Chapter 4

Tools of Budget Analysis

Jonathan Gruber
Public Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

 Introduction
 Just as households deal with budget issues, so
does the government.
 Federal government has hundreds of revenue-
raising tools and thousands of programs on which
to spend this revenue.
 Budget process is complicated by the dynamic
nature of budgeting. Many federal programs have
implications for many years to come.
 Introduction
 This lesson:
 Describes the federal budgeting process and efforts
to limit the deficit.
 Discusses measurement issues.
 Explains why we should care about reducing the
budget deficit.
 FEDERAL BUDGETING:
The Budget Deficit in Recent Years
 Government debt is the amount that a government
owes to others who have loaned it money.
 It is a stock variable; the debt is an amount owed at
any point in time.
 Government deficit is the amount by which
spending exceeds revenues in a given year.
 It is a flow variable; the deficit flow is added to the
previous year’s debt stock to produce a new stock
of debt owed.
 Figure 1 shows trends in revenue, spending, and
the surplus/deficit.
Figure 1
The fiscal pictureMany of these positive
changed in the 1990s –trends reversed
Expenditure grew Revenues
spending increased
fell. themselves in recent
Tax Federal
revenue did not Government Finances
steadily to 1992. due to tax increases
keep pace. years.
25 and rising asset values.

20

15
Thus, large deficits
% of GDP

10 appeared. And the deficit turned

5
into a surplus.

-5

-10
1965 1970 1975 1980 1985 1990 1995 2000

Revenues Expenditures Surplus/Deficit

Source: CBO, The Budget and Economic Outlook: FY 2005-2014, Appendix F

 The Budget Process
 Budget process begins with President submitting
budget to Congress on or near the first Monday in
February.
 House and Senate then work out that year’s
Congressional Budget Resolution, a blueprint for
budget activities.
 The Budget Process
 Entitlement spending refers to funds for programs
for which funding levels are automatically set by
the number of eligible recipients.
 Social Security and Medicare are two prominent
examples.
 Discretionary spending refers to spending set by
annual appropriation levels. Funding is optional.
 The Budget Process
 The House and Senate Appropriations Committees
each take the total amount of discretionary
spending available, and divide it into 13
suballocations for each of their 13 subcommittees.
 Each subcommittee develop a spending bill for its
areas of government.
 The 13 bills must be approved by the full
Appropriations Committee; differences between
House and Senate versions are worked out in
conference.
 The Budget Process
 This process must be finished by June 30 th.
 Bills are then sent to the President, who may sign
them, veto them, or allow them to become law
without his signature.
 The budget process sets discretionary spending
only, not entitlement spending.
 If Congress wishes to change entitlement
programs like Social Security, it must include
“reconciliation instructions.”
 ti on
ca
Ap p l i
Efforts to Control the Deficit
 There have been a number of efforts to control the
deficit.
 Gramm-Rudman-Hollings Deficit Reduction Act
of 1985 (GRH)
 Budget Enforcement Act of 1990 (BEA)
 i on
a t
pli Efforts to Control the Deficit
c
Ap

