Deficits, Surpluses and the Public Debt

CHAPTER EIGHTEEN DEFICITS, SURPLUSES AND THE PUBLIC DEBT

CHAPTER OVERVIEW Three interrelated topics of national concern—Federal budget deficits, surpluses, and the public debt— are the focus of this chapter. It begins by considering several contrasting budget philosophies. Table 18- 1 provides statistical evidence that is useful in tracing the growth of the debt and assessing its current quantitative significance. The material on the public debt is designed to explode two popular misconceptions as to the character and problems associated with a large public debt: (1) the debt will force the U.S. into bankruptcy and (2) the debt imposes a burden on future generations. The debt discussion, however, also entails a look at substantive economic issues. Potential problems of a large public debt include greater income inequality, reduced economic incentives, and crowding out of private investment. Now attention turns to what to do about budget surpluses. The chapter examines the Federal deficits of the 1990s, the large surpluses of the late 1990s and early 2000s, and how they quickly turned to deficits. The impending problems of the Social Security system are presented in The Last Word.

WHAT’S NEW The last time this chapter was revised, “surpluses” was added to the title because of the surpluses expected and realized in the late 1990s/early 2000s. This edition of the chapter extends that discussion to address how the recent surpluses have quickly turned back into deficits.

The discussion of tax cuts as a cause of expanding public debt has been revised to reflect the fact that tax cuts don’t necessarily result in deficits if they are matched with restraints on government spending.

A new Last Word examines impending budgetary problems in “The Long-Run Fiscal Imbalance: Social Security.”

Data and end-of-chapter questions have been updated and revised.

INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to

1. Differentiate between deficit and debt. 2. Explain each of the three budget philosophies. 3. Identify three principal causes of the public debt. 4. State the absolute size of the debt and the relative size as a percentage of GDP. 5. Describe the annual interest charges on the debt, who holds the debt, and the impact of inflation on the debt. 6. Explain why the debt can also be considered public credit. 7. Identify and discuss two widely held myths about the public debt. 8. Explain the real or potential effect of the debt on income distribution, economic incentives, fiscal policy, and private investment.

252 Deficits, Surpluses and the Public Debt

9. State how debt plays a positive role in society. 10. Explain the policy options for when surpluses occur. 11. Explain why the surpluses of the early 2000s turned to deficits beginning in 2002. 12. Describe the long-run budgetary problems facing the Social Security system. 13. Define and identify the terms and concepts at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS 1. In the discussion of myths about the debt, remind students that the debt is not completely harmless. Explode the myths, but also discuss the substantive impact of the debt. Also, note the Global Perspectives on debt in other nations. 2. Current data on the public debt and on the Federal budget are reported in the most recent Economic Report of the President, the Survey of Current Business, or Federal Reserve Bulletins. These sources can be used to update chapter data. The Federal deficit can be measured in several ways, and these differences can lead to different conclusions about its impact.

STUDENT STUMBLING BLOCK 1. The national debt has been an issue of great concern to politicians and citizens. Students probably have major misconceptions based on the publicity surrounding the deficit and debt. The concern is most often centered around the “myths” that the government can go bankrupt or that debt necessarily is a burden on future generations. Spend some time discussing why these particular concerns are not the major issues about which we should worry. Paying down the debt using current surplus is a policy option discussed in this chapter. Point to pros and cons. 2. “ Millions, billions, trillions,” most people have a difficult time maintaining perspective and proportion when using really large numbers. For most of us, $100 million dollars sounds like an incredible fortune. Ask students to calculate the percentage $100 million dollars represents out of one trillion dollars. Check your figures before you try this in class. (The answer is .01 percent.) This demonstration may help students understand why cutting a government budget can be so difficult. What sounds like a huge sum of money may represent an extremely small percentage of the total amount. Remind students of current GDP, and budget and surplus statistics.

LECTURE NOTES I. Definitions of deficit, surplus, and debt A. A budget deficit is the amount by which government’s expenditures exceed its revenues during a particular year. In contrast, a surplus is the amount by which its revenues exceed expenditures. 1. In 2002 there was a Federal deficit of $158 billion. 2. In 2000 there was a surplus of $236 billion. B. The national or public debt is the total accumulation of the Federal government’s total deficits and surpluses that have occurred through time. State and local governments historically have a collective budget surplus. In 2002 the public debt was $6.2 trillion.

