4

CHAPTER 4:

Budget Analysis and

Deficit Financing

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 CHAPTER 4: Budget Analysis and Deficit Financing

Budget Analysis and Deficit Financing 1

4.1 Government Budgeting

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

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 CHAPTER 4: Budget Analysis and Deficit Financing

Budget Analysis and Deficit Financing 2

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 CHAPTER 4: Budget Analysis and Deficit Financing

Excerpts from Inaugural Speeches and

the U.S. Deficit 1
“We will continue along the path toward a balanced budget in a
balanced economy.” President Lyndon Johnson
• Deficit in first year in office (1964): 0.9% of GDP
• Deficit in last year in office (1968): 2.9% of GDP

“We must balance our federal budget so that American families

will have a better chance to balance their family budgets.”
President Richard Nixon
• Deficit in first year in office (1969): –0.3% of GDP (surplus)
• Deficit in last year in office (1974): 0.4% of GDP

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Excerpts from Inaugural Speeches and

the U.S. Deficit 2
“We can achieve a balanced budget by 1979 if we have the
courage and the wisdom to continue to reduce the growth of
federal spending.” President Gerald Ford
• Deficit in first year in office (1975): 3.4% of GDP
• Deficit in last year in office (1976): 4.2% of GDP

“With careful planning, efficient management, and proper

restraint on spending, we can move rapidly toward a balanced
budget, and we will.” President Jimmy Carter
• Deficit in first year in office (1977): 2.7% of GDP
• Deficit in last year in office (1980): 2.7% of GDP

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Excerpts from Inaugural Speeches and

the U.S. Deficit 3
“[This budget plan] will ensure a steady decline in deficits, aiming
toward a balanced budget by the end of the decade.” President
Ronald Reagan
• Deficit in first year in office (1981): 2.6% of GDP
• Deficit in last year in office (1988): 3.1% of GDP

“[This budget plan] brings the deficit down further and balances
the budget by 1993.” President George H. W. Bush
• Deficit in first year in office (1989): 2.8% of GDP
• Deficit in last year in office (1992): 4.7% of GDP

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 CHAPTER 4: Budget Analysis and Deficit Financing

Excerpts from Inaugural Speeches and

the U.S. Deficit 4
“[This budget plan] puts in place one of the biggest deficit
reductions . . . in the history of this country.” President William
Clinton
• Deficit in first year in office (1993): 3.9% of GDP
• Deficit in last year in office (2000): –2.4% of GDP (surplus)

“Unrestrained government spending is a dangerous road to

deficits, so we must take a different path.” President George W.
Bush
• Deficit in first year in office (2001): –1.3% of GDP (surplus)
• Deficit in last year in office (2008): 3.2% of GDP

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Excerpts from Inaugural Speeches and

the U.S. Deficit
“This budget builds on these reforms . . . it’s a step we must take if
we hope to bring down our deficit in the years to come.” President
Barack Obama
• Deficit in first year in office (2009): 9.8% of GDP
• Deficit in most recent year in office (2015, projected): 3.2% of
GDP

“We can do so much more with the money we spend. With $20
trillion in debt . . . the government must learn to tighten its belt,
something families all over the country have had to learn to do.”
President Donald Trump
• Deficit in first year in office (2017): 3.5% of GDP
• Deficit in most recent year in office (2018, projected): 4.2% of
GDP
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 CHAPTER 4: Budget Analysis and Deficit Financing

Government Budgeting

• Debt: The amount that 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.

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The Budget Deficit in Recent Years

Figure 4-1

Federal government spending rose fairly steadily from 1965 through the
mid-1980s, but tax revenues did not keep pace, leading to a large deficit.
This deficit was eroded and turned to a surplus in the 1990s, but by 2001,
the United States was back in deficit again.

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Spending, Taxes, Deficits, and Debts: Government
Revenues and Expenditures, 1980−2020 • Mismatch in
income and
expenditure
leads to
borrowing,
Defici
t resulting in an
Deficit Surplus
annual
increase in the
national debt.
• Revenue>Expe
nditure :
Surplus
• Revenue<Expe
nditure :
Expetinditu
Deficit
re
Revenue

11
 CHAPTER 4: Budget Analysis and Deficit Financing

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.
• Discretionary spending: Optional spending set by appropriation
levels each year, at Congress’s discretion.

