Chapter 13 – Fiscal Policy, Deficits, and Debt
CHAPTER THIRTEEN
FISCAL POLICY, DEFICITS, AND DEBT
CHAPTER OVERVIEW
This chapter explores the tools of government stabilization policy in terms of the aggregate demand-
aggregate (AD-AS) model. Next, the chapter examines fiscal policy measures that automatically adjust
government expenditures and tax revenues when the economy moves through the business cycle phases.
The recent use and resurgence of fiscal policy as a tool are discussed, as are problems, criticisms, and
complications of fiscal policy.
The material on the public debt is designed to explode two popular misconceptions as to the character
and problems associated with a large public debt: (1) the debt will force the U.S. into bankruptcy; and
(2) the debt imposes a burden on future generations. The debt discussion, however, also entails a look at
substantive economic issues. Potential problems of a large public debt include greater income inequality,
reduced economic incentives, and crowding out of private investment.
The chapter concludes with a Last Word on the problems associated with Social Security and Medicare.
WHAT’S NEW
There are two new learning objectives for this chapter, but there aren’t any significant changes to the text.
There are extensive data updates throughout the chapter.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Define and explain the role of the CEA.
2. Distinguish between discretionary and nondiscretionary fiscal policy.
3. Differentiate between expansionary and contractionary fiscal policy.
4. Recognize the conditions for recommending an expansionary or contractionary fiscal policy.
5. Explain expansionary fiscal policy and its effects on the economy and Federal budget.
6. Explain contractionary fiscal policy and its effects on the economy and Federal budget.
7. Give two examples of how built-in stabilizers help eliminate recession or inflation.
8. Explain the differential impacts of progressive, proportional, and regressive taxes in terms of
stabilization policy.
9. Explain the significance of the “cyclically-adjusted budget” concept.
10. Describe recent U.S. fiscal policy actions and the motivation behind them.
11. List three timing problems encountered with fiscal policy.
12. State political problems that limit effective fiscal policy.
13. Identify actions by households, and by state and local governments that can frustrate fiscal policy.
14. Differentiate between deficit and debt.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
15. State the relative size of the debt as a percentage of GDP and describe how that has changed in
recent years.
16. Describe the annual interest charges on the debt, who holds the debt, and the impact of inflation on
the debt.
17. Explain why the debt can also be considered public credit.
18. Identify and discuss two widely held myths about the public debt.
19. Explain the real or potential effect of the debt on income distribution, economic incentives, fiscal
policy, and private investment
20. Explain and recognize graphically how crowding out is a concern caused by a large public debt.
21. Define and identify terms and concepts at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Fiscal policy, especially tax policy, is one of the subjects that students usually find very interesting.
The chapter provides an excellent opportunity to establish the ties between theory and real-world
applications.
2. To give a more human dimension to this chapter, students may identify current members of the
Council of Economic Advisers. You could assign excerpts from the latest Economic Report of the
President, which the Council helps to prepare.
3. Current federal tax or spending issues can illustrate the timing, administrative, and political
problems with discretionary fiscal policy. The series of Bush tax cuts illustrate many of these
issues.
4. Current data on the federal budget can be obtained from the Federal Reserve Bulletin, Economic
Indicators, the Survey of Current Business, or the Economic Report of the President.
5. Remind students of the multiplier impacts that result from changes in government spending and/or
taxes. Most students can understand these concepts without reference to the numerical examples.
Numbers often confuse those with “math anxiety,” and if you skipped Chapter 10, they will benefit
from a brief overview of the concept.
6. In the discussion of myths about the debt, remind students that the debt is not completely harmless.
Explode the myths, but also discuss the substantive impact of the debt. Also, note the Global
Perspectives on debt in other nations.
7. The Last Word for the chapter is on the “leading indicators.” The stock market often reacts
immediately to changes in various indicators. One assignment could focus on the impact of the
latest report.
STUDENT STUMBLING BLOCKS
1. The biggest concern is with the magnitude of information in this chapter. Give students an
opportunity to focus on a few concepts at a time rather than assigning the entire chapter at once.
