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Chapter 15

Government Spending and Its Financing

I. The Government Budget: Some Facts and Figures

in this chapter we shift our focus away from monetary policy

now we analyze fiscal policy and its macroeconomic effects

fiscal policy refers to actions taken by “the government”—the

President and the Congress working together

the tools of fiscal policy are taxes (T, t, and τ) and government
purchases (G)

A. Government Outflows

1. Three Categories of Government Spending

(1) Government Purchases (G)

this category is divided into government investment (1/6 of G)

and government consumption (5/6 of G)

(2) Transfer Payments (TR)

transfers are expenditures for which the government receives no

current goods or services in return

it is just a one-way transfer of wealth

transfers that are of major public concern in the U.S.: social

security benefits, pensions for government retirees, welfare
payments, health care

(3) Net Interest Payments (INT)

this category refers to interest payments on federal government

debt (Treasury securities)

defined as interest paid to holders of government bonds less

interest received by the government

(4) Other: federal subsidies paid out minus government-run

business surpluses received

this category is very small, so ignore it!

2. Total government outflows make up approximately 1/3 of


this includes federal, state, and local spending

the largest increase in government purchases (and overall

government spending) occurred during World War II

each category of government spending has its own unique

growth trend:

(1) after spiking in the 1940s, government purchases (G) have
actually steadily decreased since 1960

G has dropped from about 23 percent of GDP to approximately

19 percent of GDP

(2) transfer payments (TR) have been rising steadily

in 2000, transfer payments reached 12 percent of GDP

but due to expanding social programs (Social Security,

Medicare, Medicaid, Health Care), transfer payments are
expected to exponentially rise over the next few decades

(3) net interest payments (INT) has been volatile

from 1941 – 1946, interest on the national debt doubled because

of the increased debt issued to finance WW II

in the 1980s, interest payments doubled again because both the

national debt and interest rates increased sharply

in the 1990s and 2000s, there was a slight decline because of

lower interest rates on debt

much like transfer payments, interest payments on our national

debt will grow by unprecedented amounts in the coming years

3. If we compare U.S. government spending to that of other

countries, we see that the United States spends less (as a
percentage of GDP) than almost any other OECD country
this is not the conventional wisdom of the public

only Japan and Australia have smaller governments than the


this is because other developed countries have much broader

social welfare programs than we do

B. Government Inflows

1. Taxes

like government spending, total tax collections have generally

increased over time

tax revenues increased from about 16 percent of U.S. GDP in

1940 to approximately 29 percent in 2000, but then dropped to
about 26 percent by 2008

2. Four Categories of Taxes

(1) personal taxes (t)

composed of personal income taxes and property taxes

primarily collected at the federal level, although can also be

assessed at state and local levels

(2) contributions to social insurance programs

this category of inflows has increased steadily since WW II

(3) taxes on production and imports

composed of sales taxes

usually collected at the state and local levels

(4) corporate income taxes (τ)

makes up a very small source of government revenue

only comprises 2 to 3 percent of U.S. GDP

C. Federal Budget vs. State and Municipal Budgets

1. Overall, the sources of spending and the sources of revenue

are very different for the federal government and state and local

2. Government Outflows

(1) government purchases (G)

at the state and local levels, 75 percent of spending is made up

of G

at the federal level, only 30 percent of outflows is the result of


and out of this 30 percent, almost 2/3 is strictly spending on
national defense

(2) transfer payments (TR)

this is an outflow almost entirely of the federal government

state and local governments rarely pay transfer payments

(3) interest payments (INT)

very large and positive for the federal government (interest

payments on debt > interest payments received)

but for state and local governments, it is very small and

sometimes even negative

3. Government Inflows

personal income taxes and contributions to social programs

exceed 80 percent of the federal budget

but at the state and local levels, income tax is only 20 percent of

but the situation is reversed with respect to sales taxes

at the state and local levels, over 50 percent of income comes

from sales taxes

and at the federal level, only 4 percent of revenue is from import
and excise taxes

D. Deficits and Surpluses

1. When outflows exceed revenues, there is a budget deficit;

when revenues exceed outflows, there is a budget surplus

deficit → outflows > inflows

surplus → outflows < inflows

2. Deficit = (G + TR + INT) – T < 0

technically, this is called the “total deficit”

the total deficit represents the amount the federal government

must borrow in order to cover all of its expenditures and

this is the reason why the central bank must be legally separated
from the federal treasury!