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Application: Efforts to Control the Deficit 1

Controlling the budget is a difficult process.

• The Balanced Budget and Emergency Control Act (also
known as the Gramm-Rudman-Hollings Deficit Reduction
Act, or GRH).
o Passed in 1985 in an attempt to control the budget.
o Initiated automatic spending cuts once the budget
deficit started missing specified targets.
o The cuts were avoided by gimmicks, such as changing
the targets.

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Application: Efforts to Control the Deficit 2

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 aimed to
restrain government growth.
• It created the pay-as-you-go process (PAYGO), which
prohibited any policy from increasing the estimated deficit in
the next six-year period.
• If deficits increase, the President must issue a sequestration
requirement, which reduces direct spending by a fixed
percentage.
• Apparently successful in reducing spending.

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Application: Efforts to Control the Deficit 3

PAYGO expired on September 30, 2002, and has not been

renewed.
• President Bush proposed renewing PAYGO in 2004 . . .
o but not before passing a budget that cut taxes and increased
spending.
• President Obama has publicly supported PAYGO legislation . . .
o but his proposed budget would increase deficits to almost
$2 trillion in the near term.

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Budget Policies and Deficits at the State Level 1

One tool for balancing budgets is a balanced budget requirement,

used by many states.
• 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.
• Forces revenues and expenditures at the end of each year to
actually balance.

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Budget Policies and Deficits at the State Level 2

• 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.
o Less effective than ex post BBR because rosy projections of
revenues can make a budget appear to be balanced when at
the end of the year it is revealed to actually be unbalanced
due to unrealistic expectations.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Learn by Doing: Practice Question 1

Which of the following types of spending are examples of

discretionary spending?
I. Medicaid
II. New highways
III. National defense
a) I and II only
b) II and III only
c) I and III only
d) I, II, and III

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 CHAPTER 4: Budget Analysis and Deficit Financing

Learn by Doing: Practice Question 1 (Answer)

Which of the following types of spending are examples of

discretionary spending?
I. Medicaid
II. New highways
III. National defense
a) I and II only
b) II and III only (correct answer)
c) I and III only
d) I, II, and III

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 CHAPTER 4: Budget Analysis and Deficit Financing

Measuring the Budgetary Position of the Government:

Alternative Approaches: Real Versus Nominal
• Real prices: Prices stated in some constant year’s dollars. Using
real prices allows analysts to assess how any value has changed
over time relative to the overall price level.
• 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.

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Economic Conditions

Because revenue (taxes) and spending (insurance) depend on the

economy, the deficit changes even when policy does not.
• Automatic stabilizers: Automatic reductions in revenues and
increases in outlays when the economy shrinks relative to its
potential.
• Cyclically adjusted budget deficit: A measure of the
government’s fiscal position if the economy were operating at
full potential GDP.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Budget Deficit, Accounting and Not Accounting for

Automatic Stabilizers Figure 4-2

As expected, this figure shows that in periods of economic expansion, the cyclically
adjusted deficit is actually higher than the reported deficit. When the economy is
underperforming, the cyclically adjusted deficit is significantly lower than the reported deficit.

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Cash versus Capital Accounting

Government investments in assets can worsen the budget deficit.

• 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.
• Cash accounting treats a birthday party and an office building as
identical, but capital accounting does not.

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Problems with Capital Budgeting

• Capital budgeting seems conceptually appealing, but:

o It is very hard to say when spending has increased the
government’s assets. Does buying a missile count as an
investment?
o The difficulties might make it easier for politicians to
misstate the government’s budgetary position with a capital
budget than without one.
• Some U.S. states and foreign countries use capital budgets with
mixed results.

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Static Versus Dynamic Scoring

• When policy changes, household behavior also changes,

potentially affecting the budget deficit.
• How to account for this?
o 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.
o 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.

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Static Versus Dynamic Scoring: Scoring the Stimulus

How does “stimulus spending” affect the budget deficit?

