CHAPTER 33 Fiscal Policy, Deficits, and Debt In Chapter 31, we saw


Fiscal Policy,
Deficits, and Debt

In Chapter 31, we saw that an excessive increase in aggregate demand can cause demand-pull inflation and that a significant decline in aggregate demand can cause recession and cyclical unemployment. For these reasons, the federal government sometimes tries to “stimulate the economy” or “rein in inflation.” Such countercyclical fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth. (The adjective “fiscal” simply means “financial.”)

fiscal policy Changes in government spending and tax collections designed to achieve full employment, price stability, and economic growth; also called discretionary fiscal policy.

We begin this chapter by examining the logic behind fiscal policy, its current status, and its limitations. Then we examine a closely related topic: the U.S. public debt.

Fiscal Policy and the AD-AS Model

> > LO33.1 Identify the purposes, tools, and limitations of fiscal policy.

Fiscal policy consists of changes in government spending and tax collections designed to achieve full employment, price stability, and economic growth. Fiscal policy can be either discretionary or nondiscretionary:

Discretionary fiscal policy refers to changes in government spending and taxes that are at the option of the federal government. They do not occur automatically. The current congress must pass a discretionary spending or tax bill and the president must sign it into law.

Nondiscretionary fiscal policy refers to changes in spending and taxes that occur automatically, or passively, without the need for current congressional action. They occur as the result of spending and tax provisions put into law by earlier congresses.

Discretionary fiscal policy is often initiated on the advice of the president’s Council of Economic Advisers (CEA), a group of three economists who provide expertise and assistance on economic matters. Various congressional committees have final say, however, on the contents of any discretionary spending or tax bill that is sent to the president.

Council of Economic Advisers (CEA) A group of three persons that advises and assists the president of the United States on economic matters (including the preparation of the annual Economic Report of the President).

Expansionary Fiscal Policy

When a recession occurs, the government may initiate an expansionary fiscal policy that is designed to increase aggregate demand and therefore raise real GDP. Consider Figure 33.1 (Key Graph), where lower profit expectations cause a sharp decline in investment spending that shifts the economy’s aggregate demand curve to the left from AD1 to AD2. (Disregard the arrows and dashed downward sloping line for now.)

expansionary fiscal policy An increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output.

Suppose the economy’s potential or full-employment output is $510 billion in Figure 33.1. If the price level is inflexible downward at P1, the broken horizontal line becomes relevant to the analysis. The aggregate demand curve moves leftward and reduces real GDP from $510 billion to $490 billion. The result is a GDP gap of negative $20 billion (= $490 billion − $510 billion). Unemployment increases because fewer workers are needed to produce the reduced level of output. In short, the economy is suffering both recession and cyclical unemployment.

What fiscal policy should the federal government use to stimulate the economy? It has three main options: (1) increase government spending, (2) reduce taxes, or (3) use some combination of the two. If the federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit—government spending in excess of tax revenues.

budget deficit The amount by which expenditures exceed revenues in any year.

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Increased Government Spending As an overall strategy, the government will want to shift the aggregate demand curve back where it came from, thereby returning the economy to producing $510 billion of real GDP at the intersection of AD1 and AS. One way for the government to accomplish that goal is by initiating $5 billion of new spending on highways, education, and health care. We represent this new $5 billion of government spending as the horizontal distance between AD2 and the dashed downward sloping line immediately to its right. At each price level, the amount of real output that is demanded is now $5 billion greater than that demanded before government spending increased. So aggregate demand will shift rightward, from AD2 to the dashed downward sloping line immediately to its right.

The initial increase in aggregate demand is not the end of the story. Through the multiplier effect, the aggregate demand curve will shift farther, all the way to AD1, a distance that exceeds the amount represented by the originating $5 billion increase in government purchases. This greater shift occurs because the multiplier process magnifies the initial change in spending into successive rounds of new consumption spending. If the economy’s MPC is 0.75, then the simple multiplier is 4. Thus the aggregate demand curve shifts rightward by four times the $5 billion distance between AD2 and the dashed downward sloping line. Because this particular increase in aggregate demand occurs along the horizontal dashed-line segment, real output rises by the full extent of the multiplier. Real output rises to $510 billion, up $20 billion from its recessionary level of $490 billion. Unemployment falls as firms increase their employment to the full-employment level that existed before the recession. Mission accomplished.

Tax Reductions Alternatively, the government could reduce taxes to shift the aggregate demand curve rightward from AD2 to AD1. Suppose the government cuts personal income taxes by $6.67 billion, which increases disposable income by the same amount. Consumption will rise by $5 billion (= MPC of 0.75 × $6.67 billion), and saving will go up by $1.67 billion (= MPS of 0.25 × $6.67 billion). In this case, the horizontal distance between AD2 and the dashed downward sloping line in Figure 33.1 represents only the $5 billion initial increase in consumption spending. Again, we call it “initial” consumption spending because the multiplier process yields successive rounds of increased consumption spending. The aggregate demand curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut. Real GDP rises by $20 billion, from $490 billion to $510 billion, implying a multiplier of 4. Employment increases accordingly.