 GRH 1985 aimed to reduce the deficit level, and

have a balanced budget starting in 1991. It
included a “trigger” to initiate automatic spending
cuts.
 Gimmicks, such as resetting the deficit targets and
using overly-optimistic economic projections,
undermined law’s intent.
 Failed to meet deficit targets.
 i on
a t
Ap pl i c
Efforts to Control the Deficit
 BEA 1990 tried to restrain government growth, rather than
the deficit level.
 Set caps on discretionary spending that would lead to a
fall in real spending.
 Pay-as-you-go process that prohibited any policy
changes from increasing the estimated deficit in any
year in the next 6-year period.
 If deficits did increase, the President must issue a
sequestration requirement which reduces direct
spending by fixed percentage to offset the deficit
increase.
 i on
c a t
pli
Ap
Efforts to Control the Deficit
 BEA was successful in restraining government
growth in the 1990s–discretionary government
spending fell by 10% in real terms.
 From 1998 onward, discretionary spending grew
rapidly. The BEA spending caps were avoided
with uncapped “emergency spending.”
 Some of the emergency spending was
legitimate, but other items were more suspect.
 Pay-as-you-go expired on Sept. 30, 2002 and has
not been renewed yet.
 Budget Policies and Deficits at the State
Level
 Unlike the federal budget, state budgets are almost
always in balance.
 Every state except Vermont has a balanced
budget requirement; all of which have been in
place since at least 1970.
 Budget Policies and Deficits at the State
Level
 The stringency of balanced budget requirements
vary across states. Roughly two-thirds of states
have ex-post BBRs, and the remainder have ex-
ante BBRs.
 “Ex-post” means the budget must be balanced at
the end of the fiscal year.
 “Ex-ante” means the budget must be balanced at
the beginning, which can lead to gaming via the
making of rosy economic predictions.
 Budget Policies and Deficits at the State
Level
 The National Conference of State Legislatures
provides extensive state-by-state detail on features
of these balanced budget requirements.
 See http://www.ncsl.org/programs/fiscal/
 The next figure shows the states with the most and
least stringent requirements.
 MEASURING THE BUDGETARY POSITION
OF THE GOVERNMENT: ALTERNATIVE
APPROACHES
 In measuring the size of the deficit or the debt,
there are a number of issues to consider:
 Inflation
 Business cycle and timing issues
 Capital expenditures
 Behavioral responses
 Real vs. Nominal

 The debt and deficit are often expressed in

nominal values–that is, in today’s dollars.
 Inflation changes the real value of the debt or
deficit, however, because price changes (as does
foregone consumption).
 Real vs. Nominal

 The consumer price index (CPI) measures the

cost of purchasing a typical bundle of goods. It
increased 91% between 1982 and 2003.
 This sort of inflation reduces the burden of the
debt, as long as that debt is a nominal obligation to
borrowers.
 Real vs. Nominal

 Rising prices leads to what is known as the

“inflation tax” on the holders of the debt–the
payments are worth less because of rising prices.
 In 2003, the national debt was $3.91 trillion and
inflation was 1.9%. The inflation tax was
therefore $74 billion, which would reduce the
conventionally measured deficit from $375 billion
to $301 billion.
 The Standardized Deficit

 Some short-run factors (like a recession)

temporarily reduce tax revenue and increase
spending.
 The standardized or structural deficit nets out
these sorts of fluctuations and accounts for longer-
term trends.
 The Standardized Deficit

 The Congressional Budget Office (CBO)

computes a cyclically adjusted budget deficit by
adjusting the typical deficit number for these kinds
of economic fluctuations and other short-lived
factors.
 In 2003, the baseline budget deficit was $375
billion, but the cyclically adjusted deficit was only
$305 billion (due to the slow economy).
 Figure 2 shows the actual deficit, the cyclically
adjusted deficit, and the standardized U.S. deficit.
Figure 2

Source: CBO, The Budget and Economic Outlook: FY 2005-2014, Appendix F

 Cash vs. Capital Accounting

 The government’s budgetary position is measured

by a cash accounting method–that is, the deficit is
simply the difference between current spending
and current revenues.
 Some purchases (like buildings, highways, or the
broadcast spectrum) are durable goods and retain
value for many years.
 Cash vs. Capital Accounting

 When the government sells an asset, like the

broadcast spectrum, the deficit falls but asset
holdings have fallen too.
 Capital accounting measures the government’s
budgetary situation by accounting for the change
in asset holdings.
 Cash vs. Capital Accounting

 Political difficulties with capital budgeting,

however, include:
 Some goods might be viewed as a current
expenditure or an investment.
 Missile defense or education are examples.
 In addition, hard to value some assets.
 Static vs. Dynamic Scoring

 Different government policies, like a tax cut, may

affect the size of the economy.
 Static scoring assumes redistribution changes, but
the economy’s size stays fixed.
 Dynamic scoring includes not only the policy’s
effect on resource distribution, but also its effects
on the economy’s size.
 Static vs. Dynamic Scoring

