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Federal Budgets and Public Policy

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© 2003 South-Western/Thomson Learning

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Federal Budget ProcessThe federal budget is a plan for government outlays and revenues for a specified period, usually a year

Federal outlays include bothGovernment purchasesTransfer payments

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President’s Role in Budget Process

Legislation in 1921 created the Office of Management and Budget to examine agency requests and help the president develop a budget proposal

President’s budget process usually begins a year before it is submitted to Congress

The congressional budget cycle begins in late January once Congress gets The Budget of the United States Government

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Congressional Role in the Budget Process

Once the president’s budget hits Congress, budget committees in both the House and the Senate rework until they agree on total outlays, spending by major category, and expected revenues

This agreement, called a budget resolution, establishes a framework to guide spending and revenue decisions

The fiscal year runs from October 1 of one year to September 30 of the following year

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The BudgetThe size and composition of the budget and the difference between outlays and revenues measure the budget’s fiscal impact

When outlays exceed revenues, the budget is in deficit • stimulates aggregate demand in the short

run, but reduces national saving which in the long run could impede economic growth

Alternatively, when revenues exceed outlays, the budget is in surplus • dampens aggregate demand in the short

run, but enhances domestic saving which in the long run could promote economic growth

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Problems

There are a number of problems with the federal budgeting process

Continuing Resolutions instead of Budget Decisions: Congress often ignores the budget timetable • budgets typically run on continuing

resolutions, which are agreements to allow agencies to spend at the rate of the previous year’s budget

Overlapping Committee Authority: requires the executive branch to defend the same section of the president’s budget before several committees in both House and the Senate

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Problems

Lengthy Budget Process: given that the average recession lasts less than a year and that budget preparation begin more than a year and a half before the budget takes effect, planning discretionary fiscal measures to smooth economic fluctuations is difficultUncontrollable Budget Items: Congress has only limited control over much of the budget. • About three-quarters of federal budget outlays

are determined by existing laws. • Congress has little or no say in spending on

various entitlement programs

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Problems

No separate capital budget: Congress approves a single budget that mixes capital items with current outlays. • Budgets for businesses and for state and local

governments usually distinguish between a capital budget and an operating budget

Overly-detailed budget: The federal budget is divided into thousands of accounts and sub-accounts and to the extent that the budget is a way of making political payoffs• such micromanagement allows elected officials to

reward friends and punish enemies

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Possible Budget ReformsPossible reforms

The annual budget could be converted into a two-year budget, or biennial budget.• The problem is that it would require longer-

term economic forecasts less useful as a tool of discretionary fiscal policy

Now Congress spends nearly all of the year working on the budget. Executive branch is always dealing with three budgets: • administering an approved budget, • defending a proposed budget before

congressional committees, and • preparing the next budget for submission to

Congress

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Possible Budget ReformsAnother possible reform could be to simplify the budget document by concentrating only on major groupings and eliminating line items. • Each agency would receive a total budget along

with the discretion to allocate this budget• The problem here is that agency heads may

have different priorities than those of elected representatives

Final reform is to sort federal spending into an operating budget and a capital budget• Capital budget would include spending on

physical capital• Operating budget would include spending on all

ongoing expenses

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Budget PhilosophiesSeveral budget philosophies have emerged over the years

Annually balanced budget: fiscal policy aimed at balancing the budget on an annual basis except during wartime.• Implied that spending increased during

expansions and declined during recessions fiscal policy magnified fluctuations in the business cycle

Cyclically balanced budget: the budget should be balanced over the course of the business cycle deficits during recessions and surpluses during expansions

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Budget Philosophies

Functional finance says that policy makers should be less concerned with balancing the budget annually, or even over the course of the business cycle, than with ensuring that the economy produces its potential output • if the budgets needed to keep the economy

operating at its potential involve chronic deficits, so be it.

• Since the Great Depression, this has been the basic approach taken at the federal level

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Deficits Since 1980The huge deficits in recent years have come from a combination of tax cuts and spending increases

But why has the budget been in deficit for all but 12 years since 1930?

The most obvious answer is that, unlike legislatures in 49 states, Congress is not required to balance the budget

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Deficits Since 1980But why does Congress like deficits?

One widely accepted model of the public sector assumes that elected officials try to maximize their political support, including votes and campaign contributions

Voters like public spending programs but hate paying taxes, so spending programs win support and taxes lose it

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Deficits Since 1980

Because of this asymmetry, candidates try to maximize their chances of getting elected and reelected by offering a budget that is long on benefits but short on taxes deficits

Moreover, members of Congress push their favorite programs with little concern about the overall budget

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Crowding Out and In

What effect do federal deficits and surpluses have on interest rates?

Suppose the federal government increases spending without raising taxes increases in deficit or declines in the surplus

How will this affect, national savings, interest rates, and investment?

