Government Budget Deficits and Government Debt

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Introduction

Definitions and Basics

    Government Debt and Deficits, from the Concise Encyclopedia of Economics
    Government debt is the stock of outstanding IOUs issued by the government at any time in the past and not yet repaid. Governments issue debt whenever they borrow from the public; the magnitude of the outstanding debt equals the cumulative amount of net borrowing that the government has done. The deficit is the addition in the current period (year, quarter, month, etc.) to the outstanding debt. The deficit is negative whenever the value of outstanding debt falls; a negative deficit is called a surplus....
    Federal Debt, from the Concise Encyclopedia of Economics
    A good way of judging the size of the federal debt, and hence its likely effect on the economy, is, as for an individual, to take it as a ratio of income. The federal debt reached a peak ratio of 114 percent of GDP after World War II and declined to 26 percent by 1981, before rising again. But even with the subsequent deficits, it was still only 51 percent of GDP in 1992. True "balance" in the budget, it might be suggested, would entail not a zero deficit, but one such that the debt grows at the same percentage rate as GNP, thus keeping the debt-to-GNP ratio constant....
    Federal Deficit, from the Concise Encyclopedia of Economics
    Those concerned about large deficits usually argue as follows: deficits let current generations off the hook for paying the government's bills. Therefore, current generations consume more. This reduces the amount Americans save and invest. A reduced rate of investment means less capital per worker and, therefore, lower productivity growth. When capital is scarce, its rate of return rises, causing interest rates to increase. Higher U.S. interest rates attract foreign investment to the United States....

    The simple fact is that the deficit is not a well-defined economic concept. The current measure of the deficit, or any measure, is based on arbitrary choices of how to label government receipts and payments. The government can conduct any real economic policy and simultaneously report any size deficit or surplus it wants just through its choice of words. If the government labels receipts as taxes and payments as expenditures, it will report one number for the deficit. If it labels receipts as loans and payments as return of principal and interest, it will report a very different number.

    Take Social Security, for example. Social Security "contributions" are called taxes, and Social Security benefits are called expenditures. If the government taxes Mr. X by $1,000 this year and pays him $1,500 in benefits ten years from now, this year's deficit falls by $1,000 and the deficit ten years hence will be $1,500 higher. But the taxes could just as plausibly be labeled as a forced loan to the government, and the benefits could be labeled as repayment of principal plus interest. In that case there would be no impact on the deficit.
    There are two separate official agencies devoted to making estimates of the Federal budget and its effects: the Office of Management and Budget (OMB) on behalf of the President, and the Congressional Budget Office (CBO) on behalf of Congress.
    Why two? The checks and balances in the U.S. Constitution mean that both the President and the Congress each have a different role in preparing the Federal Budget. Differences between the two budget estimates are hashed out in Congress prior to the annual budget being signed by the President.
    Budget Deficit, at Answers.com
    Excess of spending over income for a government, corporation, or individual over a particular period of time. A budget deficit accumulated by the federal government of the United States must be financed by the issuance of Treasury Bonds. Corporate deficits must be reduced or eliminated by increasing sales and reducing expenditures, or the company will not survive in the long run. Similarly, individuals who consistently spend more than they earn will accumulate huge debts, which may ultimately force them to declare bankruptcy if the debt cannot be serviced. The opposite of a deficit is a surplus.

