Fiscal Policy, Deficits, and Debt

CHAPTER FOURTEEN
FISCAL POLICY, DEFICITS, AND DEBT

ANSWERS TO END-OF-CHAPTER QUESTIONS

14-1 The Federal government establishes its budget to decide what programs to provide and how to pay
for them. How does fiscal policy differ from this ordinary fiscal activity of budgeting?
Fiscal policy is directed specifically at altering the level of macroeconomic activity in order to
stimulate growth, reduce unemployment, and/or restrain inflation. Ordinary fiscal activities
address a wider range of priorities, many of which are noneconomic in nature, at least on the
surface, or that run contrary to traditional macroeconomic objectives.

14-2 What are governments fiscal policy options for moving the economy out of a recession? Use the
aggregate demand-aggregate supply model to show the impact of these policies on real GDP.
Speculate on which of these fiscal options might be favored by a person who wants to preserve the
size of government? A person who thinks the public sector is too large?
Options are to increase government spending, reduce taxes, or some combination of both. See
Figure 14.1. A person wanting to preserve the size of government might favor spending increases.
Someone who thinks that the public sector is too large might favor tax cuts.

14-3 Explain how built-in (or automatic) stabilizers work. What are the differences between
proportional, progressive, and regressive tax systems as they relate to an economys built-in
stability?
Net tax revenues vary directly with GDP. When GDP is rising, so are tax collections, both income
taxes and sales taxes. At the same time, government payoutstransfer payments such as
unemployment compensation, and welfareare decreasing. Since net taxes are taxes less transfer
payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand,
when GDP drops in a recession, tax collections slow down or actually diminish while transfer
payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP.
A progressive tax system would have the most stabilizing effect of the three tax systems and the
regressive tax would have the least built-in stability. This follows from the previous paragraph. A
progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening
effect on rising incomes and expenditures than would either a proportional or regressive tax. The
latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three
types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does
tax revenue decline with income, it becomes proportionately less as incomes fall. This acts as a
cushion on declining incomesthe tax bite is less, which leaves more of the lower income for
spending. The reverse would be true of a regressive tax that falls, but more slowly than the
progressive tax, as incomes decline.

14-4 Define the standardized budget, explain its significance, and state why it may differ from the actual
budget. Suppose the full-employment, noninflationary level of real output is GDP 3 (not GDP2) in
the economy depicted in Figure 14.3. If the economy is operating at GDP 2 instead of GDP3, what
is the status of its standardized budget? Its current fiscal policy? What change in fiscal policy

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would you recommend? How would you accomplish that in terms of the G and T lines in the
figure?
The standardized budget (also called full-employment budget) measures what the Federal deficit or
surplus would be if the economy reached full-employment level of GDP with existing tax and
spending policies. If the full-employment budget is balanced, then the government is not engaging
in neither expansionary nor contractionary policy, even if, for example, a deficit automatically
results when GDP declines. The actual budget is the deficit or surplus that results when revenues
and expenditures occur over a year regardless of whether or not the economy is operating at full-
employment.
Looking at Figure 14.3, if full-employment GDP level was GDP 3, then the full-employment budget
is contractionary since a surplus would exist. Even though the actual budget has no deficit at
GDP2, fiscal policy is contractionary. To move the economy to full-employment, government
should cut taxes or increase spending. You would raise G line or lower T line or combination of
each until they intersect at GDP3.

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14-5 As shown in Table 14.1, between 1990 and 1991 the actual budget deficit (as a percentage of
GDP) grew more rapidly than the full-employment budget deficit. What could explain this fact?
The explanation must be that the economy entered a recessionary phase during those years (it did,
in fact), and for that reason the deficit was greater than it would have been in a full-employment
economic situation. During a recession, tax revenues are lower than they would be at full
employment and government expenditures for entitlement programs rise more than they would at
full employment. Therefore, the actual deficit is greater than the full-employment budget deficit.

14-6 Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. How
might politics complicate fiscal policy? How might expectations of a near-term policy reversal
weaken fiscal policy based on changes in tax rates? What is the crowding-out effect and why
might it be relevant to fiscal policy?
It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a
fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the
economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a
particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing
severe recession or severe demand-pull inflation.
Politics might complicate fiscal policy through the political business cycle. A political business
cycle is the concept that politicians are more interested in reelection than in stabilizing the
economy. Before the election, they enact tax cuts and spending increases to please voters even
though this may fuel inflation. After the election, if they apply the brakes to restrain inflation; the
economy will slow and unemployment will rise. In this view the political process creates economic
instability.
A decrease in tax rates might be enacted to stimulate consumer spending. If households receive the
tax cut but expect it to be reversed in the near future, they may hesitate to increase their spending.
Believing that tax rates will rise again (and possibly concerned that they will rise to rates higher
than before the tax cut), households may instead save their additional after-tax income in
anticipation of needing to pay taxes in the future.
The crowding-out effect is the reduction in investment spending caused by the increase in interest
rates arising from an increase in government spending, financed by borrowing. The increase in G
was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the
impact of the expansionary fiscal policy may be reduced.

