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The Government Deficit and the Fed

April 13, 2017 1 comment

The Federal Reserve recently announced an increase in the interest rate which it sets. This has implications for the government deficit which may not be well understood by the average person so I thought that it might make sense to discuss the connection between the Federal Reserve and the government deficit. What this discussion reveals is that the Fed has been helping to finance the government deficit in the U.S.

The Consolidated Government Budget Constraint

There is a relationship between the government and the Fed known as the Consolidated Government Budget Constraint that is written below.

Spending + Interest Payments + Net Transfer Payments =

Tax Receipts + Change in the Stock of Debt + Change in the Monetary Base

The items on the left side of the equal sign are the uses of the government’s funds. Spending refers to the fact that the government buys goods and services, it makes interest payments to the holders of government debt, and it makes transfer payments to individuals in the economy. The right side of the equation is the list of sources for the government’s spending. It receives tax payments, it issues or retires bonds, and the last item reflects bond purchases or sales by the Federal Reserve. It is these last two items that reflect the connection between the Fed and the government deficit. Read more…

The Wisdom of a Balanced-Budget Amendment

December 4, 2015 2 comments

I read in the local newspaper today that there is some discussion going on in the Michigan state legislature regarding the federal government deficit. Specifically, there is a coalition of states that has begun to form that would force the federal government to convene a constitutional convention only concerned with the adoption of a balanced-budget requirement imposed on the federal government. Michigan is apparently discussing whether the state should be a part of that coalition. This development is a very good one for reasons that I will sketch below.

By allowing government deficits to exist, there has been a perversion of government policy that may well destroy our country in the future. It is all too often observed that government programs exist mainly to line the pockets of politically-connected groups, thereby enhancing the reelection prospects of the politicians handing out the subsidies. There is an enormous list of these programs. The Export-Import Bank, farm subsidies, ethanol programs, and many more (see a previous post for others) do nothing for the welfare of the country but the recipients of these programs benefit mightily. As the late Milton Friedman said many years ago, the benefits of these programs benefit a few who lobby furiously to get them, but the costs are diffuse, spreading across many people. And so the cost to each person is small and may not even be recognized by the individual bearing these costs. As a result, it is all too easy for the government to borrow to finance yet another vote-buying scheme. All it has to do is borrow to finance any new such spending program since raising tax rates may anger taxpayers.

The problem is that the United States is heading for an explosion of its entitlement costs that has been noted many times by economists (I wrote on this previously here). No economist that I know thinks that the U.S. can finance several trillion dollars in deficits and so, when these occur in the future, what is to be done?

Read more…

Interest Rates and the Government Deficit

News reports on the federal government‘s deficit have informed the public that the deficit has declined (go to the Treasury’s Financial Management Service for the actual numbers). There are two issues that the public should bear in mind when thinking about these press reports.

One is that a major fundamental driver of the deficit is the demographic change in the country, specifically the aging  and retirement of the baby boomers. That process continues and so the deficit will continue to grow as more of the boomers retire. The deficit’s decline is only temporary and due to the tax increases imposed by Obamacare among other reasons.

Second, it has also been reported that U.S. interest rates have increased although they are still below historic levels. Short-term interest rates, meaning the interest rates on borrowing by the government over short time periods such as six months, tend to have lower interest rates than borrowing done over longer time periods. So when the government borrows short term, it makes lower interest payments to bond holders and thus reduces the deficit from what it would otherwise be if borrowing were done longer term. However, the risk to the government is that if interest rates go up, then when the short-term bonds mature and must be paid off, the government will need to issue new short-term bonds paying the new higher interest rates so the government’s deficit will rise. If the government borrowed longer term, it would not need to issue new bonds at the higher rates and so the deficit would not increase, at least for a time, until the long-term bonds mature and must be paid off. So this scenario tells us that the decline in the deficit is temporary and will be reversed when the government borrows again.

The message to the public is clear; the deficit is still going to grow. The federal government’s fiscal crisis is still with us, no matter the temporary decline that has occurred.

Raising Tax Rates on the Rich: Some Empirical Evidence

November 29, 2012 1 comment

John Cochrane is an economist in the business school at the University of Chicago. He maintains a blog which I highly recommend (check out The Grumpy Economist), a blog which contains articles using a lighthearted approach to the analysis of economics issues. This blog contains some empirical evidence on the response of rich taxpayers to an increase in their marginal income tax rate (MTR).

The evidence comes from the United Kingdom where the MTR was recently raised to 50 percent. The evidence is that, within a year of the increased MTR, the number of UK residents reporting a very high pre-tax income declined from 16,000 to 6,000 (see this post). You may recall that, in a previous article, I suggested that revenues to be raised from the rich from higher tax rates are overstated. This empirical evidence shows why those estimates are too high.

The rich tend to be smart (think Bill Gates), and they can afford first-rate tax advice. They also have the ability to change the timing of their income. For example, there are now reports in the press that dividend payments are being accelerated into the current tax year when dividends will be taxed at a lower rate compared to next year. Finally, the rich can always change their country of residence. What is surprising to an economist is how rapidly the rich seem to respond to a higher MTR. Usually, economists argue that it takes time for economic agents to respond to a shift in incentives for the simple reason that time is required to process new information. This empirical evidence reveals how quickly the rich can respond to new incentives.

The moral of the story is that increasing the MTR on the rich will generate considerably less revenue than is assumed by the federal government. The Laffer Curve (the notion that higher tax rates reduce tax revenue) is alive and well at least as far as the rich are concerned.