II. Three Budget Philosophies

A. The annually balanced budget was the goal until the 1930s Depression, but this ruled out using fiscal policy as a countercyclical, stabilizing force and even makes recession or depression worse. 1. The balanced budget is not neutral, but is procyclical, that is, it worsens the business cycle. 2. In a recession, the government would have to raise taxes and lower spending to balance the budget as tax revenues fell with recessionary income levels. This policy would worsen recessions. 3. In an inflationary boom period, a balanced budget would intensify the inflation. As tax revenues increased, the government would need to cut taxes or increase spending to avoid a budget surplus. This strategy would make the inflation worse. 4. Those who argue for the annually balanced budget want to limit the growth of government. B. The cyclically balanced budget is a spending philosophy that allows for some government stabilization policy over the length of the business cycle. Deficit spending is allowed during a recession, and surpluses during an inflationary period. Over the business cycle, deficits would be offset by surpluses. But in reality, surpluses and deficits do not offset each other. C. Functional finance is the third budget philosophy. Advocates argue that the budget is secondary, but the primary purpose of Federal finance is to achieve noninflationary full employment. Government should do what is necessary to achieve this goal regardless of the deficit or surplus in the budget. The Public Debt: Facts and Figures A. The public debt in 2002 was $6.2 trillion. This is a large number. One million seconds ago was 12 days back. One trillion seconds ago was around 30,000 B.C. B. Causes of the expansion in debt. 1. National defense and military spending have soared, especially during wartime. During World Wars I and II, debt grew rapidly. See Table 18-1 for facts that show World War II debt exceeded GDP. 2. Recessions cause a decline in revenues and growth in government spending on programs for income maintenance. Such periods included 1974-75, 1980-82, 1990-91, and 2001. 3. Tax cuts are another cause. Tax cuts in the 1980s without equivalent spending cuts led to increasing debt. The Clinton administration in 1993 is an example of how politically difficult it is to reduce spending and raise taxes to reduce the deficit. An unpopular deficit reduction act was passed in that year and many Democrats lost elections later. C. Quantitative aspects of the debt are found in Table 18-1. Note that the absolute level in column 2 is not meaningful without comparison of the relative size of debt and interest payments to the nation’s ability to pay, as estimated by GDP and shown in column 5. 1. Comparing the debt to GDP is more meaningful than the absolute level of debt by itself. Use the example of a family or corporate borrowing. For a prosperous family or firm, $100,000 worth of debt may be a small fraction of its income; for others, $100,000 worth of debt may mean they’re unable to make payments on the debt. The amount is not as important as the amount relative to the ability to pay. Also, most borrowing is made to purchase physical assets such as buildings, equipment, etc. Another way to judge government debt is to compare it to an estimate of public assets.

2. International comparisons show that other nations have relative public debts as great or greater than that of the U.S. when compared to their GDPs. See Global Perspective 18-1. 3. Interest charges as a percentage of GDP represent the primary burden of the debt today. 4. Who owns the debt is also an important question. About 43 percent of U.S. debt is held by government agencies and the Federal Reserve; the rest is held by individuals, banks, investment and insurance companies, and about 18 percent was held by foreign investors in 2002. (See Figure 18-1.) 5. Social Security Trust Fund considerations may obscure the true debt picture. Payroll taxes currently exceed social security payments so the fund’s surplus is counted as part of the Federal surplus. Some economists say this fund should not be part of the calculation of Federal deficits or surpluses because social security funds are earmarked for future beneficiaries. For example, the Federal deficit in 2002 would be $318 billion without the fund surplus of $160 billion. C. False concerns about the federal debt include several popular misconceptions. 1. Can the federal government go bankrupt? There are reasons why it cannot. a. The government does not need to raise taxes to pay back the debt, and it can borrow more (i.e., sell new bonds) to refinance bonds when they mature. Corporations use similar methods—they almost always have outstanding debt. b. The government has the power to tax, which businesses and individuals do not have when they are in debt. 2. Does the debt impose a burden on future generations? In 2002 the per capita federal debt in the U.S. was $21,476. But the public debt is a public credit—your grandmother may own the bonds on which taxpayers are paying interest. Some day you may inherit those bonds that are assets to those who have them. The true burden is borne by those who pay taxes or loan government money today to finance government spending. If the spending is for productive purposes, it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline. Borrowing allows growth to occur when it is invested in productive capital. D. Substantive issues do exist. 1. Repayment of the debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality. 2. Since interest must be paid out of government revenues, a large debt and high interest can increase the tax burden and may decrease incentives to work, save, and invest for taxpayers. 3. A higher proportion of the debt is owed to foreigners (about 18 percent) than in the past, and this can increase the burden since payments leave the country. But Americans also own foreign bonds and this offsets the concern. 4. Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear (see Figure 18-2). 5. There are some positive aspects of borrowing even with crowding out. a. If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.

