Why does redistribution cause efficiency losses?

Why might society choose to redistribute resources from one group to another when doing so reduces the overall size of the economic pie? Redistribution can cause efficiency losses if there are (negative) behavioral responses to the redistribution system. The government might raise money to fund redistribution by imposing a tax on labor income, and this might cause a reduction in the labor supply. Similarly, generous unemployment benefits might induce some who are out of work to remain unemployed. Despite these possible efficiency losses, we (collectively) choose to redistribute wealth. Some reasons for redistribution are that people have a taste or preference for a certain degree of economic equity; that the existence of a large or visible underclass is somewhat discomforting or threatening; that people are risk averse and so are willing to pay for a safety net in case they or their families ever need assistance; and that humans are naturally empathetic. In a country with many very poor people, redistribution from the few rich to the many poor may make the majority of people better off, even if it reduces the overall size of the pie. A democratic process may therefore lead to the occurrence of this sort of redistribution.

In order to make college more affordable for students from families with fewer resources, a government has proposed allowing the student of any family with less than $50,000 in savings to attend public universities for free. Discuss the direct and possible indirect effects of such a policy. This policy would make college cheaper for students from families with less than $50,000 in savings. There would be two direct effects of this policy. First, it would make the families of students who already intended to attend college better off if the families that were saving had less then $50,000 in savings. Second, it would probably encourage additional students from low-savings families to attend college. A potential indirect effect of this policy would be to reduce the savings of otherfamiliesfamilies that were saving money for a college education but would stop doing so when they could anticipate getting a free ride if they dont save.

Explain why a consumers optimal choice is the point at which her budget constraint is tangent to an indifference curve. Consumers optimize their choice when they are on the highest possible indifference curve given their budget constraint. Suppose a consumers choice is attainable (on the budget constraint) but not at a tangency, as at point A in the figure. Under these circumstances, the budget constraint must pass through the indifference curve where it intersects the chosen point. There must then be at least a segment

of the budget constraint that lies above (up and to the right of) the indifference curve associated with that choice. Any choice on that segment would yield higher utility. Only when no part of the budget constraint lies above the indifference curve associated with a consumers choice are no feasible improvements in utility possible. The single tangency point (C in the figure) is the only point at which this occurs.

Since the free market (competitive) equilibrium maximizes social efficiency, why would the government ever intervene in an economy? Efficiency is not the only goal of government policy. Equity concerns induce government to intervene to help people living in poverty, even when there are efficiency losses. In economic terms, a society that willingly redistributes resources has determined that it is willing to pay for or give up some efficiency in exchange for the benefit of living in a society that cares for those who have fewer resources. Social welfare functions that reflect this willingness to pay for equity or preference for equity may be maximized when the government intervenes to redistribute resources.

---------- CHAP 4 ---------Slide: The Budget Process 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.

Budget policies and deficits at the state level balanced budget requirement (BBR) A law forcing a given government to balance its budget each year (spending = revenue) ex post BBR A law forcing a given government to balance its budget by the end of each fiscal year. ex ante BBR A law forcing either the governor to submit a balanced budget or the legislature to pass a balanced budget at the start of each fiscal year, or both.

The Standardized Deficit standardized (structural) budget deficit A long-term measure of the governments fiscal position, with short- term factors removed. cyclically adjusted budget deficit A measure of the governments fiscal position if the economy were operating at full potential GDP.

Cash vs. Capital Accounting cash accounting A method of measuring the governments fiscal position as the difference between current spending and current revenues. capital accounting A method of measuring the governments fiscal position that accounts for changes in the value of the governments net asset holdings. Problems with Capital Budgeting implementing a capital budget: Practical difficulties with from

Very hard to distinguish government consumption investment spending. Very hard to assess governments intangible assets.

=> Politicians may misstate the governments budgetary position. While some states use capital implemented at the federal level. budgets, they have not been

The international experience with capital budgeting at the national level is mixed.

Static vs. Dynamic Scoring static scoring A method used by budget modelers that assumes that government policy changes only the distribution of total resources, not the amount of total resources. dynamic scoring A method used by budget modelers that attempts to model the effect of government policy on both the distribution of total resources and the amount of total resources

Background implicit obligation Financial obligations the government has in the future that are not recognized in the annual budgetary process. present discounted value (PDV) The value of each periods dollar amount in todays terms.

intertemporal budget constraint An equation relating the present discounted value of the governments obligations to the present discounted value of its revenues.

