Transcript Document

Federal Budgets
and Public Policy
CHAPTER
32
© 2003 South-Western/Thomson Learning
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Federal Budget Process
The federal budget is a plan for
government outlays and revenues for a
specified period, usually a year
Federal outlays include both
Government purchases
Transfer payments
Exhibit 1 shows the composition of
federal outlays by major category since
1960
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Exhibit 1: Defense’s share of Federal Outlays
Declined Since 1960; Redistribution Increased
All Other Outlays
80%
Net Interest
60%
Welfare
Medicare
40%
Social Security
20%
Defense
2000
1995
1990
1985
1980
1975
1970
1965
0%
1960
Basic implications
of this pattern is
that defense has
declined as a
percent of total
spending while
social security,
medicare, welfare,
and net interest
payments have
increased.
Percentage of total outlays
100%
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President’s Role in Budget Process
Legislation in 1921 created the Office of
Management and Budget to examine
agency requests and help the president
develop a budget proposal
President’s budget process usually
begins a year before it is submitted to
Congress
The congressional budget cycle begins
in late January once Congress gets The
Budget of the United States
Government
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Congressional Role in the Budget Process
Once the president’s budget hits Congress,
budget committees in both the House and the
Senate rework until they agree on total
outlays, spending by major category, and
expected revenues
This agreement, called a budget resolution,
establishes a framework to guide spending
and revenue decisions
The fiscal year runs from October 1 of one
year to September 30 of the following year
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The Budget
The size and composition of the budget
and the difference between outlays and
revenues measure the budget’s fiscal
impact
When outlays exceed revenues, the budget
is in deficit
• stimulates aggregate demand in the short run, but
reduces national saving which in the long run
could impede economic growth
Alternatively, when revenues exceed
outlays, the budget is in surplus
• dampens aggregate demand in the short run, but
enhances domestic saving which in the long run
could promote economic growth
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Problems
There are a number of problems with
the federal budgeting process
Continuing Resolutions instead of Budget
Decisions: Congress often ignores the
budget timetable
• budgets typically run on continuing resolutions,
which are agreements to allow agencies to spend
at the rate of the previous year’s budget
Overlapping Committee Authority: requires
the executive branch to defend the same
section of the president’s budget before
several committees in both House and the
Senate
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Problems
Lengthy Budget Process: given that the average
recession lasts less than a year and that budget
preparation begin more than a year and a half
before the budget takes effect, planning
discretionary fiscal measures to smooth
economic fluctuations is difficult
Uncontrollable Budget Items: Congress has only
limited control over much of the budget.
• About three-quarters of federal budget outlays are
determined by existing laws.
• Congress has little or no say in spending on various
entitlement programs
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Problems
No separate capital budget: Congress approves a
single budget that mixes capital items with
current outlays.
• Budgets for businesses and for state and local
governments usually distinguish between a capital
budget and an operating budget
Overly-detailed budget: The federal budget is
divided into thousands of accounts and subaccounts and to the extent that the budget is a
way of making political payoffs
• such micromanagement allows elected officials to reward
friends and punish enemies
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Possible Budget Reforms
Possible reforms
The annual budget could be converted into a
two-year budget, or biennial budget.
• The problem is that it would require longer-term
economic forecasts  less useful as a tool of
discretionary fiscal policy
Now Congress spends nearly all of the year
working on the budget.
Executive branch is always dealing with
three budgets:
• administering an approved budget,
• defending a proposed budget before
congressional committees, and
• preparing the next budget for submission to
Congress
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Possible Budget Reforms
Another possible reform could be to simplify
the budget document by concentrating only
on major groupings and eliminating line
items.
• Each agency would receive a total budget along with
the discretion to allocate this budget
• The problem here is that agency heads may have
different priorities than those of elected
representatives
Final reform is to sort federal spending into an
operating budget and a capital budget
• Capital budget would include spending on physical
capital
• Operating budget would include spending on all
ongoing expenses
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Budget Philosophies
Several budget philosophies have
emerged over the years
Annually balanced budget: fiscal policy
aimed at balancing the budget on an annual
basis except during wartime.