b. Public investment makes private investment more attractive. For example, new Federal buildings generate private business; good highways help private shipping, etc. IV. Deficits and Surpluses: 1992-2012 A. Figure 18-3 shows huge absolute deficits in the early 1990s. B. In 1993 Congress passed the Deficit Reduction Act to increase tax revenues by $250 billion over 5 years and to reduce spending by a similar amount. 1. The top marginal tax rate went from 31 to 39.6%. 2. The corporate income tax rate went up 1%, from 34% to 35%. 3. Gasoline excise taxes rose by 4.3 cents per gallon. 4. Spending was held at 1993 levels (unless increases already mandated by law). C. By 1998 there was a budget surplus for the first time since 1969. D. There are three main options for the surpluses. 1. Pay off part of the public debt. a. Less government borrowing could mean more private investment. b. Critics contend that the debt is shrinking relative to GDP and we need government securities as safe investments, for monetary policy, and for Social Security trust fund assets. c. Use interest savings to boost the Social Security trust fund. 2. Reduce taxes and reduce surplus. a. Returns money directly to those who earned it. b. Helps to limit the size of government. c. Critics fear this surplus may be temporary and tax reduction may be poorly timed if the economy is prosperous anyway. 3. Increase government spending and reduce the surplus. a. Several areas of need exist where federal spending programs could help, especially Medicare drug coverage. b. Critics say new spending could be inflationary and interfere with private investment. E. Back to Deficits in 2002 1. A series of policy actions and unforeseen events turned the surpluses of the early 2000s into deficits beginning in 2002. a. The Bush tax cuts of 2001, designed to return some of the surplus to the public, began a series of reductions in marginal income tax rates. b. The recession that began March 2001 reduced tax revenue and increased payouts for income assistance programs (unemployment and welfare). c. The events of September 11, 2001, and the subsequent “war on terrorism,” increased Federal spending by more than $100 billion. 2. In response to a weak recovery, taxes were cut further in 2003, and phased reductions from the 2001 tax cut were accelerated.

V. Last Word: The Long-Run Fiscal Imbalance: Social Security A. There is an impending long-run shortfall in Social Security funding. 1. It is “pay-as-you-go” system, meaning that current revenues are used to pay current retirees (instead of paying from funds accumulated over time). 2. Despite efforts to build a trust fund, in 2018 Social Security revenues will fall below payouts to retirees. 3. In 2042 the trust fund will be exhausted and benefits will exceed revenues by an estimated 37 percent, with that figure rising to 56 percent annually in 2075. B. Demographic changes are creating the problem. 1. Baby boomers are entering retirement age and living longer, meaning that there will be more recipients receiving payouts for longer periods of time. 2. The ratio of the number of workers contributing to the system for each recipient has declined from 5:1 in 1960 to 3:1 today. By 2040 the ratio will be only 2:1. C. Numerous solutions have been suggested. 1. Reduce benefits by reducing direct payments, taxing benefits, and/or increasing the age at which workers are eligible to receive benefits (already part of the system) 2. Increase revenues by raising payroll taxes. 3. Increase the trust fund by setting aside more of current system revenues, or by investing trust fund monies in corporate stocks and bonds. 4. Allow workers to invest half of their payroll taxes in approved stock and bond funds – sometimes referred to as “privatizing” Social Security. D. There are many possible solutions, and the political process may well result in a combination of the many policies proposed.