 One key problem with dynamic scoring is that the

impact of government policy on the economy is
not well understood.
 DO CURRENT DEBTS AND DEFICITS
MEAN ANYTHING?
A LONG-RUN PERSPECTIVE

 It is important to take a long-run perspective on

government budgets.
 Governments make implicit obligations to the
future, yet these are not recognized in the annual
budget process.
 Background: Present Discounted Value

 To understand these implicit obligations, must

review concept of present discounted value
(PDV).
 Receiving a dollar in the future is worth less than
receiving it today, because you have foregone the
opportunity to earn interest.
 PDV takes future payments and expresses them in
today’s dollars.
 It does so by discounting payments in some future
period by the interest rate.
 Background: Present Discounted Value

 A stream of payments would be discounted as:

B1 B2 Bt
PD V  B 0   ...
  1  r 
1  r 2
1  r  t

 Where B0 through Bt represent a stream of benefit

obligations, r is the interest rate, and t is the
number of periods.
 Background: Present Discounted Value

 For example, $1,000 received 7 years from now is

only worth $513 with a 10% interest rate:
1000 1000
5 1 3.1 6  
1  0 .1 0  7
1.9 4 8
 Why Current Labels May be Meaningless

 There are reasons to think that current labels may be

meaningless, because of what might be called “gimmicks.”
 For example, reducing Social Security benefits by $1 in
the far-off future, and reducing the payroll tax today by a
small amount (say 8.7 cents) are neutral in terms of the
intertemporal budget.
 Yet, this would add to the current deficit, even though it
saves money in the future. Similarly, even “money
making” policy changes, like only reducing payroll taxes
by perhaps half of the amount (4.35 cents) may be
politically infeasible.
 Alternative Measures of Long-run Government
Budgets

 The intertemporal budget constraint of the

government considers these implicit obligations.
 The basic goal is to compare the present
discounted value of the government’s
expenditures to its revenues.
 Generational Accounting

 The generational accounting measure is designed

to assess the implications of the government’s
fiscal policies for different generations of
taxpayers.
 It asks whether different generations have a net
benefit or net cost from the government’s tax and
spending policies.
 Generational Accounting

 The intertemporal budget constraint is:

PD V T A X , C U R R E N T  PD V T A X , FU T U R E  PD V S PE N D , C U R R E N T  PD V S PE N D , FU T U R E

 Where the left side is the present discounted value

of tax payments, and the right side is the present
discounted value of government spending.
 Each is divided into current generations and future
generations.
 Generational Accounting

 Researchers then compute what pattern of taxes is

required over the future to meet this budget
constraint.
 Researchers assume taxes are raised on each
generation in proportion to the growth in
productivity.
 Table 1 shows the composition of U.S.
generational accounts.
 This table
Table 1 shows the net tax
payment for each generation to
satisfy the budget constraint.
Net tax payments
The Composition areAccounts
of U.S. Generational smaller for
women at all ages. NetThis gap
Tax Payment

arises because(present value in thousands of 1998 dollars)

of lower earnings
Age in 1998 and longer
Male life expectancy. Female

0 249.7 109.6

10 272.3 104.6

20 318.7 113.7

30 313.7 95.6

40 241.4 Males age 60 and older 37.9have a

Men
Future
will pay
generations
nearly $362,000
are hit very
more
50 129.7 negative net tax,male
A 70-year-old meaning
over they
-37.7 his
in taxes
hard by
than
current
they policy.
collect in
60 benefit
lifetime from $91,000
receives the policies.
more in
benefits; for women, $159,000. -5.8 -115.0

70 -91.0 benefits than taxes-155.9

paid.
80 -56.3 -99.2

90
Future generations
-25.6
pay 32.3% of -44.4

Future generations their income

361.8 in net taxes, while 158.8

Lifetime net tax rate on future generations

The 41.7%
generational
current = 32.3%/22.8%
generations imbalance -1is the
pay 22.8%. 32.3%

