Worth: Mankiw Economics 5e 410 PART V Microeconomic Policy Debates Measurement problem 1: Inflation The least controversial of the measurement issues is the correction for infation Almost all economists agree that the government's indebtedness should be mea- sured in real terms. not in nominal terms. The measured deficit should equal the hange in the government's real debt, not the change in its nominal debt The budget deficit as commonly measured, however, does not correct for in- fation. To see how large an error this induces, consider the following example Suppose that the real government debt is not changing; in other words, in real terms, the budget is balanced In this case, the nominal debt must be rising at the △D/D=丌 where T is the inflation rate and D is the stock of government debt. This implies The government would look at the change in the nominal debt AD and would report a budget deficit of TD. Hence, most economists believe that the reported budget deficit is overstated by the amount TD We can make the same argument in another way. The deficit is government expenditure minus government revenue. Part of expenditure is the interest paid on the government debt. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate i and the real interest rate r is the inflation rate t the budget deficit is overstated by TD This correction for inflation can be large, especially when inflation is high and it can often change our evaluation of fiscal policy. For example, in 1979, the federal government reported a budget deficit of $28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the pub- lic (excluding the Federal Reserve)was $495 billion. The deficit was therefore ted by 丌D=0.086×$495 billion =$43 billion Corrected for inflation, the reported budget deficit of $28 billion turns into a budget surplus of $15 billion! In other words, even though nominal government debt was rising, real government debt was falling Measurement Problem 2: Capital Assets Many economists believe that an accurate assessment of the government's budget deficit requires accounting for the governments assets as well as its liabilities. In particular, when measuring the government's overall indebtedness, we should subtract government assets from government debt. Therefore, the budget deficit should be measured as the change in debt minus the change in assets User LUKBI: Job EFFo1431: 6264_ch15: Pg 410: 28040#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 410:28040#/eps at 100% *28040* Wed, Feb 20, 2002 3:28 PM Measurement Problem 1: Inflation The least controversial of the measurement issues is the correction for inflation. Almost all economists agree that the government’s indebtedness should be measured in real terms, not in nominal terms.The measured deficit should equal the change in the government’s real debt, not the change in its nominal debt. The budget deficit as commonly measured, however, does not correct for in- flation.To see how large an error this induces, consider the following example. Suppose that the real government debt is not changing; in other words, in real terms, the budget is balanced. In this case, the nominal debt must be rising at the rate of inflation.That is, DD/D = p , where p is the inflation rate and D is the stock of government debt.This implies DD = p D. The government would look at the change in the nominal debt DD and would report a budget deficit of p D. Hence, most economists believe that the reported budget deficit is overstated by the amount p D. We can make the same argument in another way.The deficit is government expenditure minus government revenue. Part of expenditure is the interest paid on the government debt. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate i and the real interest rate r is the inflation rate p , the budget deficit is overstated by p D. This correction for inflation can be large, especially when inflation is high, and it can often change our evaluation of fiscal policy. For example, in 1979, the federal government reported a budget deficit of $28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the public (excluding the Federal Reserve) was $495 billion.The deficit was therefore overstated by p D = 0.086 × $495 billion = $43 billion. Corrected for inflation, the reported budget deficit of $28 billion turns into a budget surplus of $15 billion! In other words, even though nominal government debt was rising, real government debt was falling. Measurement Problem 2: Capital Assets Many economists believe that an accurate assessment of the government’s budget deficit requires accounting for the government’s assets as well as its liabilities. In particular, when measuring the government’s overall indebtedness, we should subtract government assets from government debt.Therefore, the budget deficit should be measured as the change in debt minus the change in assets. 410 | PART V Microeconomic Policy Debates
