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2008 Pearson Addison-Wesley. All rights reserved Chapter 15 Government Spending and its Financing Chapter Outline The Government Budget: Some Facts and Figures Government Spending, Taxes, and the Macroeconomy Government Deficits and Debt Deficits and Inflation The Government Budget: Some Facts and Figures Government outlays; three categories of government expenditures Government purchases (G) Transfer payments (TR) Net interest payments (INT) Also: Subsidies less surpluses of government enterprises; relatively small, so we ignore it Taxes Four principal categories Personal taxes (income taxes and property taxes) Contributions for social insurance Taxes on production and imports Corporate taxes The Government Budget: Some Facts and Figures Taxes The composition of outlays and taxes: the Federal government versus state and local governments The composition of the Federal government budget is quite different from state and local government budgets (Table 15.2) The Government Budget: Some Facts and Figures Table 15.2 Government Receipts and Current Expenditures, 2005 Deficits and surpluses When outlays exceed revenues, there is a deficit; when revenues exceed outlays, there is a surplus The total deficit tells the amount the government must borrow to cover all its expenditures deficit outlays tax revenues government purchases transfers + net interest tax revenues G TR INT T (15.1) The Government Budget: Some Facts and Figures Deficits and surpluses Another useful deficit definition is the primary government budget deficit, which excludes net interest payments (payments for past government spending ) The primary deficit tells if the governments receipts are enough to cover its current purchases and transfers primary deficit outlays net interest tax revenues government purchases + transfers tax revenues G TR T (15.2) The Government Budget: Some Facts and Figures Figure 15.3 The relationship between the total budget deficit and the primary deficit Deficits and surpluses Another set of deficit concepts The current deficit equals the deficit minus government investment The primary current deficit equals the primary deficit minus government investment, which equals the current deficit minus interest payments The Government Budget: Some Facts and Figures Government Spending, Taxes, and the Macroeconomy Fiscal policy and aggregate demand An increase in government purchases increases aggregate demand by shifting the IS curve up The effect of tax changes depends on the economic model Ricardian equivalence proposition Government Spending, Taxes, and the Macroeconomy Primary effect Induction effect Total effect Fiscal policy multiplier Government Spending, Taxes, and the Macroeconomy Fiscal policy and aggregate demand Automatic stabilizers and the full-employment deficit Automatic stabilizers cause fiscal policy to be countercyclical by changing government spending or taxes automatically Income tax system Government transfers (e.g. unemployment insurance) Government Spending, Taxes, and the Macroeconomy Fiscal policy and aggregate demand Because of automatic stabilizers, the government budget deficit rises in recessions and falls in booms The full-employment deficit is a measure of what the government budget deficit would be if the economy were at full employment So the full-employment deficit doesnt change with the business cycle, only with changes in government policy regarding spending and taxation Government Spending, Taxes, and the Macroeconomy Government capital formation Long-lived physical assets owned by the government, like roads, schools, and sewer systems Human capital formation through expenditures on health, nutrition, and education Government Spending, Taxes, and the Macroeconomy Incentive effects of fiscal policy Average versus marginal tax rates Average tax rate total taxes / pretax income Marginal tax rate taxes due from an additional dollar of income Government Spending, Taxes, and the Macroeconomy Incentive effects of fiscal policy Average versus marginal tax rates If the average tax rate increases, with the marginal tax rate held constant, a person will increase labor supply If the marginal tax rate increases, with the average tax rate held constant, a person will decrease labor supply Government Spending, Taxes, and the Macroeconomy Practical issues of using fiscal policy Lags Uncertainty Crowding-out effect Tax-induced distortions Government Deficits and Debt The growth of the government debt The deficit is the difference between expenditures and revenues in any fiscal year The debt is the total value of outstanding government bonds on a given date The deficit is the change in the debt in a year B nominal value of government bonds outstanding B nominal government budget deficit (15.3) Government Deficits and Debt The growth of the government debt DebtGDP ratio accounts for the ability to pay off the debt Change in debtGDP ratio deficit/nominal GDP (total debt/nominal GDP) growth rate of nominal GDP (15.4) So two things cause the debtGDP ratio to rise A high deficit relative to GDP A slow rate of GDP growth Government Deficits and Debt The burden of the government debt on future generations Higher tax rates may have to be raised in the future to pay off the debt There would be a large transfer from the poor to the rich Government deficits reduce national saving according to many economists Government Deficits and Debt Budget deficits and national saving: Ricardian equivalence revisited When will a government deficit reduce national saving? S Y C G It almost certainly does when government spending rises But it may not for a cut in taxes or increase in transfers, national saving declines only if consumption rises (assuming Y is fixed at its full-employment level) Government Deficits and Debt Ricardian equivalence across generations What if the higher future taxes are to be paid by future generations? Then people might consume more today, because they wouldnt have to pay the higher future taxes But if people care about their children, theyll increase their bequests to their children so their children can pay the higher future taxes Government Deficits and Debt Departures from Ricardian equivalence What are the main reasons Ricardian equivalence may fail? Borrowing constraints Shortsightedness Failure to leave bequests Nonlump-sum taxes Deficits and Inflation The deficit and the money supply Inflation results when aggregate demand rises more quickly than aggregate supply So budget deficits could be related to inflation (but a one- time jump in the price level) The only way for a sustained inflation to occur is for there to be sustained growth in the money supply Deficits and Inflation The deficit and the money supply Can government deficits lead to ongoing increases in the money supply? Yes, if spending is financed by printing money The revenue that a government raises by printing money is called seignorage Usually, governments dont just buy things directly with newly printed money, they do so indirectly The Treasury borrows by issuing government bonds The central bank buys the bonds with newly printed money Deficits and Inflation The deficit and the money supply The relationship between the deficit and the increase in the monetary base is deficit B Bp Bcb Bp BASE (15.6) B is the increase in government debt, which is divided into government debt held by the public Bp and government debt held by the central bank Bcb Changes in Bcb equal changes in the monetary base, BASE In an all-currency economy, the change in the monetary base is equal to the change in the money supply: deficit = B = Bp Bcb Bp M (15.7) Deficits and Inflation Real seignorage collection and inflation The real revenue the government gets from seignorage is closely related to the inflation rate Consider an all-currency economy with a fixed level of real output and a fixed real interest rate, plus constant rates of money growth and inflation M/M (15.8) Deficits and Inflation Real seignorage collection and inflation Real seignorage revenue R is M/P, but since M/M, then M = M, (15.9) R M/P M/P (15.10) Seignorage is called Inflation tax like a tax (at the rate
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