In the News and Examples

    Hennessey on the Debt Ceiling and the Budget Process. EconTalk podcast, July 25, 2011.
    Keith Hennessey of Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about the debt ceiling and the budget process. Hennessey, who worked for Senate Majority Leader Trent Lott on budget issues in the late 1990s, explains the politics of the debt ceiling and the budget process. Using his past experience as a staffer, Hennessey gives those of us on the outside a window into what is actually going on in the hallways, who has power, and how information flows up and down in the chain of constituents, members, party leaders. The conversation closes with Hennessey's best guess of which outcomes of the current negotiations are most likely and why.
    How Big is the U.S. Debt? YouTube video, LearnLiberty.org.
    Economics professor Antony Davies illustrates the size the U.S. federal government's debt and unfunded obligations. He breaks down U.S. debt and obligations into constituent parts and compares them with the size of the GDP of countries around the world, showing the magnitude of America's fiscal situation.
    Boudreaux on Public Debt. EconTalk podcast, March 26, 2012.
    Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about the nature of public debt. One view is that there is no burden of the public debt as long as the purchasers of U.S. debt are fellow Americans. In that case, the argument goes, we owe it to ourselves. Drawing on the work of James Buchanan, particularly his book Public Principles of Public Debt: A Defense and Restatement, Boudreaux argues that there is a burden of the debt and it is borne by future taxpayers. Boudreaux argues that all public expenditures have a cost--the different financing mechanisms simply determine who bears the burden of that cost. Boudreaux discusses the political attractiveness of debt finance because the taxes lie in the future and those who will pay for them may not be clearly identified. The conversation closes with a discussion of the role of expectations in both politics and economics of debt finance.
    Can We Balance the Budget By Raising Taxes? YouTube video, LearnLiberty.org.
    Economics professor Antony Davies asks whether the United States can balance the federal government's budget by raising taxes. Looking at historical data of tax rates compared with government revenue, he shows that government revenue has remained essentially constant since 1969, despite wide changes in marginal tax rates. Prof. Davies concludes by suggesting that the optimal tax policy is be a simplified system with low rates.
    Do government budget deficits matter? Government Debt and Deficits, from the Concise Encyclopedia of Economics
    The crucial factor in determining how bond finance affects the economy is whether people recognize what is going to happen over time. If everybody foresees that future taxes will nullify future payments of principal and interest, then bond finance is equivalent to tax finance, and government debt has no effect on anything important. This property is known as "Ricardian equivalence," after David Ricardo, the economist who first discussed it. If people do not foresee all the future taxes implied by government debt, then they feel wealthier when the debt is issued but poorer in the future when, unexpectedly, they have to pay higher taxes to finance the principal and interest payments. So, what do people expect? Unfortunately, there is no reliable way to discover people's expectations about taxes, and we have to use other methods to learn the effect of government debt on the economy. Even though economists have been studying this issue for more than twenty years, they have not yet reached a consensus. Direct measures of the effect of debt on economic activity are straightforward in principle but difficult to construct in practice. Overall, though, the evidence favors approximate Ricardian equivalence....
    Measuring the government budget deficit: Federal Deficit, from the Concise Encyclopedia of Economics
    The simple fact is that the deficit is not a well-defined economic concept. The current measure of the deficit, or any measure, is based on arbitrary choices of how to label government receipts and payments. The government can conduct any real economic policy and simultaneously report any size deficit or surplus it wants just through its choice of words. If the government labels receipts as taxes and payments as expenditures, it will report one number for the deficit. If it labels receipts as loans and payments as return of principal and interest, it will report a very different number.

    Take Social Security, for example. Social Security "contributions" are called taxes, and Social Security benefits are called expenditures. If the government taxes Mr. X by $1,000 this year and pays him $1,500 in benefits ten years from now, this year's deficit falls by $1,000 and the deficit ten years hence will be $1,500 higher. But the taxes could just as plausibly be labeled as a forced loan to the government, and the benefits could be labeled as repayment of principal plus interest. In that case there would be no impact on the deficit.

A Little History: Primary Sources and References

    Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence, by Morgan Rose. Teacher's Corner at Econlib
    Imagine that you are in complete control of the finances of Freedonia. You are the fiscal authority in the country, with final say over all of the taxing and spending the government does. If so much as a can of soup is to be bought, the decision has to go through you....
    Taxes Paid by the Producer, by David Ricardo. Chapter 29 in On the Principles of Political Economy and Taxation.
    If Government delayed receiving the tax for one year till the manufacture of the commodity was completed, it would, perhaps, be obliged to issue an Exchequer bill bearing interest, and it would pay as much for interest as the consumer would save in price, excepting, indeed, that portion of the price which the manufacturer might be enabled in consequence of the tax, to add to his own real gains. If for the interest of the Exchequer bill, Government would have paid 5 per cent, a tax of £50 is saved by not issuing it. If the manufacturer borrowed the additional capital at 5 per cent, and charged the consumer 10 per cent, he also will have gained 5 per cent on his advance over and above his usual profits, so that the manufacturer and Government together gain, or save, precisely the sum which the consumer pays....

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