17.1 Should We Balance the Federal Budget?

• Government Expenditures are goods and services purchased by the government and transfer payments made to citizens.

  • For example, Social Security and welfare

• A surplus is when the government’s revenues exceed its expenditures in a given year.

• A deficit is ruined by the government when it spends more than it receives in revenues from earlier taxes or fees in a given year.

• The government debt is the total of all its yearly deficits.

  • For example, if the government initially had a debt of $100 billion and then ran deficits of $20 billion the next year, $30 billion years after that, and $50 billion during the third year, its total debt at the end of the third year would be $200 billion: the initial $100 billion debt plus successive yearly deficits of $20 billion, $30 billion, and $59 billion.

• If a government ran a surplus, it would decrease its total debt.

  • For example, the debt was $100 billion and the government ran a surplus of $10 billion. The government would buy back $10 billion of debt from the private sector using the surplus. Therefore, it would reduce the remaining debt to $90 billion.

  • During the beginning of the 1980s and through most of the 1990s, the federal budget ran large deficits

• David Stockman is the director of the Office of Management and Budget in President Ronald Reagan’s administration.

  • He once said, “deficits as far as the eye can see”.

• In the fiscal year 1998, during President Bill Clinton’s administration, the federal government ran a budget surplus of $69 billion which was its first surplus in 30 years. Surplus continued to run for the next 3 fiscal years.

Two Key Reasons Surplus Emerged

• The economic growth was very rapid and tax revenues, including tax revenues from sales of stocks and bonds, grew more quickly.

• The federal budget was in place that limited total spending.

• In January 2001, George W. Bush took office and the large surplus led him to propose substantial tax cuts. It led Bush and Congress to pass a 10-year tax cut amounting to $1.35 trillion over the course of the decade.

• The Congressional Budget Office noted that, as a result of these federal government surpluses, the outstanding stock of federal debt held by the public would be reduced.

  • Since GDP would be growing over this period, the stock of debt relative to GDP would also decline.

  • CBO estimated that in 2011, the ratio of debt to GDP would decline despite Bush’s tax cuts because the tax cuts were set to expire in 2010.

• The Bush tax cuts, the collapse of the stock market twice during the decade, the recessions that began in 2001 and 2007, and the slow recovery all sharply reduced tax revenues.

• In the fiscal year 2991, the federal government ran a budget deficit of about $1.3 trillion.

• By 2014, the deficit fell to $483 billion.

Five Debates About Deficits

• Debate 1: Do deficits lead to inflation?

  • If a government is spending $2,000 but collecting only $1,600 in taxes, $400 would be needed to fill the gap.

  • One way is to borrow $400 from the public in return for government bonds, which are, in effect, IOUs. The government would have to pay back the $400 plus interest on the bonds in the future.

  • A second way is to create $400 worth of new money. Governments could use a mix of borrowing money and creating money, as long as the total covers its deficits.

  • Monetizing the deficit is what economists call the purchase by a central bank of newly issued government debt.

  • If the public is unwilling to buy its bonds, those deficits will inevitably cause inflation.

• Debate 2: Is government debt a burden on future generations?

  • National debt, which is also known as total government debt, can impose two different burdens on society.

  • A large debt can reduce the amount of capital in the economy and thereby reduce future income and real wages for its citizens by the savings of individuals and institutions flowing into capital information and increasing an economy’s capital stock.

  • When the government runs a deficit and increases its national debt, it also finances its spending by selling bonds to these same savers, who might hold both types of assets in their retirement portfolios.

  • The result of government deficits is that fewer savings are available to firms for investments.

  • The Ricardian equivalence is the proposition that it doesn't matter whether government expenditure is financed by taxes or debt. This idea is named after David Ricardian who is a nineteenth-century classical economist.

  • Ricardian equivalence requires that savings by the private sector increase when the deficit increases.

  • During the early 1980s, savings decreased somewhat when government deficits increased.

• Debate 3: How do deficits affect the size of government?

  • Nobel Laureate James Buchanan has argued that people are less aware of government deficits than of the taxes they’re forced to pay.

  • Financing government expenditure through deficits, rather than through higher taxes, will lead to higher government spending and bigger government. This presents two problems which are spending by the state needs a local government that has grown much faster than federal spending and if politicians are trying to get re-elected really prefer higher government spending and deficits to higher taxes and surpluses then they can use deficits to reduce the growth of government.