2. Although most students know this, some need to be reminded how Congress and the President
establish fiscal policy. This is particularly important when highlighting the different policy-making
process for monetary policy.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
3. The national debt has been an issue of great concern to politicians and citizens. Students probably
have major misconceptions based on the publicity surrounding the deficit and debt. The concern is
most often centered around the “myths” that the government can go bankrupt or that debt
necessarily is a burden on future generations. Spend some time discussing why these particular
concerns are not the major issues about which we should worry.
4. “Millions, billions, trillions,” most people have a difficult time maintaining perspective and
proportion when using really large numbers. For most of us, $100 million dollars sounds like an
incredible fortune. Ask students to calculate the percentage $100 million dollars represents out of
one trillion dollars. Check your figures before you try this in class. (The answer is .01 percent.)
This demonstration may help students understand why cutting a government budget can be so
difficult. What sounds like a huge sum of money may represent an extremely small percentage of
the total amount. Remind students of current GDP, budget and surplus statistics.
LECTURE NOTES
I. Introduction
A. Learning objectives – After reading this chapter, students should be able to:
1. Identify and explain the purposes, tools, and limitations of fiscal policy.
2. Explain the role of built-in stabilizers in moderating business cycles.
3. Describe how the cyclically-adjusted budget reveals the status of U.S. fiscal policy.
4. Summarize recent U.S. fiscal policy and the projections for U.S. fiscal policy over the
next few years.
5. Discuss the problems that governments may encounter in enacting and applying fiscal
policy.
6. Discuss the size, composition, and consequences of the U.S. public debt.
B. One major function of the government is to stabilize the economy (prevent unemployment or
inflation).
C. Stabilization can be achieved in part by manipulating the public budget—government
spending and tax collections—to increase output and employment or to reduce inflation.
D. This chapter will examine a number of topics.
1. It explores the tools of government fiscal stabilization policy using AD-AS model.
2. Both discretionary and automatic fiscal adjustments are examined.
3. The problems, criticisms, and complications of fiscal policy are addressed.
4. The size of and concerns about the public debt are identified and explored.
II. Fiscal Policy and the AD/AS Model
A. Discretionary fiscal policy refers to the deliberate manipulation of taxes and government
spending by Congress to alter real domestic output and employment, control inflation, and
stimulate economic growth. “Discretionary” means the changes are at the option of the
Federal government.
B. Discretionary fiscal policy changes are often initiated by the President, on the advice of the
Council of Economic Advisers (CEA).
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Chapter 13 – Fiscal Policy, Deficits, and Debt
C. Changes not directly resulting from congressional action are referred to as nondiscretionary
(or “passive”) fiscal policy.
D. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples
illustrated in Figure 13.1).
1. Expansionary Policy needed: In Figure 13.1, a decline in investment has decreased AD
from AD1 to AD2 so real GDP has fallen and also employment declined. Possible fiscal
policy solutions follow:
a. An increase in government spending (shifts AD to right by more than change in G
due to multiplier),
b. A decrease in taxes (raises income, and consumption rises by MPC x the change in
income; AD shifts to right by a multiple of the change in consumption).
c. A combination of increased spending and reduced taxes.
d. If the budget was initially balanced, expansionary fiscal policy creates a budget
deficit.
2. Contractionary fiscal policy needed: When demand-pull inflation occurs as illustrated by
a shift from AD3 to AD4 up the short-run aggregate supply curve in Figure 13.2. Then
contractionary policy is the remedy:
E. Policy options: G or T?
1. Economists tend to favor higher G during recessions and higher taxes during inflationary
times if they are concerned about unmet social needs or infrastructure.
2. Others tend to favor lower T for recessions and lower G during inflationary periods when
they think government is too large and inefficient.
III. Built-In Stability
A. Built-in stability arises because net taxes (taxes minus transfers and subsidies) change with
GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending
to rise when the economy is slumping and vice versa when the economy is becoming
inflationary. Figure 13.3 illustrates how the built-in stability system behaves.
1. Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP
falls.
2. Transfers and subsidies rise when GDP falls; when these government payments (welfare,
unemployment, etc.) rise, net tax revenues fall along with GDP.
