The Federal Budget
Today we look at the federal budget -- its composition and changes over time. We'll also examine the budget as a tool of economic policy to smooth out business fluctuations. Our focus is on fiscal policy, which refers to the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained long-term economic growth, and price stability. We begin by considering data for the fiscal 1995 federal budget that was initally proposed by President Clinton. This will allow us to get an idea of orders of magnitude of important budgetary variables.
That budget envisioned total revenues at $1,436 billion (about 20-21 percent of GDP). These revenues come primarily from personal income taxes (42%) and social insurance taxes (40%), with corporate income taxes (12%) and indirect taxes (sales taxes on gasoline, alcohol, etc.) (6%) making up the balance.
Total expenditures were estimated at $1,609 billion, or about 23 percent of GDP. Purchases of goods and services (the federal contribution to G in the national income accounts) represent only 27 percent of planned expenditures. (Note: State and local government expenditures constitute a larger share of G. However, state and local budgets do not have the stabilizing features that are present in the federal budget, and hence they are not being considered here.)
The largest component of expenditures is for transfer payments (social security, medicare/medicaid, welfare, farm subsidies, unemployment insurance, grants to state and local and foreign governments, etc.), which represent 59 percent of total expenditure. The remainder of expenditures (13%) was for payment of interest on the national debt.
Note that this situation represented a sharp departure from earlier experience. For example, in 1964 fully 56 percent of federal expenditures went to national security. Thus, expenditures on goods and services have become less important over time (relatively), while transfer payments have increased in importance. This may be seen readily by comparing G/Y and total government expenditures/Y.
With expenditures exceeding revenues, the budget had a deficit, amounting to $173 billion (deficit = revenues minus expenditures = 1436-1609). This has been the typical scenario of the past 25+ years and more -- the last time there was a federal budget surplus was in 1969. These cumulative deficits have added tremendously to the total national debt, which now stands at over $3 trillion.
This growth of the debt, in turn, has been responsible for a slow but fairly steady increase in the portion of government expenditures going to pay interest on the national debt (expenditures for interest on the debt reflect both the size of the debt and prevailing interest rates, so higher interest rates tend to increase the deficit). As Parkin notes, persistent deficits tend to be self-perpetuating -- i.e., by adding to the interest payments required, they increase the likelihood of deficits in subsequent years.
Although US budget deficits relative to GDP are small when compared to deficits for other industrialized countries and for most developing nations (except those in Central and South America), the issues of budget reform and deficit reduction have gained considerable prominence in recent years in the US. Most notable in this regard is the proposal for a balanced budget amendment to the Constitution, that would require that the federal budget be balanced each year.
Advocates of the balanced budget amendment contend that it would force Congress and the President to do what they have not been able to do on their own: balance the budget. Up until this year, Congress had been incapable of resisting demands for continued expenditures in excess of revenues. Earlier this year, Congress and the President both came up with deficit-reduction plans, but they were not able to agree on a plan.
Proponents argue that a Constitutional amendment is the only way to accomplish the objective of balancing the budget. In addition, advocates argue that the process of debating such an amendment would increase knowledge of the importance of fiscal discipline for the federal government.
Although the balanced budget amendment has received support from some prominent economists, most economists are opposed to it. As we will see shortly, a budgetary deficit tends to have a stimulating effect on the economy, while a surplus tends to have a dampening effect. Consequently, most economists argue that we will have greater macroeconomic stability with cyclically unbalanced budgets -- i.e., budget deficits in periods of recession (when actual GDP is less than potential GDP), and surpluses when actual GDP exceeds potential GDP -- than with a balanced budget every year. More on this below...
In brief, a balanced budget amendment would eliminate the use of fiscal policy as a tool for promoting full employment in the economy.
Fiscal policy
Fiscal policy may be either automatic or discretionary. Automatic fiscal policy refers to a change in the budget triggered by the state of the economy. For example, when a recession begins to emerge, more people will become unemployed, and this will result in an automatic increase in unemployment compensation expenditures (cf., new claims). Correspondingly, the reduction in income during recessions also translates into reduced tax revenues. Hence, there is an automatic tendency toward an increased deficit when recession appears; and there is an opposite tendency toward a reduced deficit when expansion emerges.
Discretionary fiscal policy refers to a deliberate policy action that is put into effect by an act of Congress. Changes in tax laws or in government spending are general examples of discretionary fiscal policy. As Parkin shows, changes in government purchases of goods and services have a multiplier effect on the economy (i.e., they generate multiplied changes in equilibrium expenditure), as do changes in lump-sum taxes or transfers.
As noted above, automatic fiscal policy refers to a change in the budget triggered by the state of the economy. We have automatic stabilizers, which operate without any explicit action by the government, because income taxes and transfer payments fluctuate with real GDP. In time of expansion, with real GDP increasing, taxes tend to rise and transfers fall; while in time of recession, real GDP falls, tax revenues decrease, and transfer payments rise.
The presence of these automatic stabilizers means that the budget deficit automatically rises during recessions and falls during expansions. As Parkin's Fig. 12.8 shows, the deficit also increases just before a recession -- when real GDP growth slows -- and just after a recession before real GDP growth speeds up.
An expansionary fiscal policy consists of either an increase in government expenditures or a decrease in tax revenues. Such a policy will have a multiplier effect on equilibrium expenditure, and push out the aggregate demand curve correspondingly.
A contractionary fiscal policy entails either a decrease in government expenditure or an increase in tax revenues.
Consider the consequences of a contractionary fiscal policy. In the very short term, when prices are sticky, the aggregate expenditure curve will decline, and there will be a corresponding leftward shift in the aggregate demand curve. All other things equal, this will reduce real GDP and the price level.
But suppose that we started out in a recessionary gap situation. It should be clear that a contractionary fiscal policy would exacerbate the recession and move the economy further away from full employment. What we'd want instead would be an expansionary fiscal policy, to stimulate the economy. Note, though, that the balanced budget amendment would require contractionary fiscal policy in time of recession, when the budget deficit automatically increases. That is, it would (in the view of most economists) require precisely the wrong medicine to cure the ailing economy.
In addition to the demand-side effects of fiscal policy, there are also supply-side effects. Most notable in this regard are the possible increases in supply that some argue will result from declining tax rates (which would increase incentives to work and earn income). Most economists believe that supply-side effects of fiscal policy are likely to be small, but Jack Kemp, Steve Forbes, and some economists believe that reducing tax rates can have a big impact on aggregate supply.
The presence of such effects means that price level increases in response to expansionary fiscal policy would likely be moderated considerably, and the impact on real GDP would be greater.
Two final issues worth noting are the burden of the debt and the phenomenon of crowding out. As Parkin notes, a popular view is that continued budget deficits impose a burden on future generations. However, the deficit is financed by government bonds on which interest is paid each year from tax revenues. This means that in the future taxpayers will pay and government bondholders will benefit from the existence of the debt. In the aggregate, this burden and benefit cancel each other out; although to the extent that the debt is held by foreigners there are undesirable redistributive aspects.
More significant is the phenomenon of crowding out, which refers to the tendency for government deficits to result in decreases in investment. In brief, deficits mean that the government contributes heavily to the demand for loans, and given the supply of loans this tends to push interest rates up.
The increase in interest rates, in turn, tends to reduce the quantity of investment demanded, and lower investment today means less capital and hence lower potential GDP tomorrow. In effect, then, government debt crowds out productive capital via increased interest rates. When President Clinton argues that Bob Dole's proposed 15% tax cut will worsen the deficit, drive up interest rates, and be bad for the economy, this crowding out problem is a good part of what he believes will happen.