Worth: Mankiw Ecol CHAPTER I5 Government Debt 411 Certainly, individuals and firms treat assets and liabilities symmetrically. When person borrows to buy a house, we do not say that he is running a budget deficit. Instead, we offset the increase in assets(the house)against the increase in debt(the mortgage)and record no change in net wealth. Perhaps we should treat the governments finances the same we a budget procedure that accounts for assets as well as liabilities is called capi- tal budgeting, because it takes into account changes in capital. For example, suppose that the government sells one of its office buildings or some of its land and uses the proceeds to reduce the government debt. Under current budget procedures, the reported deficit would be lower Under capital budgeting, the revenue received from the sale would not lower the deficit because the reduc tion in debt would be offset by a reduction in assets. Similarly, under capital bud- geting, government borrowing to finance the purchase of a capital good would not raise the deficit The major difficulty with capital budgeting is that it is hard to decide which ditures should count as capital expenditures. For example, should the interstate highway system be counted as an asset of the government? If so, what is its value? What about the stockpile of nuclear weapons? Should spending on education be treated as expenditure on human capital? These diffi- cult questions must be answered if the government is to adopt a capital budget Economists and policymakers disagree about whether the federal government should use capital budgeting.(Many state governments already use it. )Oppo- nents of capital budgeting argue that, although the system is superior in principle to the current system, it is too difficult to implement in practice. Proponents of capita budgeting argue that even an imperfect treatment of capital assets wor be better than ignoring them altogether Measurement Problem 3: Uncounted liabilities Some economists argue that the measured budget deficit is misleading because it excludes some important government liabilities. For example, consider the pen- sions of government workers. These workers provide labor services to the govern- ment today, but part of their compensation is deferred to the future. In essence, these workers are providing a loan to the government. Their future pension bene- fits represent a government liability not very different from government debt. Yet this liability is not included as part of the government debt, and the accumulation timates, this implicit liability is almost as large as the official government debt es- of this liability is not included as part of the budget deficit. According to some Similarly, consider the Social Security system. In some ways, the system is like a pension plan. People pay some of their income into the system when young and expect to receive benefits when old. Perhaps accumulated future Social Security benefits should be included in the government's liabilities Estimates suggest that the government's future Social Security liabilities(less future Social Security taxes) are more than three times the government debt as officially measured. One might argue that Social Security liabilities are different from government debt because the government can change the laws determining Social Securit User LUKBI: Job EFFo1431: 6264_ch15: Pg 411: 28041#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 411:28041#/eps at 100% *28041* Wed, Feb 20, 2002 3:28 PM Certainly, individuals and firms treat assets and liabilities symmetrically.When a person borrows to buy a house, we do not say that he is running a budget deficit. Instead, we offset the increase in assets (the house) against the increase in debt (the mortgage) and record no change in net wealth. Perhaps we should treat the government’s finances the same way. A budget procedure that accounts for assets as well as liabilities is called capital budgeting, because it takes into account changes in capital. For example, suppose that the government sells one of its office buildings or some of its land and uses the proceeds to reduce the government debt. Under current budget procedures, the reported deficit would be lower. Under capital budgeting, the revenue received from the sale would not lower the deficit, because the reduction in debt would be offset by a reduction in assets. Similarly, under capital budgeting, government borrowing to finance the purchase of a capital good would not raise the deficit. The major difficulty with capital budgeting is that it is hard to decide which government expenditures should count as capital expenditures. For example, should the interstate highway system be counted as an asset of the government? If so, what is its value? What about the stockpile of nuclear weapons? Should spending on education be treated as expenditure on human capital? These diffi- cult questions must be answered if the government is to adopt a capital budget. Economists and policymakers disagree about whether the federal government should use capital budgeting. (Many state governments already use it.) Opponents of capital budgeting argue that, although the system is superior in principle to the current system, it is too difficult to implement in practice. Proponents of capital budgeting argue that even an imperfect treatment of capital assets would be better than ignoring them altogether. Measurement Problem 3: Uncounted Liabilities Some economists argue that the measured budget deficit is misleading because it excludes some important government liabilities. For example, consider the pensions of government workers.These