• This government spending can be very large and is explicitly
intended to grow the economy; static scoring would suggest
that it is very expensive.
• Dynamic scoring by the CBO suggested that the stimulus
increased GDP by 0.1–1.9% in 2012–2013.
• But in the long run, the stimulus may slightly decrease growth.
• Overall, it is difficult to assess the impact of policy on the
aggregate economy.

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Do Current Debts and Deficits Mean Anything? A Long-Run

Perspective
Many government programs create future expenses even if they
are not explicitly in law.
• Implicit obligation: Financial obligations that the government
has in the future that are not recognized in the annual
budgetary process.
• Example: Social Security payments are promised into the far
future.
• Deciding whether to spend $1 this year or next affects the
current deficit by $1 but has very little impact on the
government’s financial position.

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Background: Present Discounted Value 1

How much do future obligations or payments cost today?

• 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:
𝐹1 𝐹2 𝐹3
𝑃𝐷𝑉 = + 2
+ 3
+⋯
(1 + 𝑟) 1+𝑟 1+𝑟

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Background: Present Discounted Value 2

Example: Pitcher Max Scherzer was offered a 7-year, $210 million

contract. However, a provision of the contract stated that he would
receive $15 million installments over 14 years. The present value
of his contact was “only” $166 million.

$15𝑀1 $15𝑀2 $15𝑀14

𝑃𝐷𝑉 = + 2
+⋯ 14
(1 + 0.047) 1 + 0.047 1 + 0.047
= $166M

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Why Current Labels May Be Meaningless

• Looking at only the current revenues and expenditures can lead

to biased government policy making that favors policies that
look good in terms of current budgets, even if they have bad
long-term consequences for the fiscal position of the
government.
• Suppose the government offers to pay you $1 more in Social
Security benefits in return for an increase in payroll tax today of
half of the present value of that dollar.
o From today’s perspective, this is an increase in taxes, which
is good for the government.
o In the long term, the government will lose money when it
pays the increased benefits.
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 CHAPTER 4: Budget Analysis and Deficit Financing

Measuring Long-Run Government Budgets: Intertemporal

Budget Constraint
• One way to account for current and future expenditures and
revenue is the intertemporal budget constraint.
• Intertemporal budget constraint: An equation relating the
present discounted value of the government’s obligations to the
present discounted value of its revenues.
• Using this approach, the Trustees of the Medicare and Social
Security Funds released data in 2012 on the long-run fiscal
imbalance of the Social Security and Medicare programs.
The results are stunning: from the perspective of 2012, the
fiscal imbalance of these two programs is $64.8 trillion.

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Measuring Long-Run Government Budgets: Problems with

Long-Run Measures
There are limitations to this approach.
• Fiscal imbalance calculations assume an interest rate of 3.2%.
• These calculations require potentially heroic assumptions about
interest rates, costs, and incomes in the very distant future.
• They assume that government policy remains unchanged.
• They consider the pattern over time only of transfer programs,
not of other investments and government policies.

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 CHAPTER 4: Budget Analysis and Deficit Financing

What Does the U.S. Government Do?

The current U.S. budgeting approach scores policies on a 10-year

window.
• Replaces 1- and 5-year windows used before 1996,
incorporating some long-run concerns.
• Avoids imposing assumptions about revenue and expenditure in
the very distance future.
• Nonetheless, difficult to forecast over even a 5-year period:
o Actual and projected deficits can differ by more than $500
billion.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Projected Versus Actual Surplus/Deficit

Figure 4-3

CBO projections of the budget surplus/deficit five years ahead have deviated significantly
from the actual surplus/deficit, particularly during the high-deficit years of the early 1990s
and the high-surplus years of the late 1990s and early twenty-first century.

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 CHAPTER 4: Budget Analysis and Deficit Financing

APPLICATION 1: The Financial Shenanigans of 2001

• The tax reduction enacted in June 2001 was one of the largest
tax cuts in our nation’s history.
• The tax cut consisted of a convoluted set of phase-ins and
phaseouts of various tax cuts to comply with a congressional
budget plan limiting the 11-year cost to $1.35 trillion.
• Included a sunset provision: All of the tax cuts disappear on
December 31, 2010, reducing the 2011 cost of the tax cut to
zero.