You may have noted that a tax cut must be somewhat larger than an increase in government spending to achieve the same amount of rightward shift in the aggregate demand curve. Why? Part of a tax reduction increases saving, rather than consumption. To increase initial consumption by a specific amount, the government must reduce taxes by more than that amount. When the MPC is 0.75, taxes must fall by $6.67 billion to increase consumption by $5 billion because $1.67 billion of the $6.67 billion tax reduction is saved (not consumed). The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption.

Combined Government Spending Increases and Tax Reductions The government may combine spending increases and tax cuts to produce the desired initial increase in spending and the eventual increase in aggregate demand and real GDP. For example, the government might increase its spending by $1.25 billion while reducing taxes by $5 billion. As an exercise, you should explain why this combination will produce the targeted $5 billion initial increase in new spending.

Contractionary Fiscal Policy

When demand-pull inflation occurs, a restrictive or contractionary fiscal policy may help control it. Look at Figure 33.2, where the full-employment level of real GDP is $510 billion. The economy starts at equilibrium at point a, where the initial aggregate demand curve AD3 intersects aggregate supply curve AS. Suppose that after going through the multiplier process, a $5 billion initial increase in investment and net export spending shifts the aggregate demand curve to the right by $20 billion, from AD3 to AD4. (Ignore the downward sloping dashed line for now.) Given the upward sloping AS curve, the equilibrium GDP does not rise by the full $20 billion, however. It rises by only $12 billion, to $522 billion, thereby creating an inflationary GDP gap of $12 billion (= $522 billion − $510 billion). The upward slope of the AS curve means that some of the rightward movement of the AD curve ends up causing demand-pull inflation rather than increased output. The price level rises from P1 to P2, and the equilibrium moves to point b.

contractionary fiscal policy A decrease in government purchases of goods and services, an increase in net taxes, or some combination of the two, for the purpose of decreasing aggregate demand and thus controlling inflation.

Without a government response, the inflationary GDP gap will cause further inflation (as input prices rise in the long run to meet the increase in output prices). If the government looks to fiscal policy to eliminate the inflationary GDP gap, it can (1) decrease government spending, (2) raise taxes, or (3) use some combination of those two policies. When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus—tax revenues in excess of government spending.

budget surplus The amount by which the revenues of the federal government exceed its expenditures in any year.

Decreased Government Spending To control demand-pull inflation, the government can decrease aggregate demand by reducing government spending. Look at Figure 33.2 and consider what would happen if the government attempted to design a spending-reduction policy to eliminate the inflationary GDP gap. Because the $12 billion gap was caused by the $20 billion rightward movement of the aggregate demand curve from AD3 to AD4, the government might naively think that it could solve the problem by causing a $20 billion leftward shift that would put the aggregate demand curve back in its original position. It could reduce government spending by $5 billion and then allow the multiplier effect to expand that initial decrease into a $20 billion decline in aggregate demand, thus shifting the aggregate demand curve leftward by $20 billion, putting it back at AD3.

This policy would work fine if prices were flexible. The economy’s equilibrium would move back from point b to point a, with equilibrium GDP returning to the full-employment level of $510 billion and the price level falling from P2 back to P1.

But this scenario is not what will actually happen. Instead, the price level is stuck at P2, so that the dashed horizontal line at price level P2 becomes important to the analysis. The fixed price level means that when the government reduces spending by $5 billion to shift the aggregate demand curve back to AD3, it will actually cause a recession! The new equilibrium will not be at point a. It will be at point d, where aggregate demand curve AD3 crosses the dashed horizontal line. At point d, real GDP is only $502 billion, $8 billion below the full-employment level of $510 billion.

The problem is that, with the price level downwardly inflexible at P2, the $20 billion leftward shift of the aggregate demand curve causes a full $20 billion decline in real GDP. None of the change in aggregate demand can be dissipated as a decline in the price level. As a result, equilibrium GDP declines by the full $20 billion, falling from $522 billion to $502 billion, which is $8 billion below potential output. By failing to account for the inflexible price level, the government has overdone the decrease in government spending, replacing a $12 billion inflationary GDP gap with an $8 billion recessionary GDP gap. This was clearly not its goal.

Here’s how it can avoid this scenario. The government first determines the size of the inflationary GDP gap. It is $12 billion. Second, it knows that with the price level fixed, the multiplier will be in full effect. Thus, it knows that any decline in government spending will be multiplied by a factor of 4. It then reasons that government spending will have to decline by only $3 billion Page 650rather than $5 billion. Why? Because the $3 billion initial decline in government spending will be multiplied by 4, creating a $12 billion decline in aggregate demand. Under the circumstances, a $3 billion decline exactly offsets the $12 billion GDP gap.

Please note that the inflationary GDP gap is the problem that government wants to eliminate in Figure 33.2. To succeed, it doesn’t have to undo the full $20 billion increase in aggregate demand that caused the inflation in the first place. With the price level stuck at P2, the government only has to move the AD curve leftward by $12 billion.

Graphically, the horizontal distance between AD4 and the dashed downward sloping line to its left represents the $3 billion decrease in government spending. Once the multiplier process is complete, this spending cut shifts the aggregate demand curve leftward by $12 billion, from AD4 to AD5. With the price level fixed at P2, the economy will come to equilibrium at point c. The economy operates at its potential output of $510 billion, and the inflationary GDP gap is eliminated. Furthermore, the government will not accidentally push the economy into a recession by decreasing government spending by too much.

