Chapter 12

The Government
Budget, the
Public Debt, and
Social Security

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Key Questions

What difference does it make if the government

runs a surplus or deficit?
What will be the long-run consequence of allowing
the post-2001 deficits to continue?
Will a persistent government budget deficit cause
the public debt to explode without limit?

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12-2

Fiscal Policy, Growth, and

Economic Welfare
Recall: We argued that an increase in the national saving
rate is likely to stimulate economic growth.
NS can be increased by fiscal policy via higher taxes or lower
spending.

The Rate of Time preference is the extra amount a

consumer would be willing to pay to be able to obtain a
given quantity of consumption goods now rather than a
year from now.
The U.S. saves too little if the rate at which individuals discount
future consumption is less than the rate of return on private
investment.

Should fiscal policy be used to increase NS or should

nothing be
done?
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2009
Pearson AddisonWesley. All rights reserved.

12-3

Figure 12-1 Two Alternative Paths

of Consumption per Person

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12-4

Government Budget Deficit, NS, and

Growth

Recall: National Saving is the sum of private and

government saving: NS = S + (T G)
Recall: The magic equation: NS = I + NX
If NS Either I or NX must fall
The only way I can be maintained if NS falls is if the fall in NS is completely
offset by a decline in foreign investment or increase in foreign borrowing.
This is possible in a small open economy.
In a large open economy, if NS must cause both a decline in I and NX.

To stimulate growth via higher investment spending, NS must be raised

either through higher private saving or higher government saving.

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12-5

Government Investment vs.

Consumption
The ultimate aim of policies to boost NS is to increase the
ratio of investment to real GDP.
Two Types of Investment
Private investment on machines and structures
Government investment, for instance, on education and highways
Government investment generates a future return consisting of the
benefits to future generations created by the investment.
Government consumption provides only current benefits.

Is government debt harmful?

The true burden of government debt depends on the extent to which
government debt is used to finance government investment or
consumption.
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2009 Pearson Addison-

Wesley. All rights reserved.

12-6

Measuring Government Debt

One measure of indebtedness is the ratio of nominal

federal debt to nominal GDP: D/PY
The government deficit = G T = D
The growth rate of D/PY = d (p + y)

Stability in indebtedness requires that the growth rate

of D/PY equals zero d = p + y
The Allowable Deficit that keeps the debt-GDP ratio
constant is: dD = (p + y)D
Implication: The debt-GDP ratio remains constant if the deficit
equals the outstanding debt times the growth rate of nominal GDP.

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12-7

International Perspective: The

Debt-GDP Ratio: How Does the
United States Compare?

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12-8

When Is There Too Much

Government Debt?
There is a limit to the size of government
debt since the government must pay
interest on the debt held by the public.
The government can meet its interest bill
forever by issuing more bonds without
increasing the debt-GDP ratio only if the
economys real growth rate of output equals or
exceeds its real interest rate.
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12-9

Figure 12-2 The Ratio of

U.S. Government Debt to GDP,
17902008

Sources: Historical Statistics of the United States

Millennial Edition and Economic Report of the President
2008. Details in Appendix C-4.

Copyright 2009 Pearson AddisonWesley. All rights reserved.

12-10

Figure 12-3 Federal Government

Revenues and Expenditures as a
Percent of Natural GDP, 19602008

Sources: Bureau of
Economic
AnalysisPearson
NIPA Tables and Congressional
Budget Office. Details in Appendix C-4.
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2009
AddisonWesley. All rights reserved.

12-11

Figure 12-4 Components of Federal

Government Expenditures as a
Percent of Natural GDP, 19602007

Copyright
2009 Pearson AddisonSource: Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.
Wesley. All rights reserved.

12-12

Supply Side Economics

Supply Side Economics, embraced by the Reagan administration,

posits that high tax rates stifle individual initiative and saving.

Income tax reduce the after-tax reward to work and saving.

An increase in the after-tax reward to work and saving creates a
significant increase in the amount of work and saving.
The resulting increase in work and saving is enough to boost tax revenue
as compared to before the tax cuts.

Empirical problems with supply side economics:

After Reagans tax cuts in 1981, the labor force participation grew more
slowly.
The personal saving rate fell after rising in rising during 1977-81.
Productivity growth grew only moderately, and not nearly as quickly as
after the tax hikes of 1993.

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12-13

Figure 12-5 The Laffer Curve

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12-14

Barro-Ricardo Equivalence
Theorem
In 1974, Robert Barro argued that changes in
taxes would not affect output because tax cuts are
balanced by an increase in saving rate rather than
an increase in consumption.
Tax cuts financed by deficit spending require higher
future tax payments to meet the interest on the public
debt, so people will save for those future obligations.

Criticisms
Decision horizons are often quite short.
1981
tax2009
cutsPearson
did notAddisonsee an increase in saving.
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12-15

The Social Security Debate

The Social Security system is the basic source of
retirement benefits for U.S. households.
The Pay-As-You-Go system works by collecting taxes
from workers and uses those taxes to pay benefits to
retired people and their spouses.
Surplus taxes are put into the Social Security trust fund and
invested in government bonds.

Problem: Because of the growing number of

retirees and increased longevity, the Social
Security system will run continuous deficits after
2018 and will run out of money after 2046.
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12-16

Social Security Solvency

Solutions
Is there even a problem?
The projections of future benefits payments and tax receipts are based on
very conservative estimates.

Population may be growing faster than assumed.

Immigration is assumed to be fixed.
Wage growth is assumed to be very slow.
Inflation may also be highly variable.

A few possible solutions to the problem:

Raise the ceiling on wages subject to the payroll tax.
Increase the retirement age from 67 to 70.
Increase payroll taxes by 0.5%.

Should Social Security funds be invested in the stock market?

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12-17

Figure 12-6 Social Security

Outlays, Revenues, and the Trust
Fund, 19852085 (1 of 2)

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12-18

Figure 12-6 Social Security

Outlays, Revenues, and the Trust
Fund, 19852085 (2 of 2)

Copyright 2009 Pearson AddisonSource: Congressional Budget Office. Details in Appendix C-4.
Wesley. All rights reserved.

12-19

Figure 12-6 Social Security

Outlays, Revenues, and the Trust
Fund, 19852085

Copyright 2009 Pearson AddisonSource: Congressional Budget Office. Details in Appendix C-4.
Wesley. All rights reserved.

12-20

Chapter Equations

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12-21

Chapter Equations
S T G I NX

(12.1)

NS I NX
D
Growth Rate of
d p y
PY
d p y
General Form

(12.2)

(12.3)

Numerical Example

dD
p y D2009 Pearson
(0.05) $4,500
billion $225 billion
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AddisonWesley. All rights reserved.

(12.4)
12-22