Economics Chapter 15 The Difference Between The Number Hours Worker

CHAPTER 15: GOVERNMENT SPENDING AND ITS FINANCING

LEARNING OBJECTIVES

I. Goals of Chapter 15

A. Examine fiscal policy and its macroeconomic effects

B. Look at definitions and facts about the government’s budget

C. Discuss fiscal policy issues

TEACHING NOTES

I. The Government Budget: Some Facts and Figures (Sec. 15.1)

A. Defining the government sector

1. The government sector in Canada is defined by four major sectors:

a. The federal government

B. Government expenditure

1. Three categories of government expenditures

a. Government purchases (G)

(1) Spending on currently produced goods and services

(2) Examples: spending on schools, government workers’

(1) Interest paid to holders of government bonds

2. Total government expenditure (federal, provincial, and local) is

currently about forty percent of GDP (text Fig.15.1)

a. Government purchases increased enormously in World War II

(1) After falling to less than 10% of GDP in the late 1940s, the

share of GDP devoted to government purchases increased

Government Spending and Its Financing 289

(2) Many social programs, including Old Age Security and

2009

c. Net interest payments have also changed over time

(1) They more than doubled during1929-1933, reflecting

borrowing to finance spending during the Great Depression

3. A comparison of the Canadian government spending to that of other

OECD countries shows that over a span of seventeen years, from

1987 to 2009, the level of government spending in Canada adjusted

from being significantly above the OECD average in 1987 to being

slightly below in 2009 (text Table 15.1)

C. Revenues

1. Total tax collections have increased more or less from 1926 to 1998,

when they peaked at 44% of GDP. It is now 38.4% in 2009 (text Fig.

15.2)

2. Three principal categories

a. Direct taxes

(1) Personal income taxes

b. Indirect taxes

(1) Mostly sales taxes

3. The composition of spending and taxes: the Federal government

versus provincial and local governments

a. To see the overall picture of government spending, we usually

combine federal, provincial, and local government spending

b. But the composition of the federal government budget is quite

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(2) Transfer payments

(a) The federal government spends more on transfer

payments to individuals than provincial and local

their revenue.

Analytical Problem 1 looks at the reasons for inter-government transfers.

(3) Interest payments

(a) Net interest is significant and positive for the federal

(4) Composition of revenue

(a) Personal taxes account for about 57% of federal

C. A Closer Look 15.1: Provincial economic accounts

1. There are notable differences between provinces in spending,

revenue, and deficits, and in the allocation by province of federal

government spending and revenue

2. The Provincial Economic Accounts contain GDP accounting for each

surpluses except in Quebec, Ontario, New Brunswick, PEI and Yukon

D. Surpluses or Deficits

1. When outlays exceed revenues, there is a deficit; when revenues

exceed outlays, there is a surplus

Government Spending and Its Financing 291

a. The total surplus tells how much the government can pay down

in debt and still pay for total expenditure

because those are payments for past government spending

Numerical Problems 1, 2, 6, and 7 and Analytical Problem 4 deal with various aspects

of the deficit (surplus) and primary deficit (surplus).

4. The deficit and primary surplus usually move together over time (text

Fig. 15.3)

a. Large deficits occurred in the Great Depression, although these

were combined with primary surpluses.

e. The government fell into deficit again in 2009

Analytical Problem 2 asks students to look at actual data on the government budget

balance and see what does the size of the actual budget balance relative to the size of

the cyclically adjusted budget balance imply about the state of the economy.

Policy Application

Not everyone agrees with the budgetary choices that the Canadian federal government

has made. The Alternative Federal Budget is a document prepared by the Canadian

II. Government Spending, Taxes, and the Macroeconomy (Sec. 15.2)

A. Fiscal policy and aggregate demand

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

3. Classicals and Keynesians disagree about using fiscal policy to

stabilize the economy

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(2) There are long time lags, because the political process

takes time to make changes

4. Automatic stabilizers and the full-employment surplus or deficit

a. Automatic stabilizers cause fiscal policy to be countercyclical by

changing government spending or taxes automatically

b. One example is Employment Insurance, which causes transfers

d. Because of automatic stabilizers, the government budget

surplus falls in recessions and rises in booms

(1) The full-employment surplus is a measure of what the

government budget surplus would be if the economy were

Numerical Problem 3 looks at how automatic stabilizers affect the budget deficit over

the business cycle.