Generational accounting An accounting method that considers how current fiscal policies affect future generations. Generational accounting analyzes whether government spending and tax programs that benefit current members of society will produce an unfair tax obligation for future generations. The purpose of this accounting style is to achieve generational balance, where current and future generations have equivalent lifetime net tax rates, which allows for fiscal sustainability. (book) This budget measure was designed to assess the implications of the governments current (or proposed) fiscal policies for different generations of taxpayers. It answers the question: How much does each generation of taxpayers (those born in different years) benefit, on net, from the governments spending and tax policies,

assuming that the budget is eventually brought into long-run balance? The budget measure answers the question by first estimating the governments intertemporal budget constraint: PDV of Remaining Tax payments of Existing generations + PDV of Tax Payments of Future generations = PDV of All Future Govt Consumption + Current Govt Debt

Problems with these measures They depend critically on a wide variety of assumptions about future growth rates in costs and incomes, as well as assumptions about the interest rate used to discount future taxes and spending. The calculations require potentially heroic assumptions about interest rates, costs, and incomes in the very distant future, also assuming that government policy remains unchanged. The long-run imbalance measures only consider the pattern over time of transfer programs, and not of other investments and government policies. Short-Run vs. Long-Run Effects of the Government on economy short-run stabilization issues The role of the government in combating the peaks and troughs of the business cycle. automatic stabilization Policies that automatically alter taxes or spending in response to economic fluctuations in order to offset changes in household consumption levels. discretionary stabilization Policy actions taken by the government in response to particular instances of an underperforming or overperforming economy.

Savings and Economic Growth The earliest economic growth models emphasized a central role for savings as an engine of growth, and this insight remains important for growth economics today. More Capital, More Growth As there is more capital in an economy, each worker is more productive, and total social product rises. A larger capital stock means more total output for

any level of labor supply. Thus, the size of the capital stock is a primary driver of growth. More Savings, More Capital interest rate The rate of return in the second period of investments made in the first period. In a competitive capital market, the equilibrium amount of capital is determined by the intersection of these demand and supply curves.

The Federal Budget, Interest Rates, and Economic Growth The simple supply and demand framework is complicated by introducing the federal government into the market. What if there is a federal deficit and the government must borrow to finance the difference between its revenues and its expenditures? The key concern about federal deficits is that the federal governments borrowing might compete with the borrowing of private firms. If a fixed supply of savings is used to finance both the capital of private firms and the borrowing of the government, then the governments borrowing may crowd out the borrowing of the private sector and lead to a lower level of capital accumulation. In reality, there are a number of complications of how government financing affects interest rates and growth.

International Capital Markets There is a large body of economics literature that has investigated the integration of international capital markets. It has generally concluded that while integration is present (and perhaps growing), it is far from perfect. As a result, the supply of capital to the United States may not be perfectly elastic, and government deficits could crowd out private savings

intergenerational equity The treatment of future generations relative to current generations. GENERATIONAL ACCOUNTING

Generational accounting is a method of long-term fiscal analysis that has been developed over the past decade by Laurence Kotlikoff, Alan Auerbach, Jagadeesh

Gokhale, and associates in this country and around the world. It is used to assess the sustainability of fiscal policy and the fiscal burdens facing past, current, and future generations. For a given set of policy assumptions, it estimates the present value of taxes that the average person of any age today will ever pay and the present value of benefits that he or she will ever receive as transfer payments; the implications of this policy for the net taxes (taxes paid less transfers received) of people born in the future; and the lifetime net tax rates of generations born in specific years in the past and born in the future. Generational accounts are thus forward looking, based on estimates made far into the future. They are calculated in four steps: 1. The future net taxes paid by all living generations are estimated over their remaining lifetimes: for people who are 10 years old in the base year, 25 years old, 50 years old, and so forth. 2. The present value of goods and services that the government will purchase in the future is estimated. 3. The present value of future net taxes paid by future generations is calculated as a required amount -- the net taxes that future generations must pay if the government is to pay its bills as determined by steps #1 and #2 and is to service its debt. Since this requirement is a residual, the calculation cannot distinguish among different future generations, all of which are assumed to pay the same average net tax rate. 4. Lifetime net tax rates for all generations are estimated based on the net taxes and lifetime labor incomes of each generation. Generational accounts can thus be presented as either:

The present value of net taxes of each living generation and of "future generations" as a whole. The lifetime net tax rate of each living generation and of "future generations" as a whole.