Increased Taxes Just as government can use tax cuts to increase consumption spending, it can use tax increases to reduce consumption spending. If the economy in Figure 33.2 has an MPC of 0.75, the government must raise taxes by $4 billion to achieve its fiscal policy objective. The $4 billion tax increase reduces saving by $1 billion (= the MPS of 0.25 × $4 billion). This $1 billion reduction in saving is, by definition, a reduction in savings, not spending. But the $4 billion tax increase also reduces consumption spending by $3 billion (= the MPC of 0.75 × $4 billion), as shown by the distance between AD4 and the dashed downward sloping line to its left in Figure 33.2. After the multiplier process is complete, this initial $3 billion decline in consumption spending causes aggregate demand to shift leftward at each price level by $12 billion (= multiplier of 4 × $3 billion). With the economy moving to point c, the inflationary GDP gap is closed and the inflation is halted.

Combining Government Spending Decreases with Tax Increases The government may choose to combine spending decreases and tax increases in order to reduce aggregate demand and control inflation. To check your understanding, determine why a $1.5 billion decline in government spending combined with a $2 billion increase in taxes will shift the aggregate demand curve from AD4 to AD5.

Built-In Stability

Tax Collections and the Business Cycle

> > LO33.2 Explain how built-in stabilizers moderate business cycles.

Under normal circumstances, government tax revenues change automatically over the course of the business cycle in ways that stabilize the economy. This automatic response, or built-in stability, constitutes what is commonly referred to as nondiscretionary (or “passive” or “automatic”) budgetary policy. We did not include this built-in stability in the discussion about fiscal policy that we had in the last section because we implicitly assumed that the same amount of tax revenue was being collected at each level of GDP. But the actual U.S. tax system is such that net tax revenues vary directly with GDP. (Net taxes are tax revenues less transfers and subsidies. From here on, we will use “taxes” to mean “net taxes.”)

Virtually any tax will yield more tax revenue as GDP rises. In particular, personal income taxes have progressive rates and thus generate more-than-proportionate increases in tax revenues Page 651as GDP expands. Furthermore, as GDP rises and more goods and services are purchased, revenues from corporate income taxes and from sales taxes and excise taxes also increase. And, similarly, revenues from payroll taxes rise as economic expansion creates more jobs. Conversely, when GDP declines, tax receipts from all these sources also decline.

Transfer payments (or “negative taxes”) behave in the opposite way from tax revenues. Unemployment compensation payments and welfare payments decrease during economic expansion and increase during economic contraction.

Automatic or Built-In Stabilizers

A built-in stabilizer is anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers. As Figure 33.3 reveals, this is precisely what the U.S. tax system does. Government expenditures G are fixed and assumed to be independent of the level of GDP. Congress decides on a particular level of spending, but it does not determine the magnitude of tax revenues. Instead, it establishes tax rates, and the tax revenues then vary directly with the level of GDP that the economy achieves. Line T represents that direct relationship between tax revenues and GDP.

built-in stabilizer A mechanism that increases government’s budget deficit (or reduces its surplus) during a recession and increases government’s budget surplus (or reduces its deficit) during an expansion without any action by policymakers. The tax system is one such mechanism.

Economic Importance The economic importance of the direct relationship between tax receipts and GDP becomes apparent when we consider that:

Taxes reduce spending and aggregate demand.

Reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping.

As shown in Figure 33.3, tax revenues automatically increase as GDP rises during prosperity, and since taxes reduce household and business spending, they restrain the economic expansion. That is, as the economy moves toward a higher GDP, tax revenues automatically rise and move the budget from deficit toward surplus. In Figure 33.3, observe that the high and perhaps inflationary income level GDP3 automatically generates a contractionary budget surplus.

Conversely, as GDP falls during recession, tax revenues automatically decline, increasing spending by households and businesses and thus cushioning the economic contraction. With a falling GDP, tax receipts decline and move the government’s budget from surplus toward deficit. In Figure 33.3, the low level of income GDP1 will automatically yield an expansionary budget deficit.

Tax Progressivity Figure 33.3 reveals that the size of the automatic budget deficits or surpluses—and therefore built-in stability—depends on the responsiveness of tax revenues to changes in GDP. If tax revenues change sharply as GDP changes, the slope of line T in the figure will be steep and the vertical distances between T and G (the deficits or surpluses) will be large. If tax revenues change very little when GDP changes, the slope will be gentle and built-in stability will be low.

The steepness of T in Figure 33.3 depends on the tax system itself:

In a progressive tax system, the average tax rate (= tax revenue/GDP) rises with GDP.

In a proportional tax system, the average tax rate remains constant as GDP rises.

In a regressive tax system, the average tax rate falls as GDP rises.

progressive tax At the individual level, a tax whose average tax rate increases as the taxpayer’s income increases. At the national level, a tax for which the average tax rate (= tax revenue/GDP ) rises with GDP.

proportional tax At the individual level, a tax whose average tax rate remains constant as the taxpayer’s income increases or decreases. At the national level, a tax for which the average tax rate (= tax revenue/GDP ) remains constant as GDP rises or falls.

regressive tax At the individual level, a tax whose average tax rate decreases as the taxpayer’s income increases. At the national level, a tax for which the average tax rate (= tax revenue/GDP ) falls as GDP rises.

