rule requiring a balanced cyclically adjusted budget is that we do not directly observe this budget. That is, we need to estimate how far we are from full employment; then we need to estimate how expenditures and taxes would differ if we were at this full-employment level. None of these estimates can be made precisely. 5. The Congressional Budget Office (www.cbo.gov) regularly provides budget forecasts. One excellent CBO publication that summarizes these forecasts is the “The Budget and Economic Outlook.” For example, in the January 2015 update of this publication, the CBO projected that the debt held by the public would rise to 74 percent of GDP by the end of 2015, and 79 percent of GDP by 2025. Under current rules for producing baseline projections of the debt, the CBO makes several assumptions. Spending will grow faster than the economy for Social Security, major health care programs, and net interest costs. Other mandatory spending plus defense and nondefense discretionary spending will shrink relative to the size of the economy. Revenues are projected to rise due to the expiration of several tax laws and by the ongoing economic expansion. Revenues from individual income tax are expected to rise relative to GDP, but this will be offset by reductions in revenues from the corporate income tax and other sources. Real GDP is predicted to grow by an average of 2.2 percent per year. Potential output is expected to grow more slowly than it did during the 1980s and 1990s because the labor force is expected to grow more slowly due to ongoing retirement of the baby boomers, a relatively stable labor force participation rate among working-age women, and by federal tax and spending policies set in current law. These assumptions, which serve the purpose of providing a neutral benchmark, are unlikely to hold in practice. Policymakers may increase real spending on discretionary programs as the economy grows over time. They may also change taxes, although the direction is harder to predict. If the United States experiences a productivity slowdown, this will reduce output growth and hence growth in tax revenue. As a consequence, future government debt likely will be somewhat different than currently projected. IN THIS CHAPTER, YOU WILL LEARN: ▪ about the size of the U.S. government’s debt and how it compares to that of other countries ▪ problems measuring the budget deficit ▪ the traditional and Ricardian views of the government debt ▪ other perspectives on the debt 1 The U.S. experience in recent years Early 1980s through early 1990s ▪ debt–GDP ratio: 25.5% in 1980, 48.9% in 1993 ▪ due to Reagan tax cuts, increases in defense spending & entitlements Early 1990s through 2000 ▪ $290b deficit in 1992, $236b surplus in 2000 ▪ debt–GDP ratio fell to 32.5% in 2000 ▪ due to rapid growth, stock market boom, tax hikes The U.S. experience in recent years Early 2000s ▪ the return of huge deficits due to Bush tax cuts, 2001 recession, Iraq war The 2008-2009 recession and its aftermath ▪ fall in tax revenues ▪ huge spending increases (bailouts of financial institutions and auto industry, stimulus package) ▪ a weak recovery did not stop the debt–GDP ratio from rising further The troubling long-term fiscal outlook ▪ The U.S. population is aging. ▪ Health care costs are rising. ▪ Spending on entitlements like Social Security and Medicare is growing. ▪ Deficits and the debt are projected to significantly increase… Problems measuring the deficit 1. Inflation 2. Capital assets 3. Uncounted liabilities 4. The business cycle MEASUREMENT PROBLEM 1: Inflation ▪ Suppose the real debt is constant, which implies a zero real deficit. ▪ In this case, the nominal debt D grows at the rate of inflation: ΔD/D = π or ΔD = π D ▪ The reported deficit (nominal) is π D even though the real deficit is zero. ▪ Hence, should subtract π D from the reported deficit to correct for inflation. MEASUREMENT PROBLEM 1: Inflation ▪ Correcting the deficit for inflation can make a huge difference, especially when inflation is high. ▪ Example: In 1979, nominal deficit = $28 billion inflation = 8.6% debt = $495 billion π D = 0.086 × $495b = $43b real deficit = $28b − $43b = $15b surplus MEASUREMENT PROBLEM 2: Capital Assets ▪ Currently, deficit = change in debt ▪ Better, capital budgeting: deficit = (change in debt) − (change in assets) ▪ EX: Suppose 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 w/ cap budgeting: Determining which govt expenditures count as capital expenditures. MEASUREMENT PROBLEM 3: Uncounted liabilities ▪ Current measure of deficit omits important liabilities of the government: ▪ future pension payments owed to current govt workers ▪ future Social Security payments ▪ contingent liabilities, e.g., covering federally insured deposits when banks fail (Hard to attach a dollar value to contingent liabilities, due to inherent uncertainty.) MEASUREMENT PROBLEM 4: The business cycle ▪ The deficit varies over the business cycle due to automatic stabilizers (unemployment insurance, the income tax system). ▪ These are not measurement errors but do make it harder to judge fiscal policy stance. ▪ E.g., is an observed increase in deficit due to a downturn or an expansionary shift in fiscal policy? MEASUREMENT