3. The “current deficit” equals the total deficit minus the

government investment category (but we keep government

very large current deficits occurred in WW II, in the mid-1970s,

and in the early 1980s

mainly, these were caused because the federal government had
much higher levels of consumption than investment

II. Government Spending, Taxes, and the Macroeconomy

generally speaking, economists emphasize three main channels

through which government decisions on spending and taxes can
influence macro variables like real output, employment, and the
general price level

these three fiscal policy mechanisms are (1) aggregate demand,

(2) government capital formation, and (3) economic incentives
via tax rates

A. Fiscal Policy and Aggregate Demand

1. An increase in government purchases (G) increases aggregate

demand by shifting the IS curve up and to the right

2. The effect of changes in taxes depend on the economic model

this is the traditional classical vs. Keynesian debate

classical economists think changes in taxes do not affect Sd or


in other words, classical economists accept Ricardian


Keynesians argue that a tax cut will ↑ C, ↓ Sd, and ↑ A.D.

3. Classicals and Keynesians disagree about using fiscal policy
to stabilize the economy

classicals oppose activist policy (let the market work)

Keynesians favor it (even though Keynesians accept that fiscal

policy is not flexible and has very long lags)

4. Automatic stabilizers and the “full-employment deficit”

an “automatic stabilizer” causes fiscal policy to be counter-

cyclical by changing government spending or taxes

for example, unemployment insurance ↑ TR in recessions and

the income tax system leads to fewer revenues in recessions

because of these automatic stabilizers, the government budget

deficit rises in recessions and falls in booms

the “full-employment deficit” is a measure of what the

government budget deficit would be if the economy were at full

the full-employment deficit does not change with the business

cycle; it only changes with government policy regarding
spending and taxes

B. Government Capital Formation

1. Fiscal policy affects the economy through the formation of
government capital

“government capital” is long-lived physical assets owned by the

government like roads, schools, and sewer systems

the health of the economy depends not only on how much the
government spends, but also on how it spends its resources

these things contribute to an economy’s long-run economic

growth (as we will see in Chapter 6)

Example: Why did President Eisenhower champion the

construction of the U.S. Interstate Highway system?

2. Also, fiscal policy affects human capital formation through

expenditures on health, nutrition, and education

3. Data on government investment include only physical capital,

not human capital

NOTE: In 2008, 70 percent of government investment was for

national defense and 30 percent was for non-defense capital.
(Specifically, equipment at the national level.)

C. Incentive Effects of Fiscal Policy

1. Average vs. Marginal Tax Rates

“average tax rate” = [total taxes / pretax income] = [$ 2000 / $

18 000] = 11.1 %
“marginal tax rate” = taxes due from an additional dollar of

marginal tax rates are divided into income brackets like

$ 0 - $ 10 000 = 0 %

above $ 10 000 = 25 %

the average vs marginal distinction affects people’s decisions

about how much labor to supply

(1) ↑ average tax rate → pure income effect → ↓ income, ↓ C, ↓

leisure, ↑ labor supplied → the NS curve shifts down and to the

(2) ↑ marginal tax rate → pure substitution effect → a lower

after-tax reward leads to ↓ labor supplied → the NS curve shifts
up and to the left

2. Tax Reform Proposals in 2005

the U.S. tax code is extremely complicated and distorts

economic behavior (because people try to get tax advantages
rather than engaging in the optimal actions)

President George W. Bush appointed a panel in 2005 to find

ways to make the tax code “simpler, fairer, and more conducive
to economic growth”

the panel recommended the following changes:

(1) streamline the entire tax system, and make filing taxes easier
for everyone

(2) reduce marginal tax rates for everyone, yet retain the
progressive nature of the current system

(3) extend tax benefits from owning a home and from charitable
giving to everyone (not just to those who itemize their

(4) do not tax health insurance

(5) reform the entire tax system in order to encourage more

saving and investment

(6) completely repeal the Alternative Minimum Tax (AMT)

despite their best efforts, the panel failed to agree to one specific
plan, and a comprehensive tax reform bill was killed in summer

3. Supply-Side Economics

“supply-siders” believe that all aspects of economic behavior

(especially labor supply, saving, and investment behavior)
respond to economic incentives

specifically, economic agents respond to the incentives provided

by the tax code
↓ taxes → ↑ labor supplied, ↑ saving, ↑ investment

although this theory was popular in the 1980s, there has been
very little empirical support for supply-side economics

tax reforms usually result in an increase in labor supply of less

than one percent (very negligible)