ANSWERS TO END-OF-CHAPTER QUESTIONS 18-1 (Key Question) Assess the leeway for using fiscal policy as a stabilization tool under (a) an annually balanced budget, (b) a cyclically balanced budget, and (c) functional finance. (a) There is practically no potential for using fiscal policy as a stabilization tool under an annually balanced budget. In an economic downturn, tax revenues fall. To keep the budget in balance, fiscal policy would require the government to reduce its spending or increase its tax rates, adding to the deficiency in spending and accelerating the downturn. If the economy were booming and tax revenues were mounting, to keep the budget balanced fiscal policy would have to increase government spending or reduce taxes, thus adding to the already excessive demand and accelerating the inflationary pressures. An annually balanced budget would intensify cyclical ups and downs. (b) A cyclically balanced budget would be countercyclical, as it should be, since it would bolster demand by lowering taxes and increasing government spending during a recession and restrain demand by raising taxes and reducing government spending during an inflationary boom. However, because boom and bust are not always of equal intensity and duration, budget surpluses during the upswing need not automatically match budget deficits during the downswing. Requiring the budget to be balanced over the cycle may necessitate inappropriate changes in tax rates or levels of government expenditures.

(c) Functional finance pays no attention to the balance of deficits and surpluses annually or over the cycle. What counts is the maintenance of a noninflationary, full-employment level of spending. Balancing the economy is what counts, not the budget. 18-2 What have been three major sources of the public debt historically? Historically, wars and recessions have caused the public debt to increase. It would have been possible to finance World War II entirely through taxes, but this would have greatly decreased the work incentives deemed essential to get the job done. It would have been possible to finance the war effort by printing new money but, in the conditions of the already excessive demand then existing, this would have been highly inflationary. So, the government borrowed from the public. This reduced purchasing power without greatly impairing the growing wealth and work incentives of the civilian labor force. Recessions have also been responsible for the growing debt. Government deficits to bolster the economy during recessions have not been equaled by surpluses during booms. 18.3 (Key Question) What are the two main ways the size of the public debt is measured? Distinguish between refinancing the debt and retiring the debt. How does an internally held public debt differ from an externally held public debt? Contrast the effects of retiring an internally held debt and retiring an externally held debt. Two ways of measuring the public debt: (1) measure its absolute dollar size; or (2) measure its size as a percentage of GDP. Refinancing the public debt simply means rolling over outstanding debt—selling “new” bonds to retire maturing bonds. Retiring the debt means purchasing bonds back from those who hold them or paying the bonds off at maturity. An internally held debt is one in which the bondholders live in the nation having the debt; an externally held debt is one in which the bondholders are citizens of other nations. Paying off an internally held debt would involve buying back government bonds. This could present a problem of income distribution because holders of the government bonds generally have higher incomes than the average taxpayer. But paying off an internally held debt would not burden the economy as a whole—the money used to pay off the debt would stay within the domestic economy. In paying off an externally held debt, people abroad could use the proceeds of the bonds sales to buy products or other assets from the U.S. However, the dollars gained could be simply exchanged for foreign currency and brought back to their home country. This reduces U.S. foreign reserves holdings and may lower the dollar exchange rate.

18-4 True or false? If false, explain why. a. “A internally held debt is like a debt of the left hand to the right hand.” b. The Federal Reserve and Federal government agencies hold more than half of the public debt. c. The U.S. public debt was smaller in percentage terms in 2000 than it was in 1990. d. In recent years, Social Security payments have exceeded Social Security tax revenues.

(a) The statement is true about a national debt held internally, but this does not mean a large debt is entirely problem free. (b) False, the Federal Reserve and Federal government held only 43 percent of the public debt in 2002. (c) False, but just barely. The public debt was 55% of GDP in 1990, 57% in 2000.

