public finance lecture notes gruber chapter 2

Budgeting Basics

• Deficits and debt• Comparisons over time• Categories of spending used in budgeting/economics jargon• Alternative measures of the deficit• Cash accounting versus capital accounting

Deficits and Debt

Debt = The amount a government owes to those who have loaned it money.

Deficit = The amount by which a government’s spending exceeds its revenues in a given year.

Represents the accumulation of deficits and interest over time.

The Federal Budget Deficit in Recent Years

Financing of Deficits/Debt

• To finance deficits, governments have to borrow money from private and public investors – for U.S. federal govt, debt is “sold” as Treasury bonds,

which have different “maturities” (5-year, 10-year, 30-year) and different “yields” (rate of return)

– rates higher for longer-term bonds• Purchasers of U.S. debt: individual investors, foreign and domestic

firms, pension and investment funds, as well as some countries• Of the 14.3% trillion in (“official”) U.S. federal debt (2011)

– about 20% held by Social Security Trust Fund– about 10% is held by the Federal Reserve Bank (to conduct

monetary policy)– about 30% held by foreign investors (China – 8%)

Financing of Deficits/Debt

• The rate of return the govt must pay is determined “by the market” – rate must be sufficiently high to attract the necessary amount of demand

• Over recent history, Treasury rates have been very close to the inflation rate, which suggests that investors are convinced the U.S. govt will not default – governments at risk of default have to pay higher interest rates

on debt (“risk premium”)

The Fiscal Outlook

• If investors began to see U.S. debt as a risky investment, interest rates (on that debt) should rise

• One benchmark economists have commonly used to gauge a “dangerous deficit” is that it should not (in good times) exceed the rate of economic growth – e.g. if economy is growing at 2%, deficits should not exceed 2%

of GDP – if the deficit (as a percent of GDP) exceeds the rate of GDP

growth, that implies the debt (as a percent of GDP) is growing – this is unsustainable in the long-term

• But deficits would ideally be lower, since every dollar borrowed has to be paid back (with interest) by future taxpayers

Importance of Inflation• Inflation refers to the rate at which prices are increasing in the

economy -- important for a couple reasons• First, to compare changes in spending/revenues/deficit, one would

want to convey the data in “real” terms (i.e. adjusted for inflation)– It’s more common that people present these in “percent of GDP”– One problem with this (the “pct of GDP” approach) is that it is

magnifies the impact of business cycles• Second, inflation has interesting implications for the financing of

debt – An unanticipated increase in inflation reduces the real cost of

paying off existing debt– If inflation is permanently high, or is anticipated to increase,

investors will demand higher returns to purchase debt• Countries “debt crises” are often followed by “inflation crisis”

Categories of Spending

• The U.S. federal budget distinguishes between two types of spending

Entitlement spending = Mandatory funds for programs for which funding levels are automatically set by the number of eligible recipients, not the discretion of Congress.

Discretionary spending = Optional spending set by appropriation levels each year, at Congress’s discretion.


• Economists often like to distinguish types of spending along other dimensions as well…

• For instance, we sometimes refer to extra spending that naturally arises during a recession as cyclical spending – Think unemployment benefits, food stamps and income

support programs


• Economists often recommend that policymakers distinguish between “consumption spending” and “investment spending”– investment spending is on things increase national

productivity in future periods– the current cost of such investments overstates their true cost

to the government by ignoring the impact on future tax revenues

– the current cost of such investments overstates their true cost to society by also ignoring the impact on future (after-tax) earnings and profits

Future Topic – PDV

• When we get to the section on cost-benefit analysis, we’ll talk about the methods that should be used to evaluate public investment projects

• A big part of this is will be how to compare costs and benefits that accrue over different periods of time – i.e. “present discounted values”

Alternative ways of measuring the deficit

• The usual way of presenting the deficit uses the “cash accounting” method – As in the figure above, it’s just the difference between “cash

in” and “cash out” in a given year

• This can given a poor perspective on how the budget situation evolves over time because it includes short term factors like the business cycle and policy changes with temporary implications– As a result, cash accounting makes fiscal situation look

better in “boom times” and worse in “weak economic times”

Alternative ways of measuring the deficit

Standardized (structural) budget deficit = A long-term measure of the government’s fiscal position, removing the effect of cyclical and other short- term factors.