• Implied that spending increased during
expansions and declined during recessions 
fiscal policy magnified fluctuations in the business
cycle
Cyclically balanced budget: the budget
should be balanced over the course of the
business cycle  deficits during recessions
and surpluses during expansions
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Budget Philosophies
Functional finance says that policy makers
should be less concerned with balancing the
budget annually, or even over the course of
the business cycle, than with ensuring that
the economy produces its potential output
• if the budgets needed to keep the economy
operating at its potential involve chronic deficits,
so be it.
• Since the Great Depression, this has been the
basic approach taken at the federal level
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Deficits Since 1980
The huge deficits in recent years have
come from a combination of tax cuts
and spending increases
But why has the budget been in deficit
for all but 12 years since 1930?
The most obvious answer is that, unlike
legislatures in 49 states, Congress is not
required to balance the budget
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Deficits Since 1980
But why does Congress like deficits?
One widely accepted model of the public
sector assumes that elected officials try
to maximize their political support,
including votes and campaign
contributions
Voters like public spending programs
but hate paying taxes, so spending
programs win support and taxes lose it
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Deficits Since 1980
Because of this asymmetry, candidates
try to maximize their chances of getting
elected and reelected by offering a
budget that is long on benefits but short
on taxes  deficits
Moreover, members of Congress push
their favorite programs with little
concern about the overall budget
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Exhibit 2: Government Debt
as Percent of GDP
Annual deficit or surplus as
percentage of GDP
3
2
1
0
-1
-2
-3
-4
-5
-6
1970 1975 1980 1985 1990 1995 2000
After decades of deficits, the U.S. federal budget
was in surplus from 1998 to 2001.
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Crowding Out and In
What effect do federal deficits and
surpluses have on interest rates?
Suppose the federal government
increases spending without raising
taxes  increases in deficit or declines
in the surplus
How will this affect, national savings,
interest rates, and investment?
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Crowding Out and In
An increase in the deficit or a decrease in
the surplus reduces the supply of national
savings
 higher interest rates
 crowd out some private investment
 reducing the stimulating effect of the
government’s deficit
Some argue that the amount of crowding out
is relatively small 
• discretionary fiscal policy will result in a net increase
in aggregate demand
Others believe the crowding out is more
extensive
• borrowing from the public in this way results in little
or no net increase in aggregate demand
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Crowding Out and In
Another possibility: If the economy is
operating well below its potential, the
additional fiscal stimulus provided by a
larger deficit or a smaller surplus could
encourage firms to invest more
Recall that an important determinant of
investment is business expectations and
government stimulus may improve
expectations
firms more willing to invest
crowding in
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Twin Deficits
To finance the huge deficits of the
1980s, the U.S. Treasury had to sell a lot
of bonds, pushing up market interest
rates  foreigners were more willing to
buy dollar-denominated bonds 
foreigners had to exchange their
currencies for dollars
The greater demand for dollars caused
the dollar to appreciate relative to
foreign currencies
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Twin Deficits
The rising value of the dollar made
foreign goods cheaper in the U.S. and
U.S. goods more expensive abroad 
foreign trade deficit increased
The higher trade deficits meant that
foreigners were accumulating dollars
and with these dollars purchased U.S.
assets, including U.S. government bonds
thereby helping to fund the deficits
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Exhibit 3: Outlays Relative to GDP, since 1970
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Budget Surplus
In the early 1990s, outlays started to
decline relative to GDP, while revenues
increased  deficit declined and, by
1998, created a budget surplus
What turned a hefty deficit into a surplus,
and why has the surplus slipped lately?
Tax increases during the elder President Bush
and President Clinton terms
Vigorous recovery during the 1990s
Slower growth in Federal Outlays
Reversal in 2001
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Relative Size of the Public Sector
Exhibit 4 shows government outlays at
all levels of government relative to GDP
in ten industrial economies in 1993 and
in 2000
Government outlays in the United
States in 2000 were 29.3% relative to
GDP, the smallest share in the group
and between 1993 and 2000 declined in
nine of the ten industrial countries
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National Debt
The federal deficit is a flow variable
measuring the amount by which outlays
exceed revenues in a particular year
The federal debt, or the national debt, is
a stock variable measuring the
accumulation of past deficits  the
total amount owed by the federal
government
Changes over time
U.S. debt levels compared to those in other
countries
Interest on the debt
Prospect of paying off the debt
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Exhibit 4: Government Outlays As a Percentage of
GDP Declined Between 1993 & 2000 in Major Industrial
Economies except Japan
60
50
40
30
20
10
0
U.S.