B. The size of automatic stability depends on responsiveness of changes in taxes to changes in
GDP: The more progressive the tax system, the greater the economy’s built-in stability. In
Figure 13.3 line T is steepest with a progressive tax system.
1. The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the
change in GDP that would otherwise occur.
2. Automatic stability reduces instability, but does not eliminate economic instability.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
IV. Evaluating Expansionary or Contractionary Fiscal Policy
A. A cyclically-adjusted budget in Year 1 is illustrated in Figure 13.4(a) because budget revenues
equal expenditures when full employment exists at GDP1.
B. At GDP2 there is unemployment and assume no discretionary government action, so lines G
and T remain as shown.
1. Because of built-in stability, the actual budget deficit will rise with the decline of GDP;
therefore, actual budget varies with GDP.
2. The government is not engaging in expansionary policy since the budget is balanced at
full- employment output.
3. The cyclically-adjusted budget measures what the Federal budget deficit or surplus would
be with existing taxes and government spending if the economy is at full employment.
4. Actual budget deficit or surplus may differ greatly from the cyclically-adjusted budget
deficit or surplus estimates.
C. In Figure 13.4b, the government reduced tax rates from T1 to T2, now there is a cyclically-
adjusted deficit.
1. Structural deficits occur when there is a deficit in the cyclically-adjusted budget as well
as the actual budget.
2. This is expansionary policy because true expansionary policy occurs when the cyclically-
adjusted budget has a deficit.
D. If the cyclically-adjusted deficit of zero was followed by a cyclically-adjusted budget surplus,
fiscal policy is contractionary.
E. Recent U.S. fiscal policy is summarized in Table 13.1.
1. Observe that standardized deficits are less than actual deficits.
2. Column 3 indicates contractionary fiscal policy in 2000 and 2001before becoming
expansionary.
3. Fiscal policy from 2000 – 2007
a. In 2001, Bush decreased taxes to help pull the economy out of a recession.
b. March 2002, Congress decreased taxes more and extended unemployment benefits
causing the cyclically-adjusted budget to change from 1.1% to -1.3%.
c. The economy remained slow and government decreased taxes more in 2003 and the
economy grew from 2003 – 2007.
4. Fiscal policy during the Great Recession
a. In 2007, the crisis in the mortgage loans developed, threatening stability in other
financial markets, pessimism grew, spending decreased, and the economy entered the
steepest, longest recession since the Great Depression.
b. In 2008 Congress passed $152 billion in stimulus through tax breaks increasing the
cyclically-adjusted deficit from -1.3% of potential output in 2007 to -2.9% in 2008
showing expansionary policy.
c. There were no real changes in spending from the tax breaks.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
d. In 2009 Obama passed the American Recovery and Reinvestment Act – $787 billion
stimulus with tax rebates and large expenditures on infrastructure, education, and
health care.
e. The cyclically-adjusted budget increased from -2.8% of potential GDP in 2008 to
-7.1% in 2009.
5. Figure 13.5 shows deficits are predicted through 2018.
F. Global Perspectives 13.1 gives a fiscal policy snapshot for selected countries.
V. Problems, Criticisms and Complications of Implementing Fiscal Policy
A. Problems of timing
1. Recognition lag is the elapsed time between the beginning of recession or inflation and
awareness of this occurrence.
2. Administrative lag is the difficulty in changing policy once the problem has been
recognized.
3. Operational lag is the time elapsed between change in policy and its impact on the
economy.
B. Political considerations: Government has other goals besides economic stability, and these
may conflict with stabilization policy.
1. A political business cycle may destabilize the economy: Election years have been
characterized by more expansionary policies regardless of economic conditions.
C. Future policy reversals can prevent fiscal policy from being effective if people believe that
the fiscal policy changes are temporary.
D. State and local finance policies may offset federal stabilization policies. They are often
procyclical, because balanced-budget requirements cause states and local governments to
raise taxes in a recession or cut spending making the recession possibly worse. In an
inflationary period, they may increase spending or cut taxes as their budgets head for surplus.
E. The crowding-out effect may be caused by fiscal policy.
1. “Crowding-out” may occur with government deficit spending. It may increase the interest
rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.