The progressive tax system has the steepest tax line T of the three. However, tax revenues will rise with GDP under both the progressive and the proportional tax systems, and they may rise, fall, or stay the same under a regressive tax system. The main point is this: The more progressive the tax system, the greater the economy’s built-in stability.

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The built-in stability provided by the U.S. tax system has reduced the severity of business fluctuations, perhaps by as much as 8 to 10 percent of the change in GDP that otherwise would have occurred.1 In recession-year 2009, for example, revenues from the individual income tax fell by a staggering 22 percent. This decline helped keep household spending and real GDP from falling even more than they did. But built-in stabilizers can only dampen, not counteract, swings in real GDP. Discretionary fiscal policy (changes in tax rates and expenditures) or monetary policy (central bank–caused changes in interest rates) therefore may be needed to try to counter a recession or an inflation of any appreciable magnitude.

Evaluating How Expansionary or Contractionary Fiscal Policy Is Determined

> > LO33.3 Describe how the cyclically adjusted budget reveals the status of U.S. fiscal policy.

How can we determine whether a government’s discretionary fiscal policy is expansionary, neutral, or contractionary? We cannot simply examine the actual budget deficits or surpluses that take place under the current policy because they will necessarily include the automatic changes in tax revenues that accompany every change in GDP. In addition, the expansionary or contractionary strength of any change in discretionary fiscal policy depends not on its absolute size but on how large it is relative to the size of the economy. So, in evaluating the status of fiscal policy, we must adjust deficits and surpluses to eliminate automatic changes in tax revenues and also compare the sizes of the adjusted budget deficits and surpluses to the level of potential GDP.

Cyclically Adjusted Budget

Economists use the cyclically adjusted budget (also called the full-employment budget) to adjust actual federal budget deficits and surpluses to account for the changes in tax revenues that happen automatically whenever GDP changes. The cyclically adjusted budget measures what the federal budget deficit or surplus would have been under existing tax rates and government spending levels if the economy had achieved its full-employment level of GDP (its potential output). The idea essentially is to compare actual government expenditures with the tax revenues that would have occurred if the economy had achieved full-employment GDP. That procedure removes budget deficits or surpluses that arise simply because of cyclical changes in GDP and thus tell us nothing about whether the government’s current discretionary fiscal policy is fundamentally expansionary, contractionary, or neutral.

cyclically adjusted budget The estimated annual budget deficit or surplus that would occur under existing tax rates and government spending levels if the the economy were to operate at its full-employment level of GDP for a year; the full-employment budget deficit or surplus.

Consider Figure 33.4a, where line G represents government expenditures and line T represents tax revenues. In full-employment year 1, government expenditures of $500 billion equal tax revenues of $500 billion, as indicated by the intersection of lines G and T at point a. The cyclically adjusted budget deficit in year 1 is zero—government expenditures equal the tax revenues forthcoming at the full-employment output GDP1. Obviously, the cyclically adjusted deficit as a percentage of potential GDP is also zero. The government’s fiscal policy is neutral.

Now suppose that a recession occurs and GDP falls from GDP1 to GDP2, as shown in Figure 33.4a. Let’s also assume that the government takes no discretionary action, so lines G and T remain as shown in the figure. Tax revenues automatically fall to $450 billion (point c) at GDP2, while government spending remains unaltered at $500 billion (point b). A $50 billion budget deficit (represented by distance bc) arises. But this cyclical deficit is simply a by-product of the economy’s slide into recession, not the result of discretionary fiscal actions by the government. We would be wrong to conclude from this deficit that the government is engaging in an expansionary fiscal policy. The government’s fiscal policy has not changed. It is still neutral.

cyclical deficit Federal budget deficit that is caused by a recession and the consequent decline in tax revenues.

That fact is highlighted when we remove the cyclical part of the deficit and thus consider the cyclically adjusted budget deficit for year 2 in Figure 33.4a. The $500 billion of government expenditures in year 2 is shown by b on line G. And, as shown by a on line T, $500 billion of tax revenues would have occurred if the economy had achieved its full-employment GDP. Because both b and a represent $500 billion, the cyclically adjusted budget deficit in year 2 is zero, as is this deficit as a percentage of potential GDP. Since the cyclically adjusted deficits are zero in both years, we know that government did not change its discretionary fiscal policy, even though a recession occurred and an actual deficit of $50 billion resulted.

Recent and Projected U.S. Fiscal Policy

> > LO33.4 Summarize recent U.S. fiscal policy.

Table 33.1 lists actual federal budget deficits and surpluses (column 2) as a percentage of actual GDP, and cyclically adjusted deficits and surpluses (column 3) as a percentage of potential GDP. Note that:

Cyclically adjusted deficits are generally smaller than actual deficits because the actual deficits include cyclical deficits, whereas the cyclically adjusted deficits eliminate them.

Only cyclically adjusted surpluses and deficits as percentages of potential GDP (column 3) provide the information needed to determine whether fiscal policy is expansionary, contractionary, or neutral.