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Crowding Out and InAn increase in the deficit or a decrease in the surplus reduces the supply of national savings

higher interest rates crowd out some private investment reducing the stimulating effect of the government’s deficitSome argue that the amount of crowding out is relatively small • discretionary fiscal policy will result in a net

increase in aggregate demand

Others believe the crowding out is more extensive• borrowing from the public in this way results in

little or no net increase in aggregate demand

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Crowding Out and InAnother possibility: If the economy is operating well below its potential, the additional fiscal stimulus provided by a larger deficit or a smaller surplus could encourage firms to invest more

Recall that an important determinant of investment is business expectations and government stimulus may improve expectations

firms more willing to invest crowding in

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Twin DeficitsTo finance the huge deficits of the 1980s, the U.S. Treasury had to sell a lot of bonds, pushing up market interest rates foreigners were more willing to buy dollar-denominated bonds foreigners had to exchange their currencies for dollars

The greater demand for dollars caused the dollar to appreciate relative to foreign currencies

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Twin DeficitsThe rising value of the dollar made foreign goods cheaper in the U.S. and U.S. goods more expensive abroad foreign trade deficit increased

The higher trade deficits meant that foreigners were accumulating dollars and with these dollars purchased U.S. assets, including U.S. government bonds thereby helping to fund the deficits

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Budget SurplusIn the early 1990s, outlays started to decline relative to GDP, while revenues increased deficit declined and, by 1998, created a budget surplus

What turned a hefty deficit into a surplus, and why has the surplus slipped lately?

Tax increases during the elder President Bush and President Clinton termsVigorous recovery during the 1990sSlower growth in Federal OutlaysReversal in 2001

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Relative Size of the Public Sector

Exhibit 4 shows government outlays at all levels of government relative to GDP in ten industrial economies in 1993 and in 2000

Government outlays in the United States in 2000 were 29.3% relative to GDP, the smallest share in the group and between 1993 and 2000 declined in nine of the ten industrial countries

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National Debt

The federal deficit is a flow variable measuring the amount by which outlays exceed revenues in a particular yearThe federal debt, or the national debt, is a stock variable measuring the accumulation of past deficits the total amount owed by the federal government

Changes over timeU.S. debt levels compared to those in other countriesInterest on the debtProspect of paying off the debt

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Changes over TimeDistinction between the gross debt and the debt held by the public

Gross debt includes U.S. Treasury securities purchased by various federal agencies debt owed to itselfDebt held by the public includes debt held by households, firms, banks, and foreign entities

As of 2001, the gross federal debt stood at about $5.8 trillion and the debt held by the public stood at $3.4 trillion

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Changes over TimeOne way to measure debt over time is relative to the economy’s GDP

The changes in the debt mirror the changes that have occurred in the deficit / surplus segment of the federal budget

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International Perspective

How does the government debt in the United States compare with debt levels in other countries?

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Interest on the National DebtBecause most federal securities are short term, the national debt “turns over” rapidly

Nearly half the debt is refinanced every year debt service payments are quite sensitive to movements in the interest rate

Interest payments on the national debt have increased from 8% of the federal budget in 1978 to 12% in 2001

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Who Bears the Burden of the Debt

Deficit spending is a way of billing future taxpayers for current spending

The national debt raises moral questions about the right of one generation to taxpayers to bequeath to the next generation the burden of its borrowing

To what extent do budget deficits shift the burden to future generations?

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We Owe It To Ourselves

It is often argued that the debt is not a burden to future generations because, although they must service the debt, those same generations receive the debt service payments

It’s true that if U.S. citizens forgo present consumption to buy bonds, they or their heirs will receive the interest payments debt service payments stay in the country it’s all in the family

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Foreign Ownership of DebtThe “we owe it to ourselves” argument does not apply to that portion of the national debt purchased by foreigners

Foreigners who buy U.S. government bonds forgo present consumption and are paid back in the future

A reliance on foreigners increases the burden of the debt on future generations because future debt service payments no longer remain in the country

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Crowding Out and Capital Formation

As previously noted, government borrowing can drive up interest rates and crowd out some private investment by making it more costly

The long-run effect of deficit spending depends on how the government spends the borrowed funds

If they are used in public investments there may be no harmful effects on the economy’s long-run productive capabilities

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Crowding Out and Capital Formation

If the additional borrowed dollars go toward current consumption, less capital formation will resultWith less investment today, there will be a smaller endowment of capital equipment and technology

slower growth of labor productivity in the future

Despite the large federal deficits of the 1980s and early 1990s, public investments in capital declined

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Paying off the Debt

What impact do surpluses have on the economy?In the short run a federal surplus could reduce aggregate demand, which would worsen a recession but relieve inflationary pressure during good timesA budget surplus would also increase the national saving rate, which should reduce interest rates

in the long run investment should increase more capital per worker more income and tax revenues

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Paying off the DebtFed Chairman Alan Greenspan felt that eliminating public debt has a small downside

Treasury debt provides an asset that is free of risk which is a characteristic that is attractive to many investors particularly during times of turbulence

They also offer a benchmark for pricing riskier debt

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Paying off the DebtIn this fashion, a budget surplus could be self-reinforcing

If the surplus is used to pay down the national debt, this over time would

reduce the cost of servicing the remaining debt • gradually freeing up budget dollars for tax

cuts, other spending programs, or • still more pay down of the national debt