DEFICIT FINANCE Chapter 20

How Big Is the Deficit?

• Deficit• Surplus• On-budget deficit• Off-budget deficit

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How Big Is the Deficit?

Source: Congressional Budget Office [2012b]

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How Big Is the Debt?

• National (Public) Debt• Stocks vs. Flows

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How Big Is the Debt?

Source: Congressional Budget Office [2012b]

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Interpreting Deficit, Surplus, and Debt Numbers

• Government Debt held by the Federal Reserve Bank• State and Local Government• Effects of Inflation– Inflation tax

• Capital versus Current Accounting• Tangible Assets• Implicit Obligations• Summing Up

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The Burden of the Debt

• Statutory versus Economic Incidence• One Hand Borrows from the Other– Internal Debt– External Debt

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Overlapping Generations ModelThe Period 2010-2030

Young Middle-Aged Old

(1) Income $12,000 $12,000 12,000

(2) Government Borrowing -6,000 -6,000

(3) Government- provided consumption 4,000 4,000 4,000

The Year 2030

Young Middle-Aged Old

(4) Government raises taxes to pay back debt

-4,000 -4,000 -4,000

(5) Government pays back debt +6,000 +6,000

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Overlapping Generations Model

• Generational Accounting– Computation of Net Tax• PV of transfers received – PV of taxes paid

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Other Models

• Neoclassical Model – Crowding Out Hypothesis– Empirical testing of the hypothesis

• Ricardian Model– Intergenerational transfers– Form of Finance is irrelevant– Empirical evidence

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To Tax or To Borrow

• Benefits-Received Principle• Intergenerational Equity• Efficiency Considerations– χ = ½εLt2

• Deficits and Functional Finance– Functional finance

• Moral and Political Considerations– Federal Debt and the Risk of a Fiscal Crisis

• Controlling the Deficit

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Present Value of Tax Payments Under Alternative Taxing/Borrowing Decisions

Policy Year 1

Year 2

All Future Years

PV @ 10% interest rate

Spend an additional $100 in year 1 100 0 0 100

Financing OptionsBalanced budget: raise 100 in taxes in year

1100 0 0 100

Deficit Finance I: borrow 100 in year 1 and pay back debt plus interest in year 2 by

raising taxes

0 110 0 100

Deficit Finance II: borrow 100 in year 1 and pay interest on debt in all subsequent

years always rolling over debt principle

0 10 10 100

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To Tax or To Borrow

Tax rate

ExcessBurden

t 2t

χ2

χ1

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Chapter 20 Summary• When government spending > revenues, it must borrow

money: debt is the sum of past deficits & surpluses• Economic research centers on whether future

generations carry the burden of government debt• Several factors influence whether government should

finance expenditures through taxes or debt– From an efficiency point of view, the excess burden of tax

vs. debt financing should be considered• Options for controlling the deficit include changing

budget-making processes and a constitutional amendment

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