Fiscal Policy from 2000 to 2007

Take a look at the data in Table 33.1 for the year 2000. The economy was fully employed that year. Tax revenues poured into the Treasury and exceeded government expenditures by 2.4 percent. But not all was well. A bubble in tech stocks burst that spring, and the U.S. economy noticeably slowed during the latter half of the year. In March 2001, the economy slid into a recession.

Congress and the Bush administration responded by cutting taxes by $44 billion in 2001 and scheduling an additional $52 billion of cuts for 2002. These stimulus policies helped boost the economy, offset the recession, and cushion the economic blow delivered by the September 11, 2001, terrorist attacks. In March 2002, Congress passed further tax cuts totaling $122 billion over two years and extended unemployment benefits.

As Table 33.1 reveals, the cyclically adjusted budget moved from a surplus of 1.5 percent of potential GDP in 2000 to a deficit of −0.8 percent in 2002. Fiscal policy had definitely turned expansionary. Nevertheless, the economy remained sluggish through 2002 and into 2003.

In June 2003, Congress again cut taxes, this time by a much larger $350 billion over several years. The new tax legislation accelerated the reduction of marginal tax rates already scheduled for future years and slashed tax rates on income from dividends and capital gains. It also increased tax breaks for families and small businesses. This tax package increased the cyclically adjusted budget deficit as a percentage of potential GDP to −2.4 percent in 2003. The economy strengthened, and both real output and employment grew between 2003 and 2007. By 2007, full employment had been restored, although a −1.3 percent cyclically adjusted budget deficit still remained.

Fiscal Policy During and After the Great Recession

In the summer of 2007, a crisis in the market for mortgage loans flared up and then quickly exploded through every part of the financial system. Banks went bankrupt, major corporations like General Motors hurtled toward bankruptcy, and the stock market fell almost 50 percent. As the crisis worsened, general pessimism spread beyond the financial markets to the overall economy. Businesses and households curtailed spending, and in December 2007, the economy entered the Great Recession. To simulate the economy, Congress passed a $152 billion economic stimulus package in 2008 that focused primarily on sending checks of up to $600 each to taxpayers, veterans, and Social Security recipients.

As a percentage of GDP, the actual federal budget deficit jumped from −1.1 percent in 2007 to −3.1 percent in 2008. This increase resulted from an automatic drop-off of tax revenues during the recession, along with the fiscal stimulus checks paid out in 2008. As Table 33.1 shows, the cyclically adjusted budget deficit rose from −1.3 percent of potential GDP in 2007 to −2.9 percent in 2008. This increase in the cyclically adjusted budget deficit reveals that fiscal policy in 2008 was in fact expansionary.

The government had hoped that those receiving checks would spend the money and thus boost consumption and aggregate demand. But households either saved the money or used it to pay down credit card loans. Spending remained low and the economy continued to founder.

In response, Congress enacted the American Recovery and Reinvestment Act of 2009. This gigantic $787 billion program consisted of tax rebates, plus large spending increases on infrastructure, education, and health care. The idea was to flood the economy with additional spending to try to boost aggregate demand and get people back to work.

Unlike the lump-sum stimulus checks of 2008, the 2009 tax rebates showed up as small increases in workers’ monthly payroll checks. By giving workers smaller amounts per month rather than a single large check, the government hoped that people would spend rather than save the bulk of their enhanced income.

The recession officially ended during the summer of 2009, but the economy did not rebound vigorously. Unemployment remained high and tax collections were low due to a stagnant economy. As a result, policymakers decided to continue with large amounts of fiscal stimulus. Annual actual (not cyclically adjusted) budget deficits amounted to −4.0, −2.7, and −2.4 percent of GDP, respectively, in 2013, 2014, and 2015. The cyclically adjusted budget deficits for those years were, respectively, −2.8, −1.8, and −1.9 percent of potential GDP. Thus, while the intensity of fiscal stimulus was gradually diminishing, it remained substantially stimulatory.

More recent years have seen a continued use of fiscal stimulus, as evidenced by the fact that the cyclically adjusted deficit rose above 3 percent in both 2017 and 2018. These were, however, full-employment years. As a result, quite a few economists questioned whether the government should have been applying so much stimulus at a time when the economy’s resources were fully employed. In their reckoning, that much stimulus would only lead to inflation. Other economists countered that strong fiscal stimulus was still needed to counter lingering problems in the financial sector.

Inflation was 2.1 percent in 2017 and 2.4 percent in 2018. Both groups of economists claimed that those figures supported their own position. The group worried about inflation pointed out that inflation was above the Federal Reserve’s 2-percent inflation target in both years and, in addition, was rising. To them, this indicated that the economy was overheating and inflation would accelerate. The other group argued that with inflation under 3 percent, overheating was unlikely.

Problems, Criticisms, and Complications of Implementing Fiscal Policy

> > LO33.5 Discuss the problems that governments may encounter in enacting and applying fiscal policy.

Governments may encounter a number of significant problems in enacting and applying fiscal policy.

Problems of Timing

Several problems of timing may arise in connection with fiscal policy:

Recognition lag is the time between the beginning of recession or inflation and the certain awareness that it is actually happening. This lag arises because the economy does not move smoothly through the business cycle. Even during good times, the economy has slow months interspersed with months of rapid growth and expansion. Recognizing a recession is difficult because several slow months will have to happen in succession before people can conclude with any confidence that the good times are over and a recession has begun.

