Public Finance and Public Policy Jonathan

CopyrightGruber
© 2010 Third
WorthEdition
Publishers
Copyright © 2010 Worth Publishers 1 of 37
 4.1 Government Budgeting

4.2 Measuring the Budgetary

Position of the Government:
Alternative Approaches
Budget Analysis and 4.3 Do Current Debts and
Deficits Mean Anything? A
Deficit Financing Long-Run Perspective
4.4 Why Do We Care About
the Government’s Fiscal
Position?
4.5 Conclusion

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 3 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.1
Government Budgeting

debt The amount a government

owes to those who have loaned
it money.

deficit The amount by which a

government’s spending exceeds
its revenues in a given year.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 4 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.1
Government Budgeting

The Budget Deficit in Recent Years

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 5 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.1
Government Budgeting
The Budget Process
The budget process distinguishes between two types of federal spending:

entitlement spending Mandatory funds for programs for which funding

levels are automatically set by the number of eligible recipients, not the
discretion of Congress. Mandatory spending is required by law on specific
programs such as social security programs which provides benefits to
retired and disabled workers and their families.

discretionary spending Optional spending set by appropriation levels

each year, at Congress’s discretion such as education, training,
science, technology, housing, transportation, national defense and
foreign aid.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 6 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.1
Government Budgeting
 APPLICATION
Efforts to Control the Deficit
 The Balanced Budget and Emergency Control Act (also known as the Gramm-
Rudman-Hollings Deficit Reduction Act, or GRH) was pushed through
Congress and onto President Reagan’s desk, where he signed the bill on
December 12.
 A trigger provision was included that initiated automatic spending cuts once the
budget deficit started missing the specified targets. The trigger was avoided by
gimmicks, for which no penalties were incurred by lawmakers.
 Failure to meet GRH deficit targets led to the 1990 adoption of the Budget
Enforcement Act (BEA): rather than trying to target a deficit level, the BEA
simply aimed to restrain government growth.
 It created the pay-as-you-go process (PAYGO) for revenues and entitlements,
which prohibited any policy changes from increasing the estimated deficit in any
year in the next six-year period. If deficits increase, the President must issue a
sequestration requirement, which reduces direct spending by a fixed percentage.
PAYGO expired on September 30, 2002. President Bush proposed its renewal after
the adoption of a 2004 budget resolution containing proposed tax cuts and spending
increases, but it remained unrenewed. President Obama has publically supported a
new PAYGO law, despite the fact that his proposed budget would increase deficits
to almost $2 trillion in the near term.
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 7 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.1
Government Budgeting

Budget Policies and Deficits at the State Level

balanced budget requirement

(BBR) A law forcing a given
government to balance its budget
each year (spending = revenue).

ex post BBR A law forcing a given

government to balance its budget by
the end of each fiscal year.

ex ante BBR A law forcing either

the governor to submit a balanced
budget or the legislature to pass a
balanced budget at the start of each
fiscal year, or both.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 8 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.2
Measuring the Budgetary Position of the Government:
Alternative Approaches
Real vs. Nominal

real prices Prices stated in some

constant year’s dollars.

nominal prices Prices stated in

today’s dollars.

Consumer Price Index (CPI) An

index that captures the change
over time in the cost of purchasing
a “typical” bundle of goods.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 9 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.2
Measuring the Budgetary Position of the Government:
Alternative Approaches
The Standardized Deficit

standardized (structural) budget deficit A long-term measure of the

government’s fiscal position, with short- term factors removed (business
income falls down).
structural deficit is when a budget deficit persists for some time. A number
of European countries in 2011, such as Greece and Spain, are now facing
structural deficits leading to a crisis of confidence regarding their ability to
pay off this debt.
cyclically adjusted budget deficit A measure of the government’s fiscal
position if the economy were operating at full potential GDP. In a recession,
the amount of borrowing will increase because of 1) less income tax and
VAT revenues 2) higher income on unemployment benefits.
The cyclically adjusted budget deficit takes into account these changes in
the business cycle to give an underlying deficit.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 10 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.2
Measuring the Budgetary Position of the Government:
Alternative Approaches
The Standardized Deficit

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 11 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.2
Measuring the Budgetary Position of the Government:
Alternative Approaches
Cash vs. Capital Accounting

cash accounting A method of measuring

the government’s fiscal position as the
difference between current spending and
current revenues.

capital accounting A method of

measuring the government’s fiscal position
that accounts for changes in the value of
the government’s net asset holdings.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 12 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.2
Measuring the Budgetary Position of the Government:
Alternative Approaches
Cash vs. Capital Accounting
Problems with Capital Budgeting

There are enormous practical difficulties with implementing a capital

budget because it is very hard to distinguish government consumption
from investment spending.