B. A Closer Look 15.2: Federal-provincial fiscal policy coordination

1. The response of the provinces to federal fiscal policy is an important

determinant of its overall deficit

a. If federal taxes fall but provincial taxes go up to compensate,

2. Reduction in transfers from one level of government to another is

called ‘off-loading’

3. Federal government transfers funds to provinces for health, post-

secondary education, and social assistance under the CHST per-

capita grant

a. Under CHST, there is differential treatment of provinces

Government Spending and Its Financing 293

2. Also, fiscal policy affects human capital formation through expenditures

D. Incentive effects of fiscal policy

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

(1) For someone earning less than $10 000, the marginal tax

d. The distinction between average and marginal tax rates affects

people’s decisions about how much labour to supply

(1) If the average tax rate increases, with the marginal tax rate

held constant, a person will increase labour supply

(2) If the marginal tax rate increase, with the average tax rate

held constant, a person will decrease labour supply

Numerical Problem 4 and Analytical Problem 3 look at the effects of tax rates on labour

supply.

2. Application: The poverty trap

a. Theory holds that reducing marginal tax rates should lead to an

increase in labour supply. This effect has been championed by

supply-side economists

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Policy Application

A classic supply-side experiment in the US was the Tax Reform Act of 1986. Four

articles evaluating the results of this act are presented in a symposium in the Winter

1992 issue of the Journal of Economic Perspectives.

3. Tax-induced distortions and tax rate smoothing

a. In the absence of taxes, the free market works efficiently

(1) Taxes change economic behaviour, reducing welfare

Policy Application

Bev Dahlby calculates that the raising of $1 in taxes in Canada imposes an excess cost

(over and above the $1) of 38 cents on the economy. See his article “The Distortionary

Effects of Rising Taxes” in William B.P. Robson and William M. Scarth ed. Deficit

Reduction: What Pain, What Gain?, C.D. Howe Institute, 1994.

e. It’s better to keep the tax rate constant over time than to raise it

and lower it, because the higher tax rate has a higher distortion

Theoretical Application

Robert Barro introduces the idea of tax smoothing in relation to the government debt in

his article “On the Determination of Public Debt,” Journal of Political Economy, October

1979, pp. 940–971.

(3) The federal government hasn’t always smoothed tax rates

III. Government Deficits and Debt (Sec. 15.3)

A. The growth of the government debt

1. The surplus or deficit is the difference between expenditures and

revenues in any fiscal year

Government Spending and Its Financing 295

4. A useful measure of government’s indebtedness that accounts for the

ability to pay off the debt is the debt–GDP ratio

a. The Canadian debt-GDP ratio (text Fig. 15.7) fell from over

100% after World War II to a low point in the mid-1970s

Numerical Problem 5 looks at tax smoothing and labour supply.

Data Application

Tiff Macklem in “Some Macroeconomic Implications of Rising Levels of Government

Debt”, Bank of Canada Review, Winter 1994–95, describes how government debt in

Canada has changed since the mid 1970s, and goes on to investigate the effects of

higher debt levels on macroeconomic performance.

Theoretical Application

Andy Abel asks the question, “Can the Government Roll Over Its Debt Forever?” in the

a. So three things cause the debt-GDP ratio to rise

(1) A high primary deficit

(2) A high real interest rate

(3) A low rate of GDP growth

b. During World War II, large primary deficits raised the debt-GDP

ratio

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Data Application

Nell Bruce and Douglas Purvis note that over the 1980s Canadian budget deficits were

considerably lower, as a percentage of GDP, when adjusted for inflation. However, even

with this adjustment, the deficit ratio (deficit to GDP) increased dramatically after the

late 1970s. See their paper “Implementing a Prudent Fiscal Policy over the Medium

Term” in Jack M. Mintz and Douglas D. Purvis ed. Policy Forum on Macropolicy Issues

in the Medium Term, John Deutsch Institute for the Study of Economic Policy, Queens

University, 1988.