The same is true with inflation. Even periods of moderate inflation have months of high inflation—so that several high-inflation months must come in sequence before people can confidently conclude that inflation has moved to a higher level.

Due to recognition lags, the economy is often 4 to 6 months into a recession or inflation before the situation is clearly discernible in the relevant statistics. As a result, the economic downslide or inflation may become more serious than it would have if the situation had been identified and acted on sooner.

Administrative lag is the time between when policymakers recognize the need for a fiscal action and when that fiscal action is actually taken. The wheels of democratic government turn slowly. Following the terrorist attacks of September 11, 2001, the U.S. Congress was stalemated for five months before passing a compromise economic stimulus law in March 2002.

Operational lag is the delay between the time fiscal action is ordered and the time that it actually begins to affect output, employment, or the price level. Tax changes have very short operational lags because they can be lowered instantly and have immediate impacts on household and business spending. By contrast, government spending on public works—new dams, interstate highways, and so on—requires long planning periods and even longer periods of construction. Such spending is of questionable use in offsetting short (for example, 6- to 12-month) periods of recession. Consequently, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending so as to reduce or eliminate operational lag.

Political Considerations

Fiscal policy is conducted in the political arena. That environment may not only slow the enactment of fiscal policy but also generate situations in which political considerations override economic considerations. Politicians are human—they want to get reelected. A strong economy at election time will certainly help them. So they may favor large tax cuts under the guise of expansionary fiscal policy even though that policy is economically inappropriate. Similarly, they may rationalize increased government spending on popular items such as farm subsidies, highways, education, and homeland security. At the extreme, elected officials and political parties might collectively “hijack” fiscal policy for political purposes, cause inappropriate changes in aggregate demand, and thereby cause (rather than avert) economic fluctuations. In short, elected officials may cause so-called political business cycles—swings in overall economic activity and real GDP resulting from election-motivated fiscal policy, rather than from a desire to offset volatility in the private sector. Political business cycles are difficult to document and prove, but there is little doubt that political considerations weigh heavily in the formulation of fiscal policy.

political business cycle Fluctuations in the economy caused by the alleged tendency of Congress to destabilize the economy by reducing taxes and increasing government expenditures before elections and to raise taxes and lower expenditures after elections.

Future Policy Reversals

Fiscal policy may fail to achieve its objectives if households expect future reversals of policy. Consider a tax cut, for example. If taxpayers believe the tax reduction is temporary, they may Page 657save a large portion of their tax cut, reasoning that rates will return to their previous level in the future. They save more now so that they will be able to draw on their extra savings in the future when taxes rise again. So a tax reduction thought to be temporary may not increase present consumption spending and aggregate demand by as much as our simple model (Figure 33.1) suggests.

The opposite may be true for a tax increase. If taxpayers think it is temporary, they may reduce their saving to pay the tax while maintaining their present consumption. They may reason they can restore their saving when the tax rate again falls. So the tax increase may not reduce current consumption and aggregate demand by as much as policymakers intended.

To the extent that consumption smoothing occurs over time, fiscal policy will lose some of its strength.

Offsetting State and Local Finance

The fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation. Unlike the federal government, most state and local governments face constitutional or other legal requirements to balance their budgets. Like households and private businesses, state and local governments increase their expenditures during prosperity and cut them during recession.

During the Great Depression of the 1930s, most of the increase in federal spending was offset by decreases in state and local spending. During and immediately following the recession of 2001, many state and local governments offset lower tax revenues by raising tax rates, imposing new taxes, and reducing spending.

The $787 billion fiscal package of 2009 made a special effort to reduce this problem by giving substantial aid dollars to state governments. Because of the sizable federal aid, the states did not have to increase taxes and reduce expenditure as much as they would have otherwise. Thus their collective fiscal actions did not offset the federal stimulus by nearly as much as would have been the case if states had not received the aid money.

Crowding-Out Effect

Another potential flaw of fiscal policy is the crowding-out effect: An expansionary fiscal policy (deficit spending) may increase the interest rate and reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy. The rising interest rate might also potentially crowd out interest-sensitive consumption spending (such as purchasing automobiles on credit). But because investment is the most volatile component of GDP, the crowding-out effect focuses on investment and whether the stimulus provided by deficit spending may be partly or even fully neutralized by an offsetting reduction in investment spending.

crowding-out effect A rise in interest rates and a resulting decrease in planned investment caused by the federal government’s increased borrowing to finance budget deficits and refinance debt.

To see the potential problem, realize that whenever the government borrows money (which it must do to engage in deficit spending), it increases the overall demand for money. If the monetary authorities are holding the money supply constant, this increase in demand will raise the price paid for borrowing money: the interest rate. Because investment spending varies inversely with the interest rate, some investment will be choked off or “crowded out.”

Crowding out is likely to be less of a problem when the economy is in recession because investment demand tends to be weak. The reason: Output purchases slow during recessions, and therefore most businesses end up with substantial excess capacity. As a result, they do not have much incentive to add new machinery or build new factories. After all, why should they add capacity when some of their existing capacity is lying idle?

With investment demand weak during a recession, the crowding-out effect is likely to be very small. Simply put, there is not much investment for the government to crowd out. Even if deficit spending does increase the interest rate, the effect on investment may be fully offset by the improved investment prospects that businesses expect from the fiscal stimulus.