Lifetime net tax rate on newborns

extent to which future generations 22.8%
pay more in taxes than the current.
Generational imbalance 41.7%
 Generational Accounting

 The United States has one of the largest

generational imbalances in the world, meaning
that taxes will need to be raised much more, in
relative terms, on future generations.
 Table 2 shows the cut in government transfers that
would be necessary to achieve generational
balance.
 Table 2

Alternative Ways to Achieve Generational Balance

in 22 Counties
Country Cut in Country Cut in
Japan and the Netherlands
government have government
transfers than the
larger imbalances U.S. transfers

Argentina 11.0% Italy 13.3

Australia 9.1 Japan 25.3
Austria 20.5 Netherlands 22.3
Canada has roughly achieved
Belgium 4.6
generational New Zealand
balance. -0.6
Brazil 17.9 Norway 8.1
Canada 0.1 Portugal 7.5
Thailand is already taxing current
Denmark 4.5
generationsSpain
more heavily than 17.0
Finland 21.2 futureSweden
generations. 18.9
In the U.S., government transfers
France 9.8 Thailand -114.2
would need to be cut by 21.9%.
Germany 14.1 United Kingdom 9.5
Ireland -4.4 United States 21.9
 Long-run fiscal imbalance

 Another way of examining government spending

is to ask: If the government continues with today’s
policies, how much more will it spend than it
collects in taxes over the entire future?
 Taking the PDV gives the governments fiscal
imbalance.
 The entire fiscal imbalance arises from the major
entitlement programs for the elderly, Social
Security, and Medicare.
 Long-run fiscal imbalance

 The Trustees of the Medicare and Social Security

Funds recently released a report that showed the
fiscal imbalance from these two programs is $72
trillion.
 Most of this is from Medicare–$61 trillion–
because of an aging trend and rapid rise in medical
care costs; $16 trillion is from the recently enacted
prescription drug program.
 Long-run fiscal imbalance

 Thus, the “implicit debt” of the United States is

roughly 18 times larger than its existing
outstanding debt.
 The payroll tax would need to increase to 27% to
finance this.
 Problems with these measures

 The numbers are sobering, but there are some

problems with them as well.
 They are sensitive to modest changes in the
underlying assumptions, like the interest rate.
 They also assume government policy remains
unchanged, such as not cutting Social Security
benefits.
 Finally, future generations benefit from some of
today’s investments.
 What Does the U.S. Government Do?

 What does the U.S. Government do?

 Move to longer-run measures of policy impact;
rather than 1-year or 5-year windows, evaluate with
10-year window.
 Longer window leads to more forecasting error,
however.
 See Figure 3.
3
 Figure 3 This figure shows the projected
budget deficits and actual budget
deficits.
Dashed line shows
predicted deficit or
Projected
surplus five years and Actual Fiscal Balance
Solidearlier.
line shows
actual deficit or
300
surplus (where
The the
forecasting errors
They were
got larger in the 1990s.
200
deficit isrelatively
a negative And got much larger more recently
small in the late 1980s.
when a 10-year window is used.
100 number).
Billions of dollars

0
-100
-200
-300
-400
-500
1986 1988 1990 1992 1994 1996 1998 2000 2002

Projected Surplus/Deficit 5 Years Previous Actual Surplus/Deficit

Source: www.cbo.gov/Spreadsheet/4195_FanSpreadsheet.xls
 What Does the U.S. Government Do?

 Based on these longer windows, in 2001 the CBO

projected a $6 trillion surplus.
 Both presidential candidates in 2000 proposed
major tax cuts.
 Of course, tax cuts, recession, and the economic
shocks of the terrorist attacks dramatically
changed the budget picture.
 i on
a t
p l i c The Financial Shenanigans of 2001
Ap