Tax Rates and the The Fiscal Cliff

November 26, 2012 2 comments

The public has been deluged with reporting about the “fiscal cliff” and I admit to some concerns about my contributing to this barrage of information. But while there has been, as usual, lots of reporting about the business cycle effects of the fiscal cliff, I have seen little systematic analysis of exactly what will happen without action by the federal government.

The Tax Policy Center of the Urban Institute and the Brookings Institution has provided what appears to me to be the most thorough analysis of what will happen to tax rates if the federal government does not act. The complete analysis is Toppling-off-the-fiscal-cliff but this is likely to be overkill for most readers. To simplify, I have extracted Tax-Tables-Toppling-off-the-Fiscal-Cliff from the report so that readers can see the effect of federal inaction on personal income tax rates. You will note that nearly every tax bracket will rise by about ten percent. And note that these are marginal tax rates which are the tax rates that affect economic incentives. Thus the returns to saving, investment, and labor supply will go down for nearly every taxpayer.

In addition, the Tax Policy Center report notes that there will be additional tax increases associated with estate taxes, Social Security, the Alternative Minimum Tax, and Obamacare (and this is not an exhaustive list of all tax increases that will occur) so that 90 percent of all taxpayers will see an increase of some sort in their tax bills. What will be the consequences of these increase in tax rates? There will likely be a recession next year and real output will fall permanently (see my previous post on this subject). But there is a larger issue underlying all of this.

The President has stressed raising tax rates on the rich. There are estimates in the media that he wants an increase in tax rates that would generate about $80 Billion in additional tax revenue. In the first month of the federal government’s fiscal year, the federal government deficit was $120 Billion. So even if the tax revenue forecast is accurate (and it is almost certainly an overestimate), the tax increases favored by the President will not cover even one month of the federal government’s deficit. This illustrates the magnitude of the financial problems that we face as a nation.

The public must realize that, without entitlement reform, the entitlements promised by the federal government will require higher tax payments by all taxpayers if we are to avoid insolvency. It is simply delusional to think that a tax increase on the rich will solve our financial problems. Is the public ready to pay more? Your guess is as good as mine.

The Looming U.S. Fiscal Crisis

February 3, 2012 Leave a comment

In a previous post (see Deficit Commission Fantasies), I argued that the Deficit Commission was an exercise in fantasy since their goal for reducing the deficit was much too small to eliminate the impending U.S. fiscal crisis.  Here I will provide some analysis designed to illustrate just how large the government deficit may be in the future without substantial policy changes by the government. To do this requires using a document provided by the Congressional Budget Office (CBO) on their web site (www.cbo.gov).

The CBO is an organization created to advise Congress on various policy issues.  Consistent with its mission, CBO issued a document last summer entitled “CBO’s 2011 Long-Term Budget Outlook.” This document provides the CBO’s best estimates of what will happen to the government’s deficit and stock of government debt under two scenarios.

One scenario provides a forecast based upon the continuation of current law. So, for example, it assumes that tax increases imposed by Obamacare will occur and it assumes that increasing numbers of individuals will pay the Alternative Minimum Tax. Therefore tax revenues rise to the historically high level of 23 percent of GDP, well above the long-term average of 18 percent. And it assumes that government spending, aside from mandatory health care spending, interest payments, and Social Security, would decline as a share of GDP to levels not seen since before World War II.

The second scenario provides a forecast under the assumption that certain legislative changes will occur, changes which are widely expected to occur. These would include, for example, changes to the Alternative Minimum Tax to prevent more taxpayers from paying this tax, and it assumes that overall tax payments are about 18 percent of GDP, their historical average.  Further they assume that the the “doctor fix” will be made so that payments to physicians under Medicare will not decline as scheduled under the law. As will be seen, these and other assumed changes in the law generate a very different picture compared to the first scenario regarding debt and deficits.

One final bit of data is required. The CBO report provides forecasts as shares of GDP. To cast these numbers into dollar figures, I need to use a value for GDP for 2021 and 2035. I assume that GDP is twenty percent higher in 2021 than it was in 2011. I also assume a twenty percent increase in GDP between 2021 and 2035.  These twenty percent increases are in the range of GDP growth in recent years. Read more…

The Tax Holiday, Obamacare, and the “Doctor Fix”

December 27, 2011 1 comment

During the rancorous debate on the merits of Obamacare, Democrats claimed that they would help to “pay” for Obamacare by not extending the Medicare “doctor fix.” The Medicare system was scheduled to cut payments to doctors by over twenty five percent in 2012 and these “savings” were to be applied to the cost of Obamacare to help pay for it. This was one element of the bill that Democrats used to claim that the deficit would not increase because of Obamacare. I have written previously that the deficit calculation used by the Democrats was quite inaccurate.  For example, the deficit calculation did not include the cost of the employees that the federal government would need to hire to administer the Obamacare program.

To his credit, John McCain pointed out during the Obamacare debate that, to paraphrase his comments to television media, “everyone” knows that the “doctor fix” will be done because no politician would be willing to take the heat if physicians refused to treat Medicare patients as a result of the scheduled payment cuts. For this and other reasons, he argued that Obamacare would exacerbate the deficit problems facing the country.

As reported by the New York Times, the tax holiday bill extending payroll tax cuts for two months contained a provision to prevent payment cuts to physicians.  So just as John McCain predicted, the “doctor fix” was made. I have seen no reference in the media pointing out the hypocrisy evident in the actions of politicians who knew full well that claims about not making the “doctor fix” were disingenuous.

It is hardly surprising that the public has such a low opinion of politicians in this country. The claims about the payments to physicians are just another example of willful deception by the political class in this country. Sadly, the politicians making these false statements still get reelected by their constituents and are thus are never held accountable for their unprincipled behavior.

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