By contrast, when the economy is operating at or near full capacity, investment demand is likely to be quite strong, and crowding out will probably be a much more serious problem. When the economy is booming, factories will be running at or near full capacity, and firms will have high investment demand for two reasons. First, equipment running at full capacity wears out fast, so firms will be investing substantial amounts to replace worn-out machinery and equipment. Second, Page 658the economy is likely to be growing overall, so firms will be investing heavily in order to increase their production capacity and thereby take advantage of the economy’s increasing demand for goods and services.

The U.S. Public Debt

> > LO33.6 Discuss the size, composition, and consequences of the U.S. public debt.

The U.S. national debt, or public debt, is the accumulation of all past federal deficits and surpluses. The deficits have greatly exceeded the surpluses and have emerged mainly from war financing, recessions, and fiscal policy. As of April 2019, the total public debt was $22.1 trillion—$16.3 trillion held by the public, and $5.8 trillion held by federal agencies and the Federal Reserve.

To provide some historical perspective, please understand that the public debt was much smaller prior to the 2007–2009 recession. In 2006, it was $8.5 trillion. It then more than doubled, to $18.2 trillion in 2015, as large budget deficits were run to fight the Great Recession. And then it continued to rise during the late 2010s despite the economy returning to full employment in 2017.

That ongoing rise despite full employment generated a large amount of consternation and concern that we will discuss and analyze in this section. As with much else in economics, the public debt brings with it both costs and benefits.

public debt The total amount owed by the federal government to the owners of government securities; equal to the sum of past government budget deficits less government budget surpluses.


The total public debt of over $22 trillion represents the total amount of money owed by the federal government to the holders of U.S. government securities: financial instruments issued by the federal government to borrow money to finance expenditures that exceed tax revenues. U.S. government securities (loan instruments) are of four types: Treasury bills (short-term securities), Treasury notes (medium-term securities), Treasury bonds (long-term securities), and U.S. savings bonds (long-term, nonmarketable bonds).

U.S. government securities U.S. Treasury bills, notes, and bonds used to finance budget deficits ; the components of the public debt.

Figure 33.5 shows that the public, not including the Federal Reserve, held 62 percent of the federal debt in 2018 and that federal government agencies and the Federal Reserve held the remaining 38 percent. Foreigners held about 29 percent of the total U.S. public debt in 2018, meaning that most of the U.S. public debt is held internally and not externally. Americans owed 71 percent of the public debt to Americans. Of the $6.2 trillion of debt held by foreigners, China held 21 percent, Japan held 19 percent, and oil-exporting nations held 3 percent.

International Comparisons

It is not uncommon for countries to have sizable public debts. As Global Perspective 33.1 shows, the public debt as a percentage of real GDP in the United States is neither particularly high nor low relative to such debt percentages in other advanced industrial nations.

Interest Charges

Many economists conclude that the primary burden of the debt is the annual interest charge accruing on the government notes and bonds sold to finance the debt. In 2018, interest on the total public debt was $371 billion. Although this amount is sizable in absolute terms, it was only Page 6601.8 percent of GDP for 2018. In other words, the federal government had to collect taxes equal to 1.8 percent of GDP to service the total public debt. This percentage was virtually unchanged from 2000 despite the much higher total public debt, mostly because the Federal Reserve kept interest rates low in the wake of the Great Recession.

False Concerns

You may wonder if the large public debt might bankrupt the United States or place a tremendous burden on your children and grandchildren. Fortunately, these are largely false concerns. People were wondering the same things 50 years ago!


The large U.S. public debt does not threaten to bankrupt the federal government or leave it unable to meet its financial obligations. There are two main reasons: refinancing and taxation.

Refinancing As long as lenders view the U.S. public debt as manageable and sustainable, the public debt is easily refinanced. As portions of the debt come due each month, the government does not cut expenditures or raise taxes to provide the funds required. Rather, it refinances the debt by selling new bonds and using the proceeds to pay off the maturing bonds. The new bonds are in strong demand because lenders obtain a tradable security that (unlike other assets such as stocks, corporate debt, and real estate) is considered nearly riskless since there is virtually zero chance that the U.S. government would default on its debt payments.

Of course, refinancing could become an issue with a high enough debt-to-GDP ratio. Some countries, including Greece, have encountered this problem. High and rising ratios in the United States might raise fears that the U.S. government might be unable to pay back loans as they come due. But this is a false concern for the United States, given the U.S. economy’s strong long-term growth prospects and how modest the U.S. debt-to-GDP ratio is as compared with those of other countries (see Global Perspective 33.1).

Taxation Financially distressed private households and corporations cannot extract themselves from their financial difficulties by taxing the public. If their incomes or sales revenues fall short of their expenses, they can indeed go bankrupt. But the federal government does have the option of imposing new taxes or increase existing tax rates to finance its debt. Such tax hikes may be politically unpopular and may weaken incentives to work and invest, but they are a means of raising funds to finance the debt.