B. A Closer Look 15.3: How large is the government debt?

1. There are different ways of thinking about government debt and hence

different ways of measuring debt

a. One way is think about government debt is as an indicator of the

current financial asset

b. Another way of thinking about government net debt is to

consider both current and long-term financial assets and

liabilities

(1) From this perspective, a government’s net debt is the

unfunded liability—that is, the excess of future spending

unfunded liabilities

C. The burden of the government debt on future generations

1. People worry that their children will have to pay back the debt that past

generations have accumulated

2. But Canadian citizens own most government bonds, so future

generations will just be paying themselves

3. However, there could be a burden, because if tax rates have to be

Government Spending and Its Financing 297

d. So the future standard of living will be lower e. However, this

assumes that government deficits reduce national saving; that is

a key and unsettled question

Policy Application

David Johnson in “Ricardian equivalence: Assessing the evidence for Canada” in

William B.P. Robson and William M. Scarth Deficit Reduction: What Pain, What Gain?

C.D. Howe 1994 argues that the evidence suggests that private saving in Canada has

not increased to match the increase in the government deficit, indicating a failure of

Ricardian equivalence.

D. Budget deficits and national saving: Ricardian equivalence revisited

1. When will a government deficit reduce national saving?

2. Ricardian equivalence: an example

a. Suppose the government cuts taxes by $100 per person

d. As a result, national saving should be unaffected

3. Ricardian equivalence across generations

a. What is the higher future taxes are to be paid by future

generations?

b. Then people might consume more today, because they wouldn’t

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Theoretical Application

The classic article on bequests and Ricardian equivalence is Robert J. Barro, “Are

Government Bonds Net Wealth?” Journal of Political Economy, 1974, pp. 1095–1117.

Barro suggests that even if there are departures from Ricardian equivalence, examining

the economy assuming Ricardian equivalence provides a useful baseline case.

E. Departures from Ricardian equivalence

1. The data show that Ricardian equivalence holds sometimes, but not

always

a. It did seem to hold in Canada in the early 1980s

2. What are the main reasons Ricardian equivalence may fail?

a. Borrowing constraints

(1) If people can’t borrow as much as they would like, a tax cut

tax cut

c. Failure to leave bequests

(1) People may not leave bequests because they don’t care

about their children, or because they think their children will

F. A Closer Look 15.4: Generational accounts

1. For many purposes, looking at the taxes and transfers people get over

their entire lifetimes is useful

Government Spending and Its Financing 299

Policy Application

A debate over the value of generational accounts is presented in the Winter 1994 issue

of the Journal of Economic Perspectives. Alan J. Auerbach, Jagadeesh Gokhale, and

Laurence J. Kotlikoff present good reasons for using them in their article “Generational

Accounting: A Meaningful Way to Evaluate Fiscal Policy,” while Robert Haveman

questions their value in his article “Should Generational Accounts Replace Public

Budgets and Deficits?”

Policy Application

In “Debt and Deficits in Canada: Some Lessons from Recent History”, Canadian Public

IV. Deficits and Inflation (Sec. 15.4)

A. The deficit and the money supply

1. Inflation results when aggregate demand rises more quickly than

aggregate supply

2. Budget deficits could be related to inflation, but we usually think of

4. Can government deficits lead to ongoing increases in the money

supply?

a. Yes, if spending is financed by printing money

b. The revenue that a government raises by printing money is

called seignorage

c. Usually, governments don’t just buy things directly with newly

printed money, they do so indirectly

(1) The Treasury borrows by issuing government bonds

5. Why would governments use money creation to finance deficits,

knowing that doing so causes inflation?