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APPLICATION 2: The Financial Shenanigans of 2001

• The bill itself contained numerous tax cuts operating on erratic

schedules.
• Many of the cuts would phase in over periods longer than in
any prior American legislation, backloading most of the fiscal
impact toward 2010.
• Convoluted scheduling allowed legislators to claim that action
had been taken on a wide range of issues while delaying the
fiscal consequences associated with these actions.

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Learn by Doing: Practice Question 2

All of these are reasons that the CBO’s projections may be off
EXCEPT:
a) Forecasting five or ten years into the future is a highly
uncertain exercise.
b) Multiple models are used while making estimations.
c) They depend on assumptions about interest rates and
growth rates.
d) They do not account for the effects of future legislation.

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Learn by Doing: Practice Question 2 (Answer)

All of these are reasons that the CBO’s projections may be off
EXCEPT:
a) Forecasting five or ten years into the future is a highly
uncertain exercise.
b) Multiple models are used while making estimations.
(correct answer)
c) They depend on assumptions about interest rates and
growth rates.
d) They do not account for the effects of future legislation.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Why Do We Care About the Government’s Fiscal Position?

The government’s budget deficit has implications for both

efficiency and (intergenerational) equality.
• Budget deficits can affect the amount of savings and growth in
the economy.
• Today’s deficits are tomorrow’s taxes, so high deficits imply
redistribution from future to current generations.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Short-Run Versus 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.
• Discretionary stabilization: Policy actions taken by the
government in response to particular instances of an
underperforming or overperforming economy.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Background: Savings and Economic Growth

• More capital, more growth: Capital accumulation is a key part

of economic growth.
• As there is more capital in an economy:
o Each worker is more productive, and total social product
rises.
o A larger capital stock means more total output for any level
of labor supply. Thus, growth in the capital stock drives (per
capita) growth.

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More Savings, More Capital

What determines the amount of capital accumulated?

• Interest rate: The rate of return in the second period of
investments made in the first period.
• The higher the interest rate, the more people want to save
(demand), but the more it costs firms to invest (supply).
• In a competitive capital market, equilibrium is determined by
the intersection of these demand-for-savings and supply-of-
investment curves.

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 CHAPTER 4: Budget Analysis and Deficit Financing

The Federal Budget, Interest Rates, and Economic Growth 1

• 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.

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 CHAPTER 4: Budget Analysis and Deficit Financing

Capital Market Equilibrium

Figure 4-4

Adding government borrowing into the capital market reduces the supply
of saved funds available to the private capital market.

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 CHAPTER 4: Budget Analysis and Deficit Financing

The Federal Budget, Interest Rates, and Economic Growth 2

• Suppose a fixed supply of savings is used to finance both the

capital of private firms and the borrowing of the government.
• Government’s borrowing reduces the supply of savings.
• This increases interest rates and crowd outs the borrowing of
the private sector, leading to a lower level of capital
accumulation.
• In reality, there are a number of complications of how
government financing affects interest rates and growth.

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International Capital Markets

• If capital markets are internationally integrated, then the

amount of savings is very large relative to government
spending.
o This might mitigate crowding out.
• Evidence: While integration is present (and perhaps growing), it
is far from perfect.
o The supply of capital to the United States may not be
perfectly elastic, and government deficits could crowd out
private savings.

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Expectations

• There are both short-term (e.g., 30-day) and long-term (e.g., 10-
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.

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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.

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Intergenerational Equity

• Intergenerational equity: The treatment of future generations

relative to current generations.
• Budget deficits mean more benefits for the current generation
relative to future generations.
• But, because of economic growth, future generations have
better standards of living than previous ones.

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Conclusion

• The deficit has been a constant source of policy interest and

political debate over the past decades.
• The existing deficit is quite large, but the long-run implicit debt
that is owed to the nation’s seniors through the Social Security
and Medicare programs is even larger.
• This could have major long-term negative effects on both
economic efficiency and intergenerational equity.

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