4. Tax-induced distortions and tax rate smoothing

with no taxes, the invisible hand and free markets work


but taxes change economic behavior and reduce welfare

these deviations from free-market outcomes are called


↑ tax rates → ↑ the magnitude of distortions

fiscal policy-makers need to raise the needed amount of

government revenue (through taxes) while minimizing
distortions (the reduction in economic surplus and welfare)

it is better to keep the tax rate constant over time than to raise it
or lower it

this is because the higher tax rate has a higher distortion

for example, keeping the tax rate at a steady 15 % is better than
having it at 10 % one year and 20 % the next, since the
distortions in the second year are much higher

this practice is called “tax-rate smoothing”

III. Government Deficits and Debt

A. The Growth of U.S. Government Debt

what is the actual relationship between the federal budget

“deficit” and the national “debt”?

1. The deficit is the difference between expenditures and

revenues in any given fiscal year

the federal budget deficit is a flow variable (it has a time


2. The national debt is the total value of outstanding

government bonds (IOUs) on a given date

the national debt is a stock variable (it is a snapshot taken at a

specific point in time)

3. Thus, the deficit is the change in the debt in a year

using the text’s notation,

∆ B = nominal government budget deficit

B = nominal value of government bonds outstanding

4. The “debt-to-GDP” ratio shows how able the government is

in paying off its debt

countries with a high GDP have relatively more resources

available to pay the principal and interest on the government’s
outstanding debt

two things cause the debt-to-GDP ratio to rise

(1) a high deficit relative to GDP

(2) a slow rate of GDP growth

B. Social Security: How can it be fixed?

1. The Social Security system may not be able to pay future

promised benefits

to be more optimistic, the system may not be able to pay the full
amount of promised benefits

current estimates are that our benefits will be reduced by 25 %,

but it’s better than zero!

2. The Social Security system is “pay as you go” (“pay-go”)

taxes collected from today’s labor force go to paying benefits to

current retirees

in the private sector, this is called a “Ponzi scheme”—and it is

3. The pay-go system worked as long as the number of workers

greatly exceeded the number of retirees

this is no longer the case because demographic changes are

decreasing the ratio of workers to retirees

in 1940: 150 workers to 1 beneficiary

in 2000: 3 workers to 1 beneficiary

by 2030: 1 worker to 1 beneficiary (estimated)

4. Eventually, the amount of promised payouts will exceed the

amount of tax revenue

5. Solutions to fixing Social Security

(1) abolish it

(2) ↑ taxes (but this will distort labor supply decisions)

(3) ↑ rate of return by investing the trust fund in the stock

market (but this could be very risky)

(4) ↓ benefits while simultaneously ↑ retirement age

(5) let people invest their own funds in individual accounts (but
this still doesn’t solve the problem of what to do with the current
retirees who were promised full benefits)

C. The burden of the national debt on future generations

1. The conventional wisdom is that our children will have to pay

back the national debt that has been accumulated by the previous
and current generations

2. The truth is that U.S. citizens own most of the government


so in a way, future generations will just be paying themselves

3. Regardless, there are mechanisms through which our national

debt can be troublesome to future generations

(1) if tax rates have to be raised in the future to pay off the debt,
the higher tax rates could be distortionary

(2) since bondholders tend to be richer (on average) than non-

bondholders, when the debt is repaid there will be a large
transfer of wealth from the poor to the rich

(3) government deficits reduce national saving (crowding-out)

if crowding-out occurs, then ↓ Sd, ↓ Id, ↓ K*, ↓ Y → a lower

standard of living

D. The American Recovery and Reinvestment Act of 2009

the “Stimulus Package of 2009”

1. The stimulus package is expected to increase federal

government spending by $ 499 billion and reduce taxes by $ 288

the net result, then, is a projected federal budget deficit of $ 787

billion over the next decade

2. The package is expected to help increase GDP and reduce


3. But the debt-to-GDP ratio is expected to rise sharply

compared with what it would have been in the absence of the
stimulus law

some numbers:

U.S. debt-to-GDP in 2011: 54.4 %

U.S. debt-to-GDP in 2019: 41.9 % (without the stimulus


U.S. debt-to-GDP in 2019: 67.8 % (with the stimulus package)

IV. Deficits and Inflation