Chapter 15
Government Spending and Its Financing
Learning Objectives
I. Goals of Chapter 15
1. Three categories of government expenditures
a. Government purchases (G)
(1) Government investment, which is about 1/6 of total government purchases, consists
of purchases of capital goods
(2) Government consumption expenditures are about 5/6 of total government purchases
2. Total (Federal, state, and local) government outlays are about one-third of GDP
(text Figure 15.1)
23% of GDP to about 17% of GDP in late 1990s, but since have risen to about 20%
of GDP
b. Transfer payments have been rising steadily
(1) They averaged about 12% of GDP in the 2000s before the financial crisis and 16% of
GDP since then
3. Comparing U.S. government spending to that of other countries shows that the United States
spends less as a percentage of GDP than almost any other OECD country (text Table 15.1)
1. Total tax collections have increased over time, from about 16% of GDP in 1940 to about
29% in 2000, though declining to about 25% in 2011 (text Figure 15.2)
2. Four principal categories
a. Personal taxes
of 1964, the Reagan tax cut of 1981, and the Bush tax cuts in the early 2000s
b. Contributions for social insurance have increased steadily as a percentage of GDP since
3. The composition of outlays and taxes: the Federal government versus state and local
governments
a. To see the overall picture of government spending, we usually combine Federal, state, and
local government spending
b. But the composition of the Federal government budget is quite different from state
1. When outlays exceed revenues, there is a deficit; when revenues exceed outlays, there is a
surplus
2. Formally, deficit outlays tax revenues government purchases transfers net interest
tax revenues G TR INT T(15.1)
3. Another useful deficit definition is the primary government budget deficit, which excludes
net interest payments:
primary deficit outlays net interest tax revenues
government purchases transfers tax revenues (15.2)
G TR T
4. The separation of government purchases into government investment and government
consumption expenditures introduces another set of deficit concepts
a. The current deficit equals the deficit minus government investment
b. The primary current deficit equals the primary deficit minus government investment,
which equals the current deficit minus interest payments
5. The current deficit and primary current deficit usually move together over time
(text Figure 15.4)
1990s, but large interest payments kept the overall deficit large until the late 1990s; the
deficit became larger in the 2000s, then grew dramatically because of increased
government spending during the Great Recession
Analytical Problem 2 asks students to look at actual data on the government budget deficit
1. An increase in government purchases increases aggregate demand by shifting the IS curve up
2. The effect of tax changes depends on the economic model
a. Classical economists accept the Ricardian equivalence proposition that lump-sum tax
3. Classicals and Keynesians disagree about using fiscal policy to stabilize the economy
a. Classicals oppose activist policy while Keynesians favor it
4. Automatic stabilizers and the full-employment deficit
a. Automatic stabilizers cause fiscal policy to be countercyclical by changing government
spending or taxes automatically
b. One example is unemployment insurance, which causes transfers to rise in recessions
c. The most important automatic stabilizer is the income tax system, since people pay less
1. Fiscal policy affects the economy through the formation of government capital—long-lived
physical assets owned by the government, like roads, schools, and sewer systems
2. Also, fiscal policy affects human capital formation through expenditures on health, nutrition,
and education
3. Data on government investment include only physical capital, not human capital
a. In 2011, 2/3 of federal government investment was on national defense and 1/3
1. Average versus marginal tax rates
a. Average tax rate total taxes/pretax income
b. Marginal tax rate taxes due from an additional dollar of income
c. Example: Suppose taxes are imposed at a rate of 25% on income over $10,000
(text Table 15.3)
3. Application: Labor supply and tax reform in the 1980s
a. Congress reduced tax rates twice in the 1980s
(1) At the beginning of the decade the highest marginal tax rate on labor income was 50%
(2) The 1981 tax act (ERTA) reduced tax rates in three stages, phased in until 1984
(3) The tax reform of 1986 further reduced personal tax rates, dropping the top marginal
4. Tax-induced distortions and tax rate smoothing
a. In the absence of taxes, the free market works efficiently
(1) Taxes change economic behavior, reducing welfare
(2) Thus tax-induced deviations from free-market outcomes are called distortions
b. The difference between the number of hours a worker would work without taxes and the