The difficulties might make it easier for politicians to misstate the

government’s budgetary position with a capital budget than without one.

While some states use capital budgets, they have not been implemented
at the federal level.

The international experience with capital budgeting at the national level

is mixed.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 13 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.2
Measuring the Budgetary Position of the Government:
Alternative Approaches
Static vs. Dynamic Scoring
static scoring A method used by budget modelers that assumes that
government policy changes only the distribution of total resources, not the
amount of total resources. For example, it assumes that if $100 is taxed at
50%, producing $50 in revenue, then a lowering the tax rate to 25% on $100
will produce $25 of revenue, "costing" the government $25 in lost revenue. It
assumes the lower tax rate won't encourage anyone to behave any differently
than they currently do.
dynamic scoring A method used by budget modelers that attempts to model
the effect of government policy on both the distribution of total resources and
the amount of total resources. For example, it assumes that if a 50% tax on $100
produces $50 in revenue, then lowering the tax rate to 25% will produce $25 in revenue,
as static scoring predicts, but also that individuals will work more because they will get to
keep more of their money. This changed behavior will produce an extra $100, for
example, which is also taxed at $25, resulting in a total of $50 in revenue, and no loss
for the state.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 14 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-Run
Perspective

implicit obligation Financial obligations the government has in

the future that are not recognized in the annual budgetary
process. ( Suppose that the government initiates two new policies this
year. One provides a transfer of $1million to poor individuals in the current
year. The other promises a transfer of $1million to poor families next year.
From the prospective of this year’s budget deficit, the famer policy costs
$1million, while the later policy is free. This view is clearly incorrect , the
later policy is almost as expensive; it is only slightly cheaper because the
promise is in the future, rather than today).

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 15 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-Run
Perspective
Background: Present Discounted Value

present discounted value (PDV)

The value of each period’s dollar
amount in today’s terms.

Mathematically, if the interest rate is r, and the payments in each future

period are F1, F2, . . . and so on, then the PDV is computed as:

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 16 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-Run
Perspective

Why Current Labels May Be Meaningless

Policy debates have traditionally focused on the extent to which this

year’s governmental spending exceeds this year’s governmental revenues.

The existence of implicit obligations in the future, however, suggests that

these debates may be misplaced.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 17 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-Run
Perspective
Alternative Measures of Long-Run Government Budgets

intertemporal budget constraint

An equation relating the present
discounted value of the government’s
obligations to the present discounted
value of its revenues.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 18 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-
Run Perspective
Alternative Measures of Long-Run Government Budgets
Generational Accounting

An influential measure of the long-run budget was the generational

accounting measure developed by Auerbach, Gokhale, and Kotlikoff in
the early 1990s.

This budget measure was designed to assess the implications of the

government’s current (or proposed) fiscal policies for different
generations of taxpayers.

It answers the question: How much does each generation of taxpayers

(those born in different years) benefit, on net, from the government’s
spending and tax policies, assuming that the budget is eventually
brought into long-run balance?

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 19 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-
Run Perspective
Alternative Measures of Long-Run Government Budgets
Generational Accounting

The budget measure answers the question by first estimating the

government’s intertemporal budget constraint:

PDV of Remaining + PDV of Tax = PDV of All + Current

Tax payments of Payments of Future Gov’t Gov’t
Existing generations Future generations Consumption Debt

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 20 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-Run
Perspective
Alternative Measures of Long-Run Government Budgets
Long-Run Fiscal Imbalance

Generational accounting summarizes how the burden of financing the

government is shared across generations, but it doesn’t really address the
central question that might interest policy makers today: If the
government continues with today’s policies, how much more will the
government spend than it will collect in taxes over the entire future?

In 2003 alone, the government added roughly $20 trillion to the fiscal
imbalance. Each year, the fiscal imbalance grows by roughly 3–4%, as
the nation accumulates interest obligations on the existing large implicit
debt.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 21 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.3
Do Current Debts and Deficits Mean Anything? A Long-
Run Perspective
What Does the U.S. Government Do?

