To answer such questions, we need to decompose changes in the deficit into changes due to fiscal policy and changes due to the level of economic activity.
The implications of the Ricardian perspective are not quite as stark if the increased deficit is due to increased government spending. The federal income tax is progressive; higher-income households generally pay a greater proportion of their incomes than lower- and moderate-income households. Ontario Investment and Trade Advisory Council: The agency has not been active since and does not receive any funding. The multi-year planning process has resulted in:. Suppose the economy went into recession, so tax revenues decreased. A key simplification in these pictures is that the level of potential GDP is independent of taxes and government spending. This group includes all households that are in the top 20 percent of the national income distribution except for the top 1 percent.
The CBO first calculates a measure of potential output The amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle. Then it calculates the outlays and revenues of the federal government under the assumption that the economy is operating at potential GDP. The deficit is calculated by subtracting revenues from outlays.
For obvious reasons, the cyclically adjusted budget deficit is also sometimes called the full-employment deficit. We first calculate the level of potential output and then use the deficit line to tell us the cyclically adjusted budget deficit or surplus for the economy. The figure shows two possibilities. In the first case, there is a government deficit when actual output is equal to potential output. In the second case, there is a government surplus when output is equal to potential output. Of course, the practical calculations are somewhat trickier than this picture suggests, but the idea is straightforward.
In panel a , the economy has a cyclically adjusted deficit, whereas in panel b , it has a cyclically adjusted surplus. Suppose that, last year, the economy was at potential output and there was a cyclically adjusted surplus point A. Now imagine that this year there is a government deficit. One possibility is that the economy went into recession, as in Figure This is called a cyclical deficit A deficit that occurs when a government budget is in deficit because of the low level of real GDP. Another is that the stance of fiscal policy has changed—for example, because of an increase in government spending, as in Figure The CBO calls this a standardized deficit or structural deficit A deficit that occurs when a government budget is in deficit because of expansionary fiscal policy.
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A key simplification in these pictures is that the level of potential GDP is independent of taxes and government spending. Chapter 27 "Income Taxes" explains why potential output itself might be affected by the tax code. The economy went from surplus A to deficit B because of recession. Real GDP declines, tax receipts decrease, and the budget goes into deficit. The economy went from surplus A to deficit C because of changes in fiscal policy. Real GDP does not change: it is at potential output in both cases.
We have identified two factors that determine the size of the deficit: the stance of fiscal policy and the state of the economy. We can use this information to learn more about the effects of a balanced-budget amendment on the economy. Suppose that the economy is at potential output. A balanced-budget requirement would say that the economy must be neither in surplus nor in deficit at this point. In other words, a balanced-budget requirement describes the overall stance of fiscal policy. Now suppose that, for some reason, the economy goes into recession. We know that this leads to a deficit, which is shown as a shift from point A to point B.
Under a balanced-budget rule, the government is not allowed to let this situation persist. Instead the government must respond by increasing taxes or cutting spending, moving the economy from point B to point C. Similarly, if the economy went into a boom, this would tend to lead to a surplus. The government would be forced to cut taxes or increase spending to bring the budget back into balance. A balanced-budget amendment would force the government to conduct procyclical fiscal policy.
In fact, the effects of a balanced-budget amendment would be even worse. The countercyclical fiscal policy would cause GDP to decrease even further, thus requiring even bigger cuts in spending or increases in taxes. If the economy were to go into recession, a balanced-budget requirement would force the government to increase taxes or cut spending to bring the budget back into balance. To evaluate the merits of a balanced-budget amendment, we need to know why governments run deficits in the first place. After all, governments may have good reasons for these policies.
We have seen one explanation for deficits: governments run deficits because of economic downturns.
Reductions in gross domestic product GDP , other things being equal, lead to increases in the budget deficit. We are more concerned with why governments choose to run persistent structural deficits, though. We first look to history for clues. These are periods in which the stock of US federal debt soared. The debt level was more than 40 times higher in than in During World War II, there was again a significant buildup of the debt. In , the outstanding debt was percent of GDP. There are two other periods that show a significant buildup of the debt relative to GDP.