Australia Canada Japan United Spain
Germany
Netherlands
Kingdom
Italy
France
1993 2000
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Changes over Time
Distinction between the gross debt and
the debt held by the public
Gross debt includes U.S. Treasury securities
purchased by various federal agencies 
debt owed to itself
Debt held by the public includes debt held
by households, firms, banks, and foreign
entities
As of 2001, the gross federal debt stood
at about $5.8 trillion and the debt held
by the public stood at $3.4 trillion
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Changes over Time
One way to measure debt over time is
relative to the economy’s GDP
Exhibit 5 shows federal debt held by the
public relative to GDP
The changes in the debt mirror the
changes that have occurred in the
deficit / surplus segment of the federal
budget
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Exhibit 5: Federal Debt Held by the Public
as Percent of GDP: 1946 to 2001
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International Perspective
How does the government debt in the
United States compare with debt levels
in other countries?
Exhibit 6 compares the net government
debt in the United States relative to
GDP with those of nine other industrial
countries
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Exhibit 6: Relative to GDP U.S. Public Debt
is About Average for Industrial Economies
Italy
Canada
Netherlands
Japan
U.S.
Spain
France
Germany
U.K.
Australia
0
20
40
60
80
Public Debt as Percentage of GDP
100
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Interest on the National Debt
Because most federal securities are
short term, the national debt “turns
over” rapidly
Nearly half the debt is refinanced every
year  debt service payments are quite
sensitive to movements in the interest
rate
Interest payments on the national debt
have increased from 8% of the federal
budget in 1978 to 12% in 2001
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Who Bears the Burden of the Debt
Deficit spending is a way of billing
future taxpayers for current spending
The national debt raises moral
questions about the right of one
generation to taxpayers to bequeath to
the next generation the burden of its
borrowing
To what extent do budget deficits shift
the burden to future generations?
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We Owe It To Ourselves
It is often argued that the debt is not a
burden to future generations because,
although they must service the debt,
those same generations receive the
debt service payments
It’s true that if U.S. citizens forgo
present consumption to buy bonds, they
or their heirs will receive the interest
payments  debt service payments stay
in the country  it’s all in the family
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Foreign Ownership of Debt
The “we owe it to ourselves” argument
does not apply to that portion of the
national debt purchased by foreigners
Foreigners who buy U.S. government
bonds forgo present consumption and
are paid back in the future
A reliance on foreigners increases the
burden of the debt on future
generations because future debt service
payments no longer remain in the
country
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Crowding Out and Capital Formation
As previously noted, government
borrowing can drive up interest rates
and crowd out some private investment
by making it more costly
The long-run effect of deficit spending
depends on how the government spends
the borrowed funds
If they are used in public investments
there may be no harmful effects on the
economy’s long-run productive
capabilities
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Crowding Out and Capital Formation
If the additional borrowed dollars go
toward current consumption, less
capital formation will result
With less investment today, there will
be a smaller endowment of capital
equipment and technology
slower growth of labor productivity in the
future
Despite the large federal deficits of the
1980s and early 1990s, public
investments in capital declined
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Paying off the Debt
What impact do surpluses have on the
economy?
In the short run a federal surplus could
reduce aggregate demand, which would
worsen a recession but relieve
inflationary pressure during good times
A budget surplus would also increase
the national saving rate, which should
reduce interest rates
in the long run investment should increase
more capital per worker
more income and tax revenues
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Paying off the Debt
Fed Chairman Alan Greenspan felt that
eliminating public debt has a small
downside
Treasury debt provides an asset that is
free of risk which is a characteristic that
is attractive to many investors
particularly during times of turbulence
They also offer a benchmark for pricing
riskier debt
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Paying off the Debt
In this fashion, a budget surplus could
be self-reinforcing
If the surplus is used to pay down the
national debt, this over time would
reduce the cost of servicing the remaining
debt
• gradually freeing up budget dollars for tax cuts,
other spending programs, or
• still more pay down of the national debt
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