14-7 Use Figure 14.4 to explain why the deliberate increase of the standardized budget deficit (resulting
from the tax cut) will reduce the size of the actual budget deficit if the fiscal policy succeeds in
pushing the economy to its full-employment output of GDP 1. In requesting a tax cut in the early
1960s, President Kennedy said, It is a paradoxical truth that tax rates are too high today and tax
revenues are too low, and the soundest way to raise tax revenues in the long run is to cut tax rates
now. Relate this quotation to your previous answer in this question.
To the extent the deficit increase is successful in expanding the economy, equilibrium GDP will be
to the right of its original position in Figure 14.4. The higher GDP means greater income and
employment, which should raise total tax revenues despite lower rates and automatically reduce
government spending on many social programs as fewer recipients qualify for support. The
expansionary policy could have a beneficial effect on both the economy and the actual budget
deficit.
Especially in the relatively noninflationary early 1960s, President Kennedy was right. The cut in
tax rates, finally achieved under President Johnson, did indeed increase real GDP. The cut in taxes

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boosted production, so that out of the increased real GDP, tax revenues became greater than they
had been before the tax cutas Figure 14.4 would have predicted.
14-8 Why did the budget deficits rise sharply in 1991 and 1992? What explains the large budget
surpluses of the late 1990s and early 2000s? What caused the swing from the budget surpluses to
a deficit in 2002 and large present deficits?
Recession in 1991 and 1992, combined with a slow recovery contributed to the rising deficit (as
did Operation Desert Storm and funding for the S&L bailout).
Large surpluses from 1999-2001 resulted from several years of economic prosperity coupled with
the results of the Deficit Reduction Act of 1993 that increased marginal tax rates on high-income
earners and corporate income tax rates. Also, Congress made a commitment to limit government
spending, and it was a period of relative peace.
Recent returns to deficits occurred because of the 2001 tax cut, the September 11, 2001 terrorist
attacks, the subsequent war on terror at home and abroad, the economic downturn of 2001, and
the fiscal policy response of extended unemployment benefits and significant reductions in tax
rates.
14-9 Distinguish between the total U.S. debt and the debt held by the public? Why is the debt as
percentage of GDP more relevant than the total debt? Contrast the effects of paying off an
internally held debt and paying off an externally held debt.
The total U.S. debt represents the total amount of money the Federal government owes to the
owners of government securities. However, only a portion of that (58 percent in 2004) is held by
the public; the remaining 42 percent is held by the Federal government the government owes the
money to itself.
Debt as a percentage of GDP is more relevant because it is a better measure of an economys (or
governments) ability to manage that debt. It is analogous to an individual household: the level of
mortgage and other debt is only a problem if the household does not have sufficient income (GDP)
to keep up with monthly payments. A $10,000 debt is a problem for someone with no income; it is
not a significant burden on someone earning $100,000 per year.
Paying off internally held debt is analogous to the left hand paying the right hand; dollars are
redistributed, but there is no domestic loss of wealth. Paying off externally held debt represents an
outflow of wealth from the country. Note that this isnt necessarily bad if the external debt was
incurred to bring in goods or assets that facilitate domestic economic growth or serve other
important priorities.
14-10 True or false? If false, explain why.
a. An internally held debt is like a debt of the left hand to the right hand.
b. The Federal Reserve and Federal government agencies hold more than half of the public debt.
c. As a percentage of GDP, The Federal debt held by the public was smaller in 2004 than it was
in 1990.
(a) The statement is true about a national debt held internally, but this does not mean a large debt
is entirely problem free.
(b) False, the Federal Reserve and Federal government held only 42 percent of the public debt in
2004.
(c) True; public debt held by the public was 42 percent of GDP in 1990, 36.5 percent in 2000.
14-11 Why might economists be quite concerned if the annual interest payments on the debt sharply
increased as a percentage of the GDP?

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The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the
debt and refinancing were automatic, there would be no debt-load at all. But interest does have to
be paid. Lenders expect that, and to pay the interest the government must either use tax revenues
or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed
by noting the size of the interest payments in relation to GDP, since the size of the GDP is a
measure of total national income or how much the government can raise in taxes to pay the interest.
It can also be thought of in terms of opportunity cost. Every dollar spent on interest payments on
the debt is a dollar that could have been used toward education, public health, national defense, tax
reduction, or some other priority.
14-12 Trace the cause-and-effect chain through which financing and refinancing of the public debt
might affect real interest rates, private investment, the stock of capital, and economic growth.
How might investment in public capital and complementarities between public and private capital
alter the outcome of the cause-effect chain?
Cause and effect chain: Government borrowing to finance the debt competes with private
borrowing and drives up the interest rate; the higher interest rate causes a decline in private capital
and economic growth slows.
However, if public investment complements private investment, private borrowers may be willing
to pay higher rates for positive growth opportunities. Productivity and economic growth could
rise.
14-13 What do economists mean when they refer to Social Security as a pay-as-you-go plan? What is the
Social Security trust fund? What is the nature of the long-run fiscal imbalance in the Social
Security retirement system? What are the broad options for fixing the long-run problem?
A pay-as-you-go plan means that current benefits are paid out of current revenues, as opposed to
benefits paid out of the accumulation of past payroll taxes.
The Social Security trust fund was created with an excess of current revenues over current payouts
and is held in the form of U.S. Treasury securities. The idea of the trust fund is to keep the system
self-sufficient in providing for beneficiaries.
The impending long-run fiscal imbalance refers to the future inability of revenues to cover
obligations, and will occur largely because of demographic changes. A large segment of the
population (baby-boomers) is moving into retirement age, and the ratio of workers to recipients
is falling (5:1 in 1960, 3:1 today, 2:1 by 2040).
Several options have been suggested for fixing the long-run problem. They include raising payroll
taxes, increasing the age of eligibility for benefits, investing a portion of the trust fund into
corporate stocks and bonds, and setting up personal security accounts, allowing people to invest
half of their payroll taxes into approved stock and bond funds.

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