 The tax reduction in 2001 was one of the largest in

U.S. history.
 It involved a convoluted set of phase-ins and
phase-outs, to comply with a congressional budget
plan limiting the 11-year cost of the cuts to $1.35
trillion.
 The most extreme was the sunset provision, by
which all of the tax cuts disappear on December
31, 2010, reducing the 2011 cost of the tax cut to
$0.
 i on
a t
p l i c The Financial Shenanigans of 2001
Ap
 Long phase-in periods with backloading of fiscal
impact toward 2010.
 For example, the estate tax limit is gradually raised,
then phased out entirely in 2010, and then
reintroduced at its 2001 limits in the year 2011.
 Such a convoluted schedule allowed legislators to
claim action on a wide range of issues, while
delaying the fiscal consequences.
 If the tax cuts were made permanent, in the
following decade (2012 to 2021), the fiscal costs
would be $4.1 trillion.
 WHY DO WE CARE ABOUT THE
GOVERNMENT’S FISCAL POSITION?

 There are several reasons to care about the

government’s fiscal position:
 Stabilization policy
 Savings and economic growth
 Intergenerational equity
 Short-run vs. Long-run Effects of the
Government on the Macroeconomy

 Stabilization policy: Government performs many

short-run stabilization issues.
 Automatic stabilization: taxes fall and spending
increase when in a recession due to progressive tax
schedule and programs like unemployment
insurance.
 Discretionary stabilization: policy actions
undertaken by government, such as a tax cut.
 More in the domain of macroeconomics than
public finance, however.
 Background: Savings and Economic
Growth

 Government finances also affect savings and

growth.
 Recall that the production function translates labor
and capital into output.
 In the short run, capital is fixed.
 In the long run, it is variable.
 Higher levels of capital lead to a higher marginal
product of labor.
 Capital stock is determined through supply and
demand. Consider the capital market in Figure 4.
4
 Supply of
r AsDemand
interestfor
rates
capital
fall, the
is Supply of
capital
The interest
driven rate is oninvestment
more attractive
by firms’ the capital
Inwhich
vertical axis, a competitive
becomes
demands firms. market,
is the
for
Leading to higher interest
price equilibrium
of capital. is where supply
rates and
equals a lower capital
demand.
r2 stock.

AsThe
interest rates
supply rise,
curve
r1 savings
individuals
represents delay Government borrowing
consumption
decisions and save.
to individuals. “crowds-out” capital in the
The capital
private market, shiftingstock is on the
horizontal axis.
supply inward. Demand
for capital

K2 K1 K

Figure 4 Capital Market Equilibrium

 The Federal Budget, Interest Rates, and
Economic Growth

 This simple supply and demand framework is

complicated by:
 International capital markets
 Ricardian equivalence
 Expectations
 The Federal Budget, Interest Rates, and
Economic Growth

 International capital markets make the supply

curve more elastic (flatter), thus lowering the
effects of U.S. government borrowing on interest
rates.
 This leads to less crowding-out of private capital.
 The Federal Budget, Interest Rates, and
Economic Growth

 Ricardian equivalence means that individuals

offset the governmental action by saving and
leaving larger bequests.
 Little empirical support in the economic literature.
 The Federal Budget, Interest Rates, and
Economic Growth

 Long-term interest rates reflect expectations about

the future.
 Entire path of surpluses and deficits matter for
these rates, which are important for businesses
making long-term capital investments.
 The Federal Budget, Interest Rates, and
Economic Growth

 Overall, the empirical literature suggests that for

every 1% of GDP increase in the government’s
budget deficit, long-term rates rise by between
0.5% and 1%.
 The Federal Budget, Interest Rates, and
Economic Growth

 Finally, deficits matter because of

intergenerational equity.
 Current government policy has the feature of
burdening future generations for the benefit of
current ones.
 The Federal Budget, Interest Rates, and
Economic Growth

 The continual increase in productivity and rising

standard of living mean that future generations
have more resources at their disposal than current
ones.
 Hence, in some sense, they are “better off.”
 One key assumption, however, is that the standard
of living will continue to rise in the future.
Recap of Tools of Budget Analysis
 Federal budgeting
 Measuring the budgetary position of the
government
 Do debts and deficits mean anything?
 Why should we care about the government’s fiscal
position?