Government Budgets and Fiscal Policy. Learning Objectives By the end of this section, you will be able to: Identify U. Self-Check Questions When governments run budget deficits, how do they make up the differences between tax revenue and spending?
When governments run budget surpluses, what is done with the extra funds? Explain your answer. Review Questions Give some examples of changes in federal spending and taxes by the government that would be fiscal policy and some that would not. Have the spending and taxes of the U. What are the main categories of U. What is the difference between a budget deficit, a balanced budget, and a budget surplus?
Have spending and taxes by state and local governments in the United States had a generally upward or downward trend in the last few decades? Critical Thinking Questions Why is government spending typically measured as a percentage of GDP rather than in nominal dollars? Why are expenditures such as crime prevention and education typically done at the state and local level rather than at the federal level?
Why is spending by the U. Why is a cut in the payroll tax fiscal policy whereas a cut in a state income tax is not fiscal policy? Glossary balanced budget when government spending and taxes are equal budget deficit when the federal government spends more money than it receives in taxes in a given year budget surplus when the government receives more money in taxes than it spends in a year.
The funds can be used to pay down the national debt or else be refunded to the taxpayers. In response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand.
Note that a fiscal deficit is fundamentally different from a trade deficit , which occurs when a country imports relatively more value of goods than it exports abroad. The U. Such a deficit occurs because the U. The deficit in the United States is the result of three factors. Annual military spending has doubled. Tax cuts are another cause of the burgeoning deficit because they reduce revenue for each dollar cut.
While the Joint Committee on Taxation expects that the cuts should stimulate growth by 0. Lastly, Social Security is another contributor to the deficit. According to the Henry J. The next few years should see an even larger deficit, as the global coronavirus pandemic caused a spike in unemployment and business closures, which reduces tax revenues for the government.
This package greatly increased the fiscal budget gap. These effects on the deficit are likely to be long-lasting. Even though the long-term macroeconomic impact of fiscal deficits is subject to debate, there is far less debate about certain immediate, short-term consequences. However, these consequences depend on the nature of the deficit. If the deficit arises because the government has engaged in extra spending projects —for example, infrastructure spending or grants to businesses—then those sectors chosen to receive the money receive a short-term boost in operations and profitability.
If the deficit arises because receipts to the government have fallen, either through tax cuts or a decline in business activity, then no such stimulus takes place. Whether stimulus spending is desirable is also a subject of debate, but there can be no doubt that certain sectors benefit from it in the short run.
All deficits need to be financed. This is initially done through the sale of government securities, such as Treasury bonds T-bonds. Individuals, businesses, and other governments purchase Treasury bonds and lend money to the government with the promise of future payment.
The clear, initial impact of government borrowing is that it reduces the pool of available funds to be lent to or invested in other businesses. Thus, all deficits have the effect of reducing the potential capital stock in the economy. This would differ if the Federal Reserve monetized the debt entirely; the danger would be inflation rather than capital reduction. Additionally, the sale of government securities used to finance the deficit has a direct impact on interest rates. Government bonds are considered to be extremely safe investments, so the interest rate paid on loans to the government represent risk-free investments against which nearly all other financial instruments must compete.
This function is used by the Federal Reserve when it engages in open market operations to adjust interest rates within the confines of monetary policy. Even though deficits seem to grow with abandon and the total debt liabilities on the federal ledger have risen to astronomical proportions, there are practical, legal, theoretical and political limitations on just how far into the red the government's balance sheet can run, even if those limits aren't nearly as low as many would like. As a practical matter, the U.
Backed only by the full faith and credit of the federal government, U. The Federal Reserve also purchases bonds as part of its monetary policy procedures. Total government debt has real and negative long-term consequences. If interest payments on the debt ever become untenable through normal tax-and-borrow revenue streams, the government faces three options.
They can cut spending and sell assets to make payments, they can print money to cover the shortfall, or the country can default on loan obligations. The second of these options, an overly aggressive expansion of the money supply, could lead to high levels of inflation , effectively though inexactly capping the use of this strategy.
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Key Takeaways A budget deficit happens when current expenses exceed the amount of income received through standard operations. Certain unanticipated events and policies may cause budget deficits. Countries can counter budget deficits by raising taxes and cutting spending. Article Sources. Investopedia requires writers to use primary sources to support their work.
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When the government runs a budget deficit, it is spending more than it is taking in. In this way, national savings decreases. When national savings decreases, investment--the primary store of national savings--also decreases. Lower investment leads to lower long-term economic growth.
Similarly, lower investment is accompanied by higher domestic interest rates, which decreases net exports. Based on this logic, a budget deficit is a drain on the long-term economy. But the Ricardian view of the budget deficit takes a much less negative position on this issue.
Supporters of this view believe that a budget deficit represents trading taxes in the future for taxes today. That is, if the government spends more than it taxes today, then it must tax more than it spends tomorrow. Given that the public intrinsically understands this, a questionable premise, then the public will spend and save accordingly. Since the public is adjusting its spending and savings schedules to account for the necessary future increases in taxes, the budget deficit should have little long-term effect on economic growth.
The third position, a bit on the fringe, claims that the budget deficit is not a reasonable measure of fiscal policy. While these economists do believe that the government can affect spending, savings, and investment, they also believe that the budget deficit is simply an incomplete measure of these variables. Based on this position, the budget deficit should not be a focal issue in the economic policy debate.
Which of these views is most reasonable? There is likely a bit of truth in all of them. The best view of the budget deficit comes from understanding the major positions on the issue and creating some sort of compromise between the traditional, Ricardian, and fringe viewpoints.
Each time a budget deficit is run, money is added to the national debt.
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