1. The deficit is the difference between expenditures and revenues in any fiscal year
2. The debt is the total value of outstanding government bonds on a given date
2. Total (Federal, state, and local) government outlays are about one-third of GDP
(text Figure 15.1)
23% of GDP to about 17% of GDP in late 1990s, but since have risen to about 20%
of GDP
b. Transfer payments have been rising steadily
(1) They averaged about 12% of GDP in the 2000s before the financial crisis and 16% of
GDP since then
3. Comparing U.S. government spending to that of other countries shows that the United States
spends less as a percentage of GDP than almost any other OECD country (text Table 15.1)
1. Total tax collections have increased over time, from about 16% of GDP in 1940 to about
29% in 2000, though declining to about 25% in 2011 (text Figure 15.2)
2. Four principal categories
a. Personal taxes
of 1964, the Reagan tax cut of 1981, and the Bush tax cuts in the early 2000s
b. Contributions for social insurance have increased steadily as a percentage of GDP since
3. The composition of outlays and taxes: the Federal government versus state and local
governments
a. To see the overall picture of government spending, we usually combine Federal, state, and
local government spending
b. But the composition of the Federal government budget is quite different from state
1. When outlays exceed revenues, there is a deficit; when revenues exceed outlays, there is a
surplus
2. Formally, deficit outlays tax revenues government purchases transfers net interest
tax revenues G TR INT T(15.1)
3. Another useful deficit definition is the primary government budget deficit, which excludes
net interest payments:
primary deficit outlays net interest tax revenues
government purchases transfers tax revenues (15.2)
G TR T
4. The separation of government purchases into government investment and government
consumption expenditures introduces another set of deficit concepts
a. The current deficit equals the deficit minus government investment
b. The primary current deficit equals the primary deficit minus government investment,
which equals the current deficit minus interest payments
5. The current deficit and primary current deficit usually move together over time
(text Figure 15.4)
1990s, but large interest payments kept the overall deficit large until the late 1990s; the
deficit became larger in the 2000s, then grew dramatically because of increased
government spending during the Great Recession
Analytical Problem 2 asks students to look at actual data on the government budget deficit
1. An increase in government purchases increases aggregate demand by shifting the IS curve up
2. The effect of tax changes depends on the economic model
a. Classical economists accept the Ricardian equivalence proposition that lump-sum tax
3. Classicals and Keynesians disagree about using fiscal policy to stabilize the economy
a. Classicals oppose activist policy while Keynesians favor it
4. Automatic stabilizers and the full-employment deficit
a. Automatic stabilizers cause fiscal policy to be countercyclical by changing government
spending or taxes automatically
b. One example is unemployment insurance, which causes transfers to rise in recessions
c. The most important automatic stabilizer is the income tax system, since people pay less
1. Fiscal policy affects the economy through the formation of government capital—long-lived
physical assets owned by the government, like roads, schools, and sewer systems
2. Also, fiscal policy affects human capital formation through expenditures on health, nutrition,
and education
3. Data on government investment include only physical capital, not human capital
a. In 2011, 2/3 of federal government investment was on national defense and 1/3
1. Average versus marginal tax rates
a. Average tax rate total taxes/pretax income
b. Marginal tax rate taxes due from an additional dollar of income
c. Example: Suppose taxes are imposed at a rate of 25% on income over $10,000
(text Table 15.3)
3. Application: Labor supply and tax reform in the 1980s
a. Congress reduced tax rates twice in the 1980s
(1) At the beginning of the decade the highest marginal tax rate on labor income was 50%
(2) The 1981 tax act (ERTA) reduced tax rates in three stages, phased in until 1984
(3) The tax reform of 1986 further reduced personal tax rates, dropping the top marginal
4. Tax-induced distortions and tax rate smoothing
a. In the absence of taxes, the free market works efficiently
(1) Taxes change economic behavior, reducing welfare
(2) Thus tax-induced deviations from free-market outcomes are called distortions
b. The difference between the number of hours a worker would work without taxes and the
1. The deficit is the difference between expenditures and revenues in any fiscal year
2. The debt is the total value of outstanding government bonds on a given date