• Debate 4: Can deficits be good for an economy?

  • Deficits automatically emerge during recessions, which also stabilize the economy.

  • Transfer payments such as welfare and food stamps rise because government spending increases while tax revenues fall and the deficit will rise. This will steer the economy back to full employment.

  • The existence of automatic stabilizers and the use of the expansionary fiscal policy during recessions suggest we should not worry about short-run government deficits.

  • Over short time droids, deficits can help the economy cope with stocks.

  • Temporarily raising tax rates to very high levels could cause distortions in economic behavior which should be avoided.

  • Overall, by running deficits and only gradually raising taxes later to service debt, we avoid creating excess distortion in the economy.

• Debate 5: Would balanced-budget amendment really work?

  • As recently as 1995, Congress came very close to passing a balanced-budget amendment, sending it back to the states for ratification. It passed the House of Representatives p, but not the Senate.

  • All the amendments that were proposed have various escape clauses like allowing borrowing during wartime. Some amendments also allow Congress to suspend the requirement to balance the budget for other reasons like during a recession when deficits naturally emerge. Some versions limit the rate of spending increases to the rate at which GDP is growing.

  • Proponents of the balanced-budget amendment say it will exert discipline on the federal government, preventing large deficits in peacetime.

17.2 Should the Fed Target Both Inflation and Employment?

• The Monetary Policy can be used to stabilize the real economy preventing unemployment from exceeding the natural rate or falling too far below the natural rate.

• In the Employment Act of 1946, the federal government was charged to pursue “maximum employment, production, and purchasing power.”

• In 1978, Congress passed the Humphrey-Hawkins legislation, which called for the nation to seek full employment and price stability as well as balances in the trade and budget.

• Debate 1: Should the Fed focus on only inflation?

  • The Fed should have one primary goal which is controlling inflation which would help to keep the Fed free of political pressures.

  • Other proponents believe an inflation-targeting regimen could be designed to give the central bank some flexibility.

  • While Ben Bernanke was a member of the Board of Governors in 2003, he gave a speech outlining his own views on the merits of inflation which is that inflation is targeting a policy of constrained discretion.

  • Economists also debate the level for an inflation target.

  • A higher average inflation rate and the higher average interest rate would allow the Fed more room to lower rates and not run up against the lower bound.

  • The Price-level targeting is that the idea would be that the Fed would target the price level, which would grow.

• Debate 2: If there were an inflation target, who would set it?

  • In the United Kingdom, in 1992, the elected government decided on the inflation target for the central bank.

  • In other countries, the central bank has even more influence in setting the inflation target.

17.3 Should We Tax Consumption Rather than Income?

• Consumption taxes are the taxes based on the consumption, not the income, of individuals.

Two Debates about Consumption Taxation

• Debate 1: Will consumption taxes lead to more savings?

  • There is no question that taxing consumption instead of savings creates an incentive to save. However, there is no guarantee the incentive will actually result in more money saved in the economy.

  • On the other hand, people will want to spend more because, with the tax cut, they are wealthier.

  • Individuals will allocate their savings to tax-favored investments over investments that are not favored.

  • The tax system imposed on corporations in the United States also creates disincentives to save and invest.

  • When the corporation earns a profit, it pays taxes on the profit at the corporate tax rate.

  • When the corporation pays you a dividend on the stock out of the profits it earns, you must pay taxes on the dividend income that you receive.

• Debate 2: Are consumption taxes fair?

  • Individuals should be taxed on what they take away from the economy’s total production that is, what they consume-not on what they actually produce.

  • If an individual produces a lot but does not consume the proceeds from what was produced and instead plows it back into the economy for investment, that individual, is contributing to the growth of total output and should be rewarded, not punished.

  • Capital Gains are the profits investors earn when they sell stocks, bonds, real estate, or other assets.

  • If capital gains and other types of capital income were not taxed, total tax revenue would fall, and the government would have to raise tax rates on everyone to maintain the same level of spending.

  • The “flat tax” designed ****by Robert E. Hall of Stanford University and Alvin Rabushka of the Hoover Institute brings the personal income tax and corporate income tax into a single, unified tax system. One low, single tax rate applies to both businesses and individuals. Businesses deduct their wage payments before they pay taxes and they can deduct any investment spending they make before their income before the tax is calculated.