Budgeting Basics

Deficits and debt Comparisons over time Categories of spending used in budgeting/economics jargon Alternative measures of the deficit Cash accounting versus capital accounting

Deficits and Debt

Deficit = The amount by which a governments spending exceeds its revenues in a given year.

Debt = The amount a government owes to those who have loaned it money.

Represents the accumulation of deficits and interest over time.

The Federal Budget Deficit in Recent Years

Financing of Deficits/Debt
To finance deficits, governments have to borrow money from private and public investors for U.S. federal govt, debt is sold as Treasury bonds, which have different maturities (5-year, 10-year, 30year) and different yields (rate of return) rates higher for longer-term bonds
Purchasers of U.S. debt: individual investors, foreign and domestic firms, pension and investment funds, as well as some countries Of the 14.3% trillion in (official) U.S. federal debt (2011) about 20% held by Social Security Trust Fund about 10% is held by the Federal Reserve Bank (to conduct monetary policy) about 30% held by foreign investors (China 8%)

Financing of Deficits/Debt
The rate of return the govt must pay is determined by the market rate must be sufficiently high to attract the necessary amount of demand
Over recent history, Treasury rates have been very close to the inflation rate, which suggests that investors are convinced the U.S. govt will not default governments at risk of default have to pay higher interest rates on debt (risk premium)

The Fiscal Outlook

If investors began to see U.S. debt as a risky investment, interest rates (on that debt) should rise One benchmark economists have commonly used to gauge a dangerous deficit is that it should not (in good times) exceed the rate of economic growth
e.g. if economy is growing at 2%, deficits should not exceed 2% of GDP if the deficit (as a percent of GDP) exceeds the rate of GDP growth, that implies the debt (as a percent of GDP) is growing this is unsustainable in the long-term

But deficits would ideally be lower, since every dollar borrowed has to be paid back (with interest) by future taxpayers

Importance of Inflation
Inflation refers to the rate at which prices are increasing in the economy -- important for a couple reasons
First, to compare changes in spending/revenues/deficit, one would want to convey the data in real terms (i.e. adjusted for inflation) Its more common that people present these in percent of GDP One problem with this (the pct of GDP approach) is that it is magnifies the impact of business cycles Second, inflation has interesting implications for the financing of debt An unanticipated increase in inflation reduces the real cost of paying off existing debt If inflation is permanently high, or is anticipated to increase, investors will demand higher returns to purchase debt

Countries debt crises are often followed by inflation crisis

Categories of Spending
The U.S. federal budget distinguishes between two types of 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 Congresss discretion.

Categories of Spending
Economists often like to distinguish types of spending along other dimensions as well For instance, we sometimes refer to extra spending that naturally arises during a recession as cyclical spending Think unemployment benefits, food stamps and income support programs

Categories of Spending
Economists often recommend that policymakers distinguish between consumption spending and investment spending investment spending is on things increase national productivity in future periods the current cost of such investments overstates their true cost to the government by ignoring the impact on future tax revenues the current cost of such investments overstates their true cost to society by also ignoring the impact on future (after-tax) earnings and profits

Future Topic PDV

When we get to the section on cost-benefit analysis, well talk about the methods that should be used to evaluate public investment projects A big part of this is will be how to compare costs and benefits that accrue over different periods of time i.e. present discounted values

Alternative ways of measuring the deficit

The usual way of presenting the deficit uses the cash accounting method As in the figure above, its just the difference between cash in and cash out in a given year This can given a poor perspective on how the budget situation evolves over time because it includes short term factors like the business cycle and policy changes with temporary implications As a result, cash accounting makes fiscal situation look better in boom times and worse in weak economic times

Alternative ways of measuring the deficit

Cyclically-adjusted budget deficit = A measure of the govts fiscal position if the economy were operating at full potential GDP
Taxes fall and some categories of spending rise in recessions

Standardized (structural) budget deficit = A long-term measure of the governments fiscal position, removing the effect of cyclical and other short- term factors.
e.g. Some policy changes cause temporary shifts in tax revenues.