2. Some economists argue that little crowding out will occur during a recession.
3. Economists agree that government deficits should not occur at F.E., it is also argued that
monetary authorities could counteract the crowding-out by increasing the money supply
to accommodate the expansionary fiscal policy.
F. Current thinking on fiscal policy
1. Some economists oppose the use of fiscal policy, believing that monetary policy is more
effective or that the economy is sufficiently self-correcting.
2. Most economists support the use of fiscal policy to help “push the economy” in a desired
direction, and using monetary policy more for “fine tuning.”
3. Economists agree that the potential impacts (positive and negative) of fiscal policy on
long-term productivity growth should be evaluated and considered in the decision-
making process, along with the short-run cyclical effects.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
VI. The U.S. Public Debt
A. The national or public debt is the total accumulation of the Federal government’s total deficits
and surpluses that have occurred through time.
B. Deficits (and by extension the debt) are the result of war financing, recessions, and lack of
political will to reduce or avoid them.
C. The public debt was $16.4 trillion in 2012.
D. Ownership of the public debt (Figure 13.6)
1. 60 percent held by the public and 40 percent by Federal government agencies, including
the Federal Reserve.
2. Foreigners held about 33% of the public debt in 2012. Of the amount of public debt held
by foreigners, China held 22% while Japan held 20%.
3. The Federal debt held by the public was 70.1 percent of GDP in 2012. (Figure 13.7)
E. Debt as a percentage of GDP increased significantly in 2008 and 2012 due to huge deficits
and a decrease in GDP. Public debt as a percentage of GDP in 2012 for a number of countries
can be seen in Global Perspective 13.2. Although the U.S. has the highest public debt in
absolute terms, a number of countries owe more relative to their ability to support it (through
income, or GDP).
F. Interest charges are the main burden imposed by the debt.
1. Interest on the debt was $360 billion in 2012, and is the fourth largest item in the Federal
budget.
2. Interest payments were 2.3 percent of GDP in 20012. The percentage is important
because it represents the average tax rate necessary just to cover annual interest on the
debt. Low interest rates have brought the percentage down since 2000.
VII. False Concerns
False concerns about the federal debt include several popular misconceptions:
A. Can the federal government go bankrupt? There are reasons why it cannot.
1. The government can borrow more (i.e. sell new bonds) to refinance bonds when they
mature. Corporations use similar methods—they almost always have outstanding debt.
2. The government has the power to tax, which businesses and individuals do not have
when they are in debt.
B. Does the debt impose a burden on future generations? In 2012 the per capita federal debt in
U.S. was $52,396. But the public debt is a public credit—your grandmother may own the
bonds on which taxpayers are paying interest. Some day you may inherit those bonds that are
assets to those who have them. The true burden is borne by those who pay taxes or loan
government money today to finance government spending. If the spending is for productive
purposes, it will enhance future earning power and the size of the debt relative to future GDP
and population could actually decline. Borrowing allows growth to occur when it is invested
in productive capital.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
VIII. Substantive Issues
A. Repayment of the debt affects income distribution. If working taxpayers will be paying
interest to the mainly wealthier groups who hold the bonds, this probably increases income
inequality.
B. Since interest must be paid out of government revenues, a large debt and high interest can
increase tax burden and may decrease incentives to work, save, and invest for taxpayers.
C. A higher proportion of the debt is owed to foreigners (about 33 percent) than in the past, and
this can increase the burden since payments leave the country. But Americans also own
foreign bonds and this offsets the concern.
D. Some economists believe that public borrowing crowds out private investment, but the extent
of this effect is not clear (see Figure 13.8).
E. There are some positive aspects of borrowing even with crowding out.
1. If borrowing is for public investment that causes the economy to grow more in the future,
the burden on future generations will be less than if the government had not borrowed for
this purpose.
2. Public investment makes private investment more attractive. For example, new federal
buildings generate private business; good highways help private shipping, etc.
IX. LAST WORD: The Social Security and Medicare Shortfalls
A. The percentage of people aged 65 and older is expected to rise substantially over the next few
decades.
B. More people will be receiving Social Security and Medicare benefits and for longer time
periods with fewer people contributing to both programs.
1. In 1960 for every individual receiving Social Security/Medicare there were 5 workers
contributing.