Burdening Future Generations

In 2018, public debt per capita was $65,709. Was each child born in 2018 handed a $65,709 bill from the federal government? Not really. The public debt does not impose as much of a burden on future generations because the United States owes a substantial portion of the public debt to itself. U.S. citizens and institutions (banks, businesses, insurance companies, governmental agencies, and trust funds) own about 71 percent of the U.S. government securities. Although that part of the public debt is a liability to Americans (as taxpayers), it is simultaneously an asset to Americans (as holders of Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds).

To eliminate the American-owned part of the public debt would require a gigantic transfer payment from Americans to Americans. Taxpayers would pay higher taxes, and debt holders would receive an equal amount for their U.S. government securities. Purchasing power in the United States would not change. Only the repayment of the 31 percent of the public debt owned by foreigners would negatively impact U.S. purchasing power.

The public debt increased sharply during the Second World War. But the decision to finance military purchases through the sale of government bonds did not shift the economic burden of the war to future generations. The economic cost of the Second World War consisted of the civilian goods society had to forgo in shifting scarce resources to war goods production. Regardless of whether society financed this reallocation through higher taxes or through borrowing, the real economic burden of the war would have been the same. That burden was borne almost entirely by those who lived during the war. They were the ones who did without a multitude of consumer goods to enable the United States to arm itself and its allies.

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The next generation inherited the debt from the war, but it also inherited an equal amount of government bonds that would pay them cash in future years. In addition, it inherited the enormous benefits from the victory—namely, preserved political and economic systems at home and the “export” of those systems to Germany, Italy, and Japan. Those outcomes enhanced postwar U.S. economic growth and helped raise the standard of living for future generations of Americans.

Substantive Issues

Although the preceding issues relating to the public debt are false concerns, several actual concerns do exist.

Income Distribution

The ownership of government securities is highly uneven. Some people own much more than the $65,709-per-person portion of government securities; other people own less or none at all. In general, the ownership of the public debt is concentrated among wealthier groups. While the overall federal tax system is progressive, interest payments on the public debt do mildly increase income inequality. Income is transferred from people who, on average, have lower incomes to the higher-income bondholders. If greater income equality is one of society’s goals, then this redistribution is undesirable.


The current public debt necessitates annual interest payments of $371 billion. With no increase in the size of the debt, that interest charge must be paid out of tax revenues. Higher taxes may dampen incentives to bear risk, to innovate, to invest, and to work. So, in this indirect way, a large public debt may impair economic growth and therefore impose a burden of reduced output (and income) on future generations.

Foreign-Owned Public Debt

The 29 percent of the U.S. debt held by foreign citizens, foreign businesses, and foreign governments (including foreign central banks) is an economic burden to Americans. Because we do not owe that portion of the debt “to ourselves,” the payment of interest and principal on this external public debt enables foreigners to buy some of our output. In return for the benefits derived from the borrowed funds, the United States transfers goods and services to foreign lenders. However, Americans also own debt issued by foreign governments, so payment of principal and interest by those governments transfers some of their goods and services to Americans.

external public debt The portion of the public debt owed to foreign citizens, firms, and institutions.

Crowding-Out Effect Revisited

A potentially more serious problem is the financing (and continual refinancing) of the large public debt, which can transfer a real economic burden to future generations by passing onto them a smaller stock of capital goods. This possibility involves the previously discussed crowding-out effect: the idea that public borrowing drives up real interest rates, thereby reducing private investment spending. If public borrowing happened only during recessions, crowding out would not likely be much of a problem. Because private investment demand tends to be weak during recessions, any increase in interest rates during a recession would at most cause only a small reduction in investment spending.

In contrast, the need to continuously finance a large public debt may be more troublesome. Continuous financing implies having to borrow large amounts of money when the economy is near or at its full-employment output. Because private investment spending is strong near economic peaks, any increase in interest rates at or near a peak may result in a substantial decline in private investment spending. If the amount of current investment crowded out is extensive, future generations will inherit an economy with a smaller production capacity and, other things equal, a lower standard of living.

Public Investments and Public-Private Complementarities But even with crowding out, two factors could partly or fully offset the net economic burden shifted to future generations. First, just as private expenditures may involve either consumption or investment, so it is with public goods. Part of the government spending enabled by the public debt is for public investment outlays (for example, highways, mass transit systems, and electric power facilities) and human capital Page 662(for example, investments in education, job training, and health). Like private expenditures on machinery and equipment, these public investments increase the economy’s future production capacity by increasing the stock of public capital passed onto future generations. That greater stock of public capital may offset the diminished stock of private capital resulting from the crowding-out effect, thereby leaving the economy’s overall production capacity unimpaired.

public investments Government expenditures on public capital (such as roads, highways, bridges, mass-transit systems, and electric power facilities) and on human capital (such as education, training, and health).

Public-private complementarities may also reduce the crowding-out effect. Some public and private investments are complementary. Thus, a public investment financed through debt could spur some private-sector investment by increasing its expected rate of return. For example, the presence of a newly built federal building in a particular city may encourage private investment in the form of nearby office buildings, shops, and restaurants. Through this complementary effect, government spending on public capital may shift the private investment demand curve to the right. Even if the government borrowing needed to build the new federal building boosts the interest rate, total private investment need not fall. However, the increase in private investment might be smaller than anticipated. If it is, then the crowding-out effect will not be fully offset.

McConnell, C. (2020). Economics (22nd ed.). McGraw-Hill Higher Education (US).