Chapter 18:
Government
Intervention
FALL 2022 SEMESTER
18.1 Introduction
• In this chapter, we learn about
• government spending, taxation, budget deficits, and the debt-
GDP ratio nationally and globally.
• the government’s intertemporal budget constraint.
• the economic consequences of budget deficits.
• the fiscal problem of the twenty-first century: how to finance
rising health expenditures.
Introduction
• The government can borrow or lend.
• But the government’s budget must balance in PDV.
• Budget deficits today must be offset by budget surpluses in
the future.
• Recent forecasts suggest current U.S. policies are
unsustainable.
18.2 U.S. Government Spending and
Revenue
• In 2018, government spending in the United States was
• $6.7 trillion.
• 20.0 percent of GDP.
• more than $20,500 per person.
• Tax revenues were 16.2 percent of GDP.
The U.S. Federal Government Budget,
2015
Government Spending and Revenue
• The budget balance
• The difference between tax revenues and spending
• A budget surplus
• Tax revenues > Spending
• A budget deficit
• Tax revenues < Spending
• The government must borrow by selling bonds.
• A balanced budget
• Tax revenues = Spending
Spending and Revenue over Time
• World War II
• Taxes and expenditures rose sharply.
• After the war spending and revenues were an
approximately stable fraction of GDP.
• Budget deficits emerged starting around 1970.
U.S. Federal Government Revenue and
Spending
The Debt-GDP Ratio—1
• Government debt
• The outstanding stock of bonds that have been issued in the
past
• In 2005
• The debt-GDP ratio was just over 35 percent.
• In 2018
• The debt-GDP ratio rose to nearly 80 percent.
• Half of the debt is owed to foreigners.
The Debt-GDP Ratio—2
• The net debt:
• Government debt that is held outside of the government
• In 2018, including debt held by the government, total
debt-GDP was more than 100 percent.
Federal Debt and Deficits in the United
States
18.3 International Evidence on
Spending and Debt
• Among the richer OECD countries, the United States has
a lower than average
• government spending-to-GDP ratio (38 percent).
• debt-GDP ratio.
• Norway
• Negative debt-GDP ratio
• Saves its surpluses
Government Spending around the
World, 2014
Debt-GDP Ratios around the World
18.4 The Government Budget
Constraint
• The flow version of the government budget constraint
holds in each period.
• The sources of funds to the government must equal the
uses of funds.
Interest
Transfer payments
Government payments on debts
purchases
New Change in
Taxes the money
borrowing
stock
The Government Budget Constraint
• Assume for this chapter
• The change in the stock of money is zero.
• Transfer payments are zero.
• Therefore:
• The primary deficit:
• It excludes spending on interest.
• The total deficit:
The Intertemporal Budget Constraint—
1
• Suppose an economy exists for only two periods.
• The budget constraint for period 1 is:
• The budget constraint for period 2 must equal zero:
• No one is willing to lend to the government in the final period
because loans can never be repaid.
The Intertemporal Budget Constraint—
2
• Substitute the budget constraint for period 2 into period
1:
• Uses must equal sources, in PDV
The Intertemporal Budget Constraint—
3
• Collect the tax and spending terms on the same side of
the equation:
• The government’s budget must balance.
• It balances not period by period, but in PDV.
• The government must have surpluses in the future to pay off
deficits today.
18.5 How Much Can the Government
Borrow?
• When considering economic consequences of deficits
and debts, we must consider
• Economic growth
• The possibility of high inflation or default
• Intergenerational equity
• The extent to which deficits crowd out investment
Economic Growth and the Debt-GDP
Ratio
• The amount the government can borrow is limited by:
• The amount it can credibly be expected to pay back
• Partly on how large the economy’s GDP is
• Stock of debt can grow time if GDP is growing even
faster.
• The debt-GDP ratio will fall if this happens.
High Inflation and Default—1
• If the debt-GDP ratio becomes too high:
• Lenders worry about the ability of the government to repay.
• Investors demand higher interest rates.
• If lenders stop:
• The government may print more money to satisfy the budget.
• This generates inflation.
High Inflation and Default—2
• Default:
• Government declares it will not repay certain debts.
• Or it will repay them at less than face value.
• When the government borrows:
• The beneficiaries of borrowing may not be the same people who
repay the debt.
• Example: World War II
• The generation that fought the war made large sacrifices.
• Future generations benefited from the victory.
• Future generations paid for the war.
Generational Accounting
• Generational accounting:
• Calculates the extent to which current policies pass on tax
burdens to future generations
• High and rising debt-GDP ratios imply higher tax rates
on future generations.
Deficits and Investment
• The national income identity
• Investment equals total saving:
• Add and subtract tax revenues from the left side of the
equation:
Deficits and Investment—2
• Investment can be financed through
• Saving from the private sector
• Government saving
• Saving by foreigners
• Disposable income
• Difference between disposable income and consumption
• Crowding out
• Budget deficits may absorb some of the savings and reduce
investment.
Deficits and Investment—3
• Ricardian equivalence implies:
• Holding the present value of government spending constant,
the timing of taxes does not affect consumption.
• Budget deficits need not crowd out investment.
• Economists still debate the extent to which budget
deficits crowd out investment.
U.S. Investment and the Budget Deficit
18.6 The Fiscal Problem of the Twenty-
First Century
• In the coming decades, with current policies in place, it
is likely that:
• Government spending will rise to 40 percent of GDP.
• Annual budget deficits could reach 20 percent of GDP.
The Problem
• Reasons for the unsustainable current policies:
• Increased generosity of entitlement programs
• Rise in Social Security
• Larger fraction of the population qualifying
• Rise in health care expenditures (Medicare/Medicaid)
• Health care costs will grow at a rate of 1 percentage point faster than
the rate of GDP growth.
U.S. Federal Spending and Revenues,
1950–2075
Components of Federal Spending,
1950–2075
Case Study: Financing the Social
Security Program
• Social Security
• Financed by an employment tax on wage income
• Pay-as-you-go system
• Current workers pay the benefits of the current recipients.
• As baby boomers retire:
• The ratio of workers to retirees will fall.
• Need increased taxes and/or reduced benefits
• Yet, the problem of funding health expenditures is more
severe.
Possible Solutions—1
• Could the budget be balanced?
• Tax revenues would have to rise by about 9 percent of GDP by
2075.
• Health spending is growing in all advanced economies.
Health Spending as a Share of GDP in
Five Countries
Possible Solutions—2
• Explanations for increasing health care costs:
• Expensive medical technologies are raising expenditures.
• Waste and fraud in the health system probably does not
explain increasing expenses.
• Health spending is growing in virtually all rich countries .
Possible Solutions—3
• A better alternative story:
• Consumption is subject to diminishing returns.
• Adding additional months of life is not subject to diminishing
returns.
• More time to enjoy high incomes is increasingly valuable.
• Thus, health spending will rise by more than consumption.
Possible Solutions—4
• It is likely optimal for health care expenditures to rise as
a fraction of GDP as incomes rise.
• Possible solutions, other than raising taxes, include:
• Private health insurance
• Mandated savings in individual health-spending accounts
• These may create new problems of their own.
18.7 Conclusion
• Economic growth is a factor that helps to solve
budgetary problems.
• Yet, economic growth cannot help to solve the problem
of rapidly growing expenditures on health care.