2. Today, there are only 3 workers contributing for every individual receiving benefits.
C. Medicare and Social Security cost 8.5% of GDP in 2011 and it is expected to rise to 12% of
GDP in 2035.
D. Social Security is a pay-as-you go system with workers paying 6.2% tax on their income up
to $113,700 and the employer paying another 6.2%.
E. Extra social security tax revenue has been collected in anticipation of the large pay-outs to
baby boomers.
1. The extra revenue was used to purchase U.S. Treasury securities and put into a fund.
2. In 2009 government had to start using the money in the fund to make up for the lack of
revenue to pay for the promised benefits.
3. By 2033 the trust fund is expected to be depleted at which time the revenues will only
cover 75% of the promised benefits.
F. Medicare is also a pay-as-you go program with workers paying 1.45% and employers paying
the other 1.45% on all earnings.
1. Medicare is in worse shape than Social Security.
2. Benefits covered by Medicare will fall from 97% in 2025 to 72% in 2035 and 69% in
2080.
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Chapter 13 – Fiscal Policy, Deficits, and Debt
G. The Unpleasant Options
1. To balance Social Security over the next 75 years government must either make a
permanent 16% reduction in benefits and/or 13% permanent increase in tax revenues.
2. To bring Medicare into balance, government must increase Medicare payroll tax to 122%,
and/or a 51% reduction in Medicare payments from their projected amounts.
3. All of the options involve difficult economic costs and dangerous political risks.
QUIZ
1. When changes to taxes and spending occur in the economy without explicit action by the Federal
government, such policy is:
A. Cyclical
B. Variable
C. Discretionary
D. Nondiscretionary
2. As the economy declines, the collection of personal income tax revenues automatically falls. This
relationship best describes how the progressive income tax system:
A. Increases crowding out in the economy
B. Decreases real interest rates in the economy
C. Offsets the timing problem for fiscal policy
D. Provides built-in stability for the economy
3. If the cyclically-adjusted budget shows a deficit of about $100 billion and the actual budget
shows a deficit of about $150 billion, it can be concluded that there is:
A. Built-in stability
B. A cyclical deficit
C. An expansionary fiscal policy
D. A contractionary fiscal policy
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Chapter 13 – Fiscal Policy, Deficits, and Debt
4. An economy is experiencing a high rate of inflation. The government wants to reduce
consumption by $36 billion to reduce inflationary pressure. The MPC is .75. By how much
should the government raise taxes to achieve its objective?
A. $6 billion
B. $9 billion
C. $12 billion
D. $16 billion
5. Which is an important consequence of the public debt of the United States?
A. It will threaten to bankrupt the Federal government
B. It transfers a portion of output from foreign nations to the U.S
C. It decreases the inequality in the distribution of income in the U.S
D. It leads to fewer incentives to bear risk and innovate
6. Which is an important problem associated with the public debt?
A. Payments of interest on the debt lead to greater income equality
B. Interest payments on the debt tend to improve economic incentives to work and produce more
unemployment
C. Government borrowing to finance the debt may increase the level of private investment
D. Payment of interest on the debt held by foreigners transfers real resources abroad
7. If the Congress passes legislation to cut taxes to counter the effects of a severe recession, then this
would be an example of a:
A. Political business cycle
B. Contractionary fiscal policy
C. Expansionary fiscal policy
D. Nondiscretionary fiscal policy
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Chapter 13 – Fiscal Policy, Deficits, and Debt
8. Fiscal policy refers to the:
A. manipulation of government spending and taxes to stabilize domestic output, employment,
and the price level.
B. manipulation of government spending and taxes to achieve greater equality in the distribution
of income.
C. altering of the interest rate to change aggregate demand.
D. fact that equal increases in government spending and taxation will be contractionary.
9. The amount by which government expenditures exceed revenues during a particular year is the:
A. public debt.
B. budget deficit.
C. full-employment.
D. GDP gap.
10. As a percent of GDP, the United States public debt is:
A. the highest among major industrial nations.
B. the lowest among major industrial nations.
C. lower than the public debts of several other major industrial nations.
D. higher than the percentages for Canada, Germany, and Italy.
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