(d) False, much of the Federal budget surplus consists of the surplus from the social security trust fund, which is included in the general Federal budget. However, by 2040 there will only be two workers for each recipient of Social Security funds. Today the ratio is 3 to 1. Therefore, some economists believe the future of the trust fund will be enhanced if more of the Federal debt is paid down and interest savings used to bolster the trust fund for future needs. 18-5 Why might economists be quite concerned if the annual interest payments on the debt sharply increased as a percentage of the GDP? The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing were automatic, there would be no debtload at all. But interest does have to be paid. Lenders expect that, and to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP is a measure of total national income or how much the government can raise in taxes to pay the interest. 18.6 Do you think that paying off the public debt would increase or decrease inequality? Explain. Probably those who hold bonds are in the upper-income, higher wealth proportion of taxpayers and since middle-income groups pay a sizable portion of taxes, interest payments on the debt increase income inequality since recipients are primarily wealthy. In the long run, therefore, paying down the debt should reduce inequality since interest payments would be diminished. 18.7 (Key Question) Trace the cause-and-effect chain through which financing and refinancing of the public debt might affect real interest rates, private investment, the stock of capital, and economic growth. How might investment in public capital and complementarities between public and private capital alter the outcome of the cause-effect chain? Cause and effect chain: Government borrowing to finance the debt competes with private borrowing and drives up the interest rate; the higher interest rate causes a decline in private capital and economic growth slows. However, if public investment complements private investment, private borrowers may be willing to pay higher rates for positive growth opportunities. Productivity and economic growth could rise. 18-8 Relate the Deficit Reduction Act of 1993 (Clinton tax increase) and the Economic Growth and Tax Relief Reconciliation Act of 2001 (Bush tax cut) to the Laffer Curve (Figure 16-10, p. 303) and to their effects on U.S. budget deficits or surpluses. The Deficit Reduction Act increased tax rates and subsequently tax revenues expanded and the deficit disappeared. Therefore, using the Laffer Curve concept, we would say that tax rates before 1993 were below their optimal level. As a result of increasing revenue (fueled also by strong economic growth), budget deficits turned into surpluses. The Economic Growth and Tax Relief Reconciliation Act reduced tax rates and tax revenues fell (although some of the decline was due to economic downturn). To the extent that the tax cut reduced revenue, it would support the notion that taxes were below their optimal level when the tax cut was implemented. The declining revenues helped turn the surpluses of 1998-2001 into deficits beginning in 2002. 18-9 What would happen to the stated sizes of Federal budget deficits or surpluses if the annual additions or subtractions from the Social Security trust fund were excluded? Because the trust fund has been in surplus, excluding it from the Federal budget would increase the size of stated deficits and reduce the size of stated surpluses.

18-10 Why did the budget deficits rise sharply in 1991 and 1992? What explains the large budget surpluses of the late 1990s and early 2000s? What caused the swing from the budget surpluses to a deficit in 2002? In 1991 and 1992 three unique events contributed to the deficit: Operation Desert Storm, more funding for the S&L bailout, and a recession that was followed by a slow recovery. Large surpluses from 1999-2001 resulted from several years of economic prosperity coupled with the results of the Deficit Reduction Act of 1993 that increased marginal tax rates on high-income earners and corporate income tax rates. Also, Congress made a commitment to limit government spending, and it was a period of relative peace. Recent returns to deficits occurred because of the 2001 tax cut, the September 11, 2001 terrorist attacks (and the subsequent “war on terrorism”), and the economic downturn of 2001. 18-11 (Last Word) What do economists mean when they refer to Social Security as a pay-as-you-go plan? What is the Social Security trust fund? What is the nature of the long-run fiscal imbalance in the Social Security system (Social Security payments and Medicare)? What are the broad options for fixing the long-run problem. A pay-as-you-go plan means that current benefits are paid out of current revenues, as opposed to benefits paid out of the accumulation of past payroll taxes. The Social Security trust fund was created with an excess of current revenues over current payouts and is held in the form of U.S. Treasury securities. The idea of the trust fund is to keep the system self-sufficient in providing for beneficiaries. The impending long-run fiscal imbalance refers to the future inability of revenues to cover obligations, and will occur largely because of demographic changes. A large segment of the population (“baby-boomers”) is moving into retirement age, and the ratio of workers to recipients is falling (5:1 in 1960, 3:1 today, 2:1 by 2040). Several options have been suggested for fixing the long-run problem. They include raising payroll taxes, increasing the age of eligibility for benefits, investing a portion of the trust fund into corporate stocks and bonds, and setting up “personal security accounts,” allowing people to invest half of their payroll taxes in approved stock and bond funds.