What do generational accounts show? First, they have always shown that the prevailing fiscal policy is not sustainable in the United States or in most other countries. An increase in net taxes or a reduction in purchases of goods and services, even if not large, is needed for the government to pay its bills if current tax and spending policy are otherwise to continue. Second, they show how much of a change is needed. This amount is sensitive to whether the increase in net tax is paid only by future generations (as the authors almost always assume) or, more realistically, also by everybody who is alive when Congress enacts the policy change. If paid only by future generations, the latest

estimate is that the lifetime net tax rate would have to increase by 72 percent (from 29 percent to 49 percent). If paid both by future generations and by everybody who is alive when taxes are raised, the income tax at all levels of government would have to increase by 20 percent or all taxes by 9 percent. Both the newly born generation and future generations would have a lifetime net tax rate of 32 percent. These increases are much smaller than calculated a few years ago, such as in early 1994, when the lifetime net tax rate of future generations was estimated as 82 percent instead of 49 percent (assuming the increase was paid only by future generations). These increases would be still smaller if the estimates were updated for the legislation enacted last summer and the recently improved budget outlook. Third, generational accounts can be used to assess what alternative fiscal policies can achieve generational balance, which is defined as the government paying all its bills. Fourth, generational accounts can be used to assess how tax and transfer policy can redistribute income among generations.

Policies that affect the deficit. For example, a temporary income tax cut would benefit the middle-aged and old at the expense of younger and future generations, because the former would pay lower taxes while the latter would pay higher taxes to finance the interest on the additional debt. Policies that are deficit neutral. For example, the deficit might be cut in equal amounts by decreasing transfer payments across-the-board or by imposing an income tax surcharge. The surcharge would be paid disproportionately by younger generations earning income, whereas the decrease in transfer payments would be borne primarily (in present value terms) by older people receiving social security, medicare, and medicaid. This illustrates how the budget can redistribute income among generations without changing the deficit or the government's capital expenditures.

Fifth, generational accounts can show distributional trends over time. The lifetime net tax rate rose in the early part of this century. For generations born from 1920 to 1995, it falls within the range of 29-33 percent. Unless changes are enacted soon that affect living generations as well as future generations, the lifetime net tax rate will be higher still for future generations. The creators of generational accounting have contended that the budget deficit cannot answer these questions and therefore is irrelevant and ought to be replaced by generational accounts. This has not happened.

Generational accounting is designed to assess the questions posed at the beginning of this paper. It does not perform the most basic function of a budget, which is to propose and enact an allocation of resources among different programs for a specified period.

Generational accounting does not perform the function of the budget deficit in serving as a measure of the government's drain on private saving. Nor can it serve as effectively as the deficit as a discipline on the government's tax and spending policy, because a policy change could always be "planned" many years in the future but without any means to ensure that it would go into effect.

Generational accounting's appeal as an analytical tool to supplement the budget has also been limited.

Generational accounting is difficult to understand. The estimates of taxes and transfer by age depend on limited data and theoretical assumptions on which there is no consensus. The future budget projections depend on economic, demographic, and policy assumptions that are uncertain and controversial. Generational accounting does not consider general equilibrium feedback effects. In particular, it does not include the effect of current deficits on capital accumulation and therefore on future income. The right discount rate to calculate present values is uncertain and controversial. Generational accounts have only been constructed for the consolidated Federal, state, and local sectors, so responsibility for the fiscal outcome is diffuse. Generational accounting does not assign any benefits to the public from the government purchasing goods and services in order to provide education, highways, national defense, and other services. This is due to the difficulty in making imputations. However, government purchases comprise one-quarter of Federal spending and three-quarters of state and local spending. Because the benefits of this spending are important, the "net tax" is not a true fiscal burden. These benefits can have a major effect on the distribution of economic well-being by generation. Different programs affect different generations differently (e.g, education compared to veterans medical care); and some government expenditures are investments whose benefits occur over many years (e.g., office buildings, aircraft carriers, highway grants, R&D, and education).

OMB published an experimental chapter on generational accounts for three years under the Bush and Clinton Administrations, but it was eventually dropped. For long-range analysis, OMB finds year-by-year budget projections more illuminating, such as those extending to 2070 in the FY 1999 Analytical Perspectives.

CBO published a careful, extensive report on generational accounts, Who Pays and When?, over two years ago. After evaluating its methods, contributions, and limitations, CBO concluded that "despite the valuable insights generational accounts afford, they should not become part of the regular budget outlook. They lie in the realm of analysis, not accounting. Therefore, CBO believes that the accounts should remain as a tool to analyze policy from a conceptual perspective, rather than serve as an official statement."

We say that * a variable is cyclical if it increases with economic booms and declines with economic recessions * a variable is countercyclical if the opposite is true Which elements of the U.S. federal budget are cyclical and which are countercyclical? Many categories of federal revenue are cyclical. For example, both the personal income tax and the corporate income tax tend to move with the economy: during a downturn, individuals and corporations have lower tax burdens, and during boom times their tax burdens increase. Revenue from excise and other taxes on consumption (such as import taxes and gift taxes) also increase during particularly prosperous (high consumption) times and decrease during downturns in the economy. In contrast, there are a number of expenditure categories that tend to be countercyclical. Examples include human services, which includes some incomesupport payments. These payments tend to rise during a recession, as more people become unemployed. Payments to bail out struggling companies or to honor insurance commitments (Federal Depository Insurance for banks, for example) also tend to increase during bad economic times.