The first is the Great Depression. This buildup was not due to a big increase in borrowing by the government. Rather, it was largely driven by the decline in the level of GDP the denominator in the ratio. The second is the period from the s to the present. The buildup of the debt in the s was unprecedented in peacetime history.
Although the increases in this ratio are typically rather sudden, the decreases are much more gradual. As seen in the figure, the debt-to-GDP ratio decreased for about 45 years, from to Part of this decrease was due to the growth in GDP over the 45 years, and part was due to a decrease in nominal debt outstanding until around It is evident that during periods of war the debt is higher.
What underlies this relationship between wars and deficits? War is certainly expensive. Take, for example, the conflicts in Iraq and Afghanistan.
When government purchases increase due to a war, a government can either increase taxes to pay for the war or issue government debt. Remember that when the government runs a deficit to pay for a war, it is borrowing from the general public. History tells us that deficits have been the method of choice: governments have chosen to tax future generations to pay for wars. There are two arguments in favor of this policy:.
Taxation is expensive to the economy because it distorts economic decisions, such as saving and labor supply. The amount people want to work depends on their real wage, after taxes. So if tax rates are increased to finance government spending, this reduces the benefit from working.
Put differently, increased income taxes increase the price of consumption relative to leisure. The fact that people work less when taxes increase is a distortionary effect of taxation. Instead of bunching all this distortionary taxation into a short amount of time, such as a year, it is more efficient for the government to spread the taxation over many years. This is called tax smoothing To reduce the distortionary effects of taxes, a government will finance some current spending by issuing debt to spread the tax burden over time.
So by running a budget deficit, the government imposes relatively small distortions over many years rather than imposing large distortions within a single year. For more analysis of the choice underlying labor supply, you can review the labor market in the toolkit. Similar arguments apply to other cases in which governments engage in substantial spending. Imagine that the government is considering putting a large amount of resources into cancer research.
The discovery of a successful cancer treatment would, of course, benefit many generations of citizens. Because households would share the gains in the future, the costs should be shared as well. By running a budget deficit, the government is able to distribute the costs across generations of citizens in parallel with the benefits. From the perspective of both fairness and efficiency, there are some gains to deficit spending. More generally, we might want to make a distinction among different types of government purchases, just as we do among private purchases.
We know that the national accounts distinguish consumption purchases broadly speaking, things from which we get short-run benefit, such as food and movies from investment purchases things that bring long-term benefit, such as factories and machinery. Likewise, we might want to distinguish between government consumption, such as wages of employees at the Department of Motor Vehicles, from government investment, such as spending on cancer research. We could then argue that it makes more sense to borrow to finance government investment rather than government consumption.
Although a very nice idea in principle, this approach to the government accounts often founders on the practicalities and the politics of implementation. First, it is not at all clear how to classify many government expenditures. Was a launch of the space shuttle consumption or investment? What about the wages of teachers in the public schools?
What about the money spent on national parks? Second, politicians would have a strong incentive to classify expenditures as investment rather than consumption, to justify deferring payment. Another benefit of deficits is that they can play a role in economic stabilization. Chapter 22 "The Great Depression" spelled out in detail the role for fiscal policy in stabilizing output.
In the short run, the level of economic activity can deviate from potential GDP. As a consequence, aggregate expenditures play a role in determining the level of output. Fiscal policy influences the level of aggregate expenditures. Changes in government purchases directly affect aggregate expenditures because they are a component of spending, and changes in taxes indirectly affect aggregate demand through their effect on consumption.
Hence deficit spending can help to stabilize the economy. In summary, there are several arguments for allowing governments to run deficits. We would forswear these benefits if we were to adopt a balanced-budget amendment. One of the arguments for deficits—funding wars—is an explicit exception and the only such exception written into the bill from that we quoted earlier. But we conclude by noting that there is a further, much less benign, reason for government deficits: they may benefit politicians even if they do not benefit the country as a whole.
Deficits allow politicians to provide benefits to constituents today and leave the bill to future generations.