Cyclically-adjusted budget deficit = A measure of the govt’s fiscal position if the economy were operating at full potential GDP

Taxes fall and some categories of spending rise in recessions

e.g. Some policy changes cause “temporary shifts” in tax revenues.

Cash Accounting vs Capital Accounting

• Another issue is whether government books should be evaluated on the basis of cash accounting or capital accounting– Cash accounting looks at money in/money out – Capital accounting would also consider changes in the value the

govt’s asset holdings• Firms generally use the latter when thinking about whether a

firm is “richer” at the end of the year, you care about the productive assets it owns, not just the amount of cash on hand– Q: If a firm spends $X this year to invest in a new factory, how

should that be accounted for in this year’s balance sheet ?


• Q: If a firm spends $X this year to invest in a new factory, how should that be accounted for in this year’s balance sheet ? – Standard approach under capital accounting is to treat the

investment as a “durable good” – an “asset” in the firm’s balance statement – that depreciates over time

– For the balance statement in a particular year, the amount that the investment depreciates over the year would be treated as the amount of “spending” on that item in that year

– Accounting rules govern the rates as which different sorts of durable investments should be depreciated over time


• Q: Now suppose the federal government decides to sell Yosemite national park to a private investor? How should that sale be treated on the federal balance sheet?

• Or what if they purchase a piece of valuable property for the site of a new administrative building? How should that be treated?

• Depends on whether one uses cash accounting method or capital accounting…


• Capital accounting might seem like an obvious improvement over cash accounting…

• The problem with implementing it is that it can be hard to distinguish government consumption spending from investment spending– Many federally-owned assets are hard to price?– How should investments in human capital be handled? (E.g. Are

investments in early education programs capital spending or consumption spending?)

– If capital spending, how should we value these investments?– Is purchase of a missile system consumption spending or capital

spending?• Even for firms, capital accounting raises some difficult questions

– like how quickly to assume an asset depreciates

Static versus Dynamic Scoring

• The Congressional Budget Office (CBO) is sometimes called the “Congressional scorekeeper” – it is charged with making official projections about the effect of

policy proposals on government spending and revenues• Recently, there has been increasing controversy over how the

CBO forms these projections– i.e. how do they “score” the budgetary effects of policy changes

• CBO projections account for many of the behavioral effects of policies, including how– changes in the size of a public benefit affects take-up rates– how tax rate changes affect the amount of “taxable income” that

gets reported and taxed• But they ignore potentially important macro-economic effects

of policy changes…


• For example, Republicans commonly argue that the CBO systematically overstates the future revenue loss from tax cuts because tax cuts (might?) increase economic growth

• How might changes in tax rates affect growth?– usual way this gets modeled is that tax cuts (could) affect

savings/investment decisions, which affects the future stock of private capital in the economy

– under standard macro models, an increase in the (future) capital stock raises the (future) productivity of workers

– if so, a tax cut that leads to greater capital accumulation is partially offset by the fact that labor income rises (and the additional labor income gets taxed)

• Important: this argument for dynamic scoring hinges how a tax cut affects the accumulation of private capital …


• Important: this argument for dynamic scoring hinges how a tax cut affects the accumulation of private capital , which partially depends on how the tax cut affects savings behavior but also depends on how the tax cut is financed

• A tax cut that is “deficit financed” reduces the accumulation of private capital in standard macro models– why? because the sale of government bonds absorbs savings that

would otherwise have been put towards private investments • See Gruber’s discussion of CBO’s dynamic scoring of the

2003 tax cut (which was financed by higher deficits)– if scored dynamically, the tax cuts were found to be more costly

to the federal budget than originally scored, unless the CBO assumes that other spending cuts or tax increases would be enacted to offset the deficit impact


• Democrats had a similar complaint about how the CBO “scored” the cost of Obama’s health care reform (the Affordable Care Act) – did not give credit for (potential) savings if providers responded

to new Medicare reimbursements by containing costs

• In both these examples, the main issue is really the same the CBO isn’t comfortable making predictions unless those predictions are on solid ground – the impact of government policy on the economy is less well-

understood than some politicians believe– and the CBO is wary about “making stuff up”

public finance lecture notes gruber chapter 2

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