Suggest one way in which generational imbalances might be understated and one way in which they might be overstated. Calculated generational imbalances suggest that our current deficit will be balanced on the backs of future generations, to their detriment. These imbalances might be understated, in which case they will be even worse than anticipated for the next generation, if assumptions about continued growth are too optimistic; if the actual interest rate is less than the assumed rate of 3.6%; or if future policies entail higher expenditures than anticipated. The imbalances might be overstated if assumptions about continued growth are too pessimistic; if the actual interest rate is greater than the assumed rate; if the

quality of life of future generations (possibly including their economic productivity) is enhanced by expenditures made today; or if demographic shifts or policy changes result in lower expenditures than anticipated.

What is the intuition behind the notion of Ricardian equivalence? How might you look for evidence to test the suggestion that people account for future generations tax burdens by saving more today? According to the theory of Ricardian equivalence, whenever there is a deficit, the current generation realizes that it is paying less in taxes than is being spent by the government. They realize that this will result in a heavier tax burden on future generations than there would be if they were paying enough taxes to balance the current budget. To reduce this intergenerational inequity, the current generation saves more than they would if their taxes were higher. This will mean that children will inherit the means to pay higher taxes later. If this theory were accurate, individuals would respond to lower taxes (for the same levels of government expenditures) by raising their savings rate. To investigate whether the theory is accurate, then, one could look at how private savings rates have changed when new tax cuts (or tax increases) were passed.

What is responsible for these large intergenerational differences? The generational accounting used to generate Table 4-1 assumes that our current deficit will be paid for by future generations. Specifically, this accounting sets current plus future tax payments equal to the current debt plus future government consumption. Future tax payments will need to be sufficient to pay off the current deficit as well as to pay for the commitments the government has made to the current generation, including the commitment to make Social Security and Medicare payments when that generation retires. The baby boom generation will require high government expenditures when they retire. Those commitments plus current deficit spending (which benefits the current generation) mean that future tax payments will have to be high to keep this account in balance. Thus the tax burden of future generations will be greater than the benefits they are predicted to receive.

Is it necessarily inequitable for future generations to face higher taxes as a result of benefits that accrue to those living today? Explain. There are some reasons why the apparent intergenerational inequity might not be as bad as it seems. First, many of the expenditures made today will yield benefits far into the future. Because future generations will benefit from these current expenditures, it is not unreasonable to ask them to shoulder some of the costs. Second, the historical trend is for future generations to live better lives (measured

on some dimensions) than their parents generation. Technological advances constantly improve productivity and increase real incomes. Therefore, future generations may be better able than the current generation to shoulder this debt.

How do you think population growth affects the degree of generational balance in government finance? If there is population growth over time, then debts incurred by the current generation will be spread out over more people in the future. The per capita burden on future generations will therefore be smaller than if there was no population growth. If this growth slows or stops, though, the per capita imbalance will worsen as there will be fewer people to pay off the debts from prior generations. On a per capita basis, then, a faster rate of population growth can be said to reduce the degree of generational imbalance (at least when the imbalance favors current generations at the expense of later generations).

How might large federal deficits affect future economic growth? How would your answer change if foreign confidence in the ability of the United States to repay its debts erodes? When governments run deficits, they compete with private individuals to borrow loanable funds. With increased deficits, the total demand for loanable funds increases, driving up the rate of interest. The quantity of private investment in assets that improve economic productivity therefore falls. This is the basic theory of crowding out. If international investors/savers lose faith in the ability of the United States to repay its debt, the supply curve of loanable funds will become steeper: foreigners will supply additional loanable funds only if they receive higher interest rates to compensate them for what they perceive to be a riskier investment. This means that deficit spending will have larger effects on interest rates, and it will crowd out private investment to an even greater extent.

What is meant by dynamic scoring of the budget? Why does dynamic scoring potentially lead to more realistic estimates of the true effective size of a budget deficit? What are some methodological issues involved in dynamic scoring? Dynamic scoring allows budget predictions to incorporate changes in the economy in response to policy. Tax increases and tax cuts have direct effects on revenue collections, and they also have indirect effects on collections because they can affect economic growth. For example, some argue that a tax cut will actually increase tax revenue because workers will have an incentive to work more when they are taxed less. If done correctly, dynamic scoring can improve estimates by

accounting for ripple effects of policy changes. Most people agree that policy changes do not happen in a vacuum; when one aspect of the economy changes, other variables change in response. However, the magnitude of those changes is not precisely known, so predictions can vary. This might encourage policy makers to overstate or understate the effects of a policy