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 22 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
Short-Run vs. Long-Run Effects of the Government on
the Macroeconomy

short-run stabilization issues The role of the government in

combating the peaks and troughs of the business cycle.

automatic stabilization Policies that automatically alter taxes or spending

in response to economic fluctuations in order to offset changes in household
consumption levels. (Providing Unemployment Insurance Program which
pays benefits to unemployed workers to offset their income losses)

discretionary stabilization Policy actions taken by the government in

response to particular instances of an underperforming or overperforming
economy. (A tax cut legislated during a recession)

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 23 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
Background: Savings and Economic Growth

The earliest economic growth models emphasized a central role for

savings as an engine of growth, and this insight remains important for
growth economics today.

More Capital, More Growth

As there is more capital in an economy, each worker is more productive,

and total social product rises. A larger capital stock means more total
output for any level of labor supply. Thus, the size of the capital stock is
a primary driver of growth.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 24 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
Background: Savings and Economic Growth
More Savings, More Capital

 FIGURE 4-4

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 25 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
Background: Savings and Economic Growth
More Savings, More Capital

interest rate The rate of return in

the second period of investments
made in the first period.

In a competitive capital market, the equilibrium amount of capital is

determined by the intersection of these demand and supply curves.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 26 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
The Federal Budget, Interest Rates, and Economic Growth
The simple supply and demand framework is complicated by introducing
the federal government into the market.
What if there is a federal deficit and the government must borrow to
finance the difference between its revenues and its expenditures? The key
concern about federal deficits is that the federal government’s borrowing
might compete with the borrowing of private firms.
If a fixed supply of savings is used to finance both the capital of private
firms and the borrowing of the government, then the government’s
borrowing may crowd out the borrowing of the private sector and lead to
a lower level of capital accumulation.
In reality, there are a number of complications of how government
financing affects interest rates and growth.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 27 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
The Federal Budget, Interest Rates, and Economic Growth
International Capital Markets

There is a large body of economics literature that has investigated the

integration of international capital markets. It has generally concluded
that while integration is present (and perhaps growing), it is far from
perfect. As a result, the supply of capital to the United States may not be
perfectly elastic, and government deficits could crowd out private
savings.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 28 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
The Federal Budget, Interest Rates, and Economic Growth
Ricardian Equivalence

A popular alternative model of savings determination was developed by

macroeconomist Robert Barro in the 1970s. He pointed out that much of
the savings in the United States is accumulated to finance bequest,
inheritances left behind for the next generation.
This model has received very little empirical support in the economics
literature.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 29 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
The Federal Budget, Interest Rates, and Economic Growth
Expectations

There are both short-term (e.g., 30-day) and long-term (e.g., ten-year)
interest rates.
Because businesses tend to make long-standing capital investments,
they focus more on the longer-term rates. As a result, the entire future
path of government surpluses and deficits matters for capital
accumulation, not just the surplus or deficit today.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 30 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
The Federal Budget, Interest Rates, and Economic Growth
Evidence

Theory therefore tells us that higher deficits lead to higher interest rates
and less capital investment, but it does not tell us how much higher and
how much less.
The existing empirical literature on this question is somewhat
inconclusive, although recent evidence suggests that projected long-term
deficits do appear to be reflected to some extent in long-term interest rates.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 31 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.4
Why Do We Care About the Government’s
Fiscal Position?
Intergenerational Equity

intergenerational equity The

treatment of future generations
relative to current generations.

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 32 of 37
 CHAPTER 4 ■ BUDGET ANALYSIS AND DEFICIT FINANCING
4.5
Conclusion

The deficit has been a constant source of policy interest and political debate
over the last decade, as the government has moved from severe deficit to
large surplus and back to severe deficit again.
The existing deficit is quite large, but what is more worrisome than this cash
flow deficit is the long-run implicit debt that is owed to the nation’s seniors
through the Social Security and Medicare programs.
This long-term debt is many multiples of current cash debt, and could have
major negative effects on both economic efficiency (through crowding out
private savings, and ultimately national growth) and intergenerational equity
(by placing the enormous burden of balancing the government’s obligations
on future generations).

Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 33 of 37