Cash Accounting vs Capital Accounting

Another issue is whether government books should be evaluated on the basis of cash accounting or capital accounting
Cash accounting looks at money in/money out Capital accounting would also consider changes in the value the govts asset holdings

Firms generally use the latter when thinking about whether a firm is richer at the end of the year, you care about the productive assets it owns, not just the amount of cash on hand
Q: If a firm spends $X this year to invest in a new factory, how should that be accounted for in this years balance sheet ?

Cash Accounting vs Capital Accounting

Q: If a firm spends $X this year to invest in a new factory, how should that be accounted for in this years balance sheet ?
Standard approach under capital accounting is to treat the investment as a durable good an asset in the firms balance statement that depreciates over time For the balance statement in a particular year, the amount that the investment depreciates over the year would be treated as the amount of spending on that item in that year Accounting rules govern the rates as which different sorts of durable investments should be depreciated over time

Cash Accounting vs Capital Accounting

Q: Now suppose the federal government decides to sell Yosemite national park to a private investor? How should that sale be treated on the federal balance sheet? Or what if they purchase a piece of valuable property for the site of a new administrative building? How should that be treated? Depends on whether one uses cash accounting method or capital accounting

Cash Accounting vs Capital Accounting

Capital accounting might seem like an obvious improvement over cash accounting
The problem with implementing it is that it can be hard to distinguish government consumption spending from investment spending Many federally-owned assets are hard to price? How should investments in human capital be handled? (E.g. Are investments in early education programs capital spending or consumption spending?) If capital spending, how should we value these investments? Is purchase of a missile system consumption spending or capital spending? Even for firms, capital accounting raises some difficult questions like how quickly to assume an asset depreciates

Static versus Dynamic Scoring

The Congressional Budget Office (CBO) is sometimes called the Congressional scorekeeper
it is charged with making official projections about the effect of policy proposals on government spending and revenues

Recently, there has been increasing controversy over how the CBO forms these projections
i.e. how do they score the budgetary effects of policy changes

CBO projections account for many of the behavioral effects of policies, including how
changes in the size of a public benefit affects take-up rates how tax rate changes affect the amount of taxable income that gets reported and taxed

But they ignore potentially important macro-economic effects of policy changes

Static versus Dynamic Scoring

For example, Republicans commonly argue that the CBO systematically overstates the future revenue loss from tax cuts because tax cuts (might?) increase economic growth How might changes in tax rates affect growth?
usual way this gets modeled is that tax cuts (could) affect savings/investment decisions, which affects the future stock of private capital in the economy under standard macro models, an increase in the (future) capital stock raises the (future) productivity of workers if so, a tax cut that leads to greater capital accumulation is partially offset by the fact that labor income rises (and the additional labor income gets taxed)

Important: this argument for dynamic scoring hinges how a tax cut affects the accumulation of private capital

Static versus Dynamic Scoring

Important: this argument for dynamic scoring hinges how a tax cut affects the accumulation of private capital , which partially depends on how the tax cut affects savings behavior but also depends on how the tax cut is financed A tax cut that is deficit financed reduces the accumulation of private capital in standard macro models
why? because the sale of government bonds absorbs savings that would otherwise have been put towards private investments

See Grubers discussion of CBOs dynamic scoring of the 2003 tax cut (which was financed by higher deficits)
if scored dynamically, the tax cuts were found to be more costly to the federal budget than originally scored, unless the CBO assumes that other spending cuts or tax increases would be enacted to offset the deficit impact

Static versus Dynamic Scoring

Democrats had a similar complaint about how the CBO scored the cost of Obamas health care reform (the Affordable Care Act)
did not give credit for (potential) savings if providers responded to new Medicare reimbursements by containing costs

In both these examples, the main issue is really the same the CBO isnt comfortable making predictions unless those predictions are on solid ground
the impact of government policy on the economy is less wellunderstood than some politicians believe and the CBO is wary about making stuff up