PROBLEM 4: The business cycle ▪Solution: cyclically-adjusted budget deficit (aka full-employment deficit) based on estimates of what govt spending & revenues would be if economy were at the natural rates of output and unemployment. The bottom line We must exercise care when interpreting the reported deficit figures. Is the govt debt really a problem? Consider a tax cut with corresponding increase in the government debt. Two viewpoints: 1. Traditional view 2. Ricardian view The traditional view ▪ Short run: Y, u ▪ Long run: ▪ Y and u back at their natural rates ▪ closed economy: r, I ▪ open economy: ε, NX (or higher trade deficit) ▪Very long run: ▪ slower growth until economy reaches new steady state with lower income per capita 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. The logic of 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. ▪ 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. ▪ Result: Private saving rises by the amount public saving falls, leaving national saving unchanged. 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. ▪ 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. Evidence against Ricardian Equivalence? Early 1980s: Reagan tax cuts increased deficit. National saving fell, real interest rate rose, exchange rate appreciated, and NX fell. 1992: Income tax withholding reduced to stimulate economy. ▪ This delayed taxes but didn’t make consumers better off. ▪ Almost half of consumers increased consumption. Evidence against Ricardian Equivalence? ▪ Proponents of R.E. argue that the Reagan tax cuts did not provide a fair test of R.E. ▪ Consumers may have expected the debt to be repaid with future spending cuts instead of future tax hikes. ▪ Private saving may have fallen for reasons other than the tax cut, such as optimism about the economy. ▪ Because the data are subject to different interpretations, both views of govt debt survive. OTHER PERSPECTIVES: Balanced budgets vs. optimal fiscal policy ▪ Some politicians have proposed amending the U.S. Constitution to require balanced federal govt budget every year. ▪ Many economists reject this proposal, arguing that deficit should be used to: ▪ stabilize output & employment ▪ smooth taxes in the face of fluctuating income ▪ redistribute income across generations when appropriate OTHER PERSPECTIVES: Fiscal effects on monetary policy ▪ Govt deficits may be financed by printing money ▪ A high govt debt may be an incentive for policymakers to create inflation (to reduce real value of debt at expense of bond holders) Fortunately: ▪ little evidence that the link between fiscal and monetary policy is important ▪ most governments know the folly of creating inflation ▪ most central banks have (at least some) political independence from fiscal policymakers OTHER PERSPECTIVES: Debt and politics “Fiscal policy is not made by angels…” – N. Gregory Mankiw, p.575 ▪ Some do not trust policymakers with deficit spending. They argue that: ▪policymakers do not worry about true costs of their spending, since burden falls on future taxpayers. ▪since future taxpayers cannot participate in the decision process, their interests may not be taken into account. ▪ This is another reason for the proposals for a balanced budget amendment (discussed above). OTHER PERSPECTIVES: International dimensions ▪ Govt budget deficits can lead to trade deficits, which must be financed by borrowing from abroad. ▪ Large govt debt may increase the risk of capital flight, as foreign investors may perceive a greater risk of default. ▪ Large debt may reduce a country’s political clout in international affairs. CASE STUDY: Inflation-indexed Treasury bonds ▪ Starting in 1997, the U.S. Treasury issued bonds with returns indexed to the CPI. ▪ Benefits: ▪ Removes inflation risk, the risk that inflation – and hence real interest rate – will turn out different than expected. ▪ May encourage private sector to issue inflation-adjusted bonds. ▪ Provides a way to infer the expected rate of inflation… 1. Relative to GDP, the U.S. government’s debt is moderate compared to that of other countries. 2. Standard figures on the deficit are imperfect measures of fiscal policy because they: ▪ are not corrected for inflation. ▪ do not account for changes in govt assets. ▪ omit some liabilities (e.g., future pension payments to current workers). ▪ do not account for effects of business cycles. 3. In the traditional view, a debt-financed tax cut increases consumption and reduces national saving. In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living. In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit). 4. The Ricardian view holds that debt-financed tax cuts do not affect consumption or national saving and therefore do not affect interest rates, investment, or net exports. 5. Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations. 6. Government debt can have other effects: ▪ may lead to inflation ▪ politicians can shift burden of taxes from current to future generations ▪ may reduce country’s political clout in international affairs or scare foreign investors into pulling their capital out of the country Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058
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