workers provide labor services to the government today, but part of their compensation is deferred to the future. In essence, these workers are providing a loan to the government.Their future pension bene- fits represent a government liability not very different from government debt.Yet this liability is not included as part of the government debt, and the accumulation of this liability is not included as part of the budget deficit.According to some estimates, this implicit liability is almost as large as the official government debt. Similarly, consider the Social Security system. In some ways, the system is like a pension plan. People pay some of their income into the system when young and expect to receive benefits when old. Perhaps accumulated future Social Security benefits should be included in the government’s liabilities. Estimates suggest that the government’s future Social Security liabilities (less future Social Security taxes) are more than three times the government debt as officially measured. One might argue that Social Security liabilities are different from government debt because the government can change the laws determining Social Security CHAPTER 15 Government Debt | 411
Worth: Mankiw Economics 5e 412 PART V Microeconomic Policy Debates benefits. Yet, in principle, the government could always choose not to repay all of its debt: the government honors its debt only because it chooses to do so. Promises to pay the holders of government debt may not be fundamentally dif ferent from promises to pay the future recipients of Social Security A particularly difficult form of government liability to measure is the contingent liability-the liability that is due only if a specified event occurs. For example, the government guarantees many forms of private credit, such as student loans, mortgages for low-and moderate-income families, and deposits in banks and savings-and-loan institutions. If the borrower repays the loan, the government pays nothing; if the borrower defaults, the government makes the repayment. When the government provides this guarantee, it undertakes a liability contin gent on the borrowers default. Yet this contingent liability is not reflected in the budget deficit, in part because it is not clear what dollar value to attach to it. Measurement Problem 4: The Business Cycle Many changes in the government's budget deficit occur automatically in re- sponse to a fluctuating economy. For example, when the economy goes into a cession, incomes fall, so people pay less in personal income taxes. Profits fall,so corporations pay less in corporate income taxes. More people become eligible for government assistance, such as welfare and unemployment insurance, so gov ernment spending rises. Even without any change in the laws governing taxation and spending, the budget deficit increases These automatic changes in the deficit are not errors in measurement, becaus the government truly borrows more when a recession depresses tax revenue and boosts government spending. But these changes do make it more difficult to use the deficit to monitor changes in fiscal policy. That is, the deficit can rise or fall either because the government has changed policy or because the economy has changed direction. For some purposes, it would be good to know which is occurring To solve this problem, the government calculates a cyclically adjusted bud get deficit(sometimes called the full-employment budget deficit). The cyclically ad- justed deficit is based on estimates of what government spending and tax revenue would be if the economy were operating at its natural rate of output and em- ployment. The cyclically adjusted deficit is a useful measure because it reflects policy changes but not the current stage of the business cycle umming Up Economists differ in the importance they place on these measurement problems Some believe that the problems are so severe that the measured budget deficit is almost meaningless. Most take these measurement problems seriously but still view the measured budget deficit as a useful indicator of fiscal policy The undisputed lesson is that to evaluate fully what fiscal po do mists and policymakers must look at more than only the measured budget deficit. And, in fact, they do. The budget documents prepared annually by the Office of Management and Budget contain much detailed information about the govern- ment's finances, including data on capital expenditures and credit programs User LUKBI: Job EFFo1431: 6264_ch15: Pg 412: 28042#/eps at 100s Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 412:28042#/eps at 100% *28042* Wed, Feb 20, 2002 3:28 PM benefits.Yet, in principle, the government could always choose not to repay all of its debt: the government honors its debt only because it chooses to do so. Promises to pay the holders of government debt may not be fundamentally different from promises to pay the future recipients of Social Security. A particularly difficult form of government liability to measure is the contingent liability—the liability that is due only if a specified event occurs. For example, the government guarantees many forms of private credit, such as student loans, mortgages for low- and moderate-income families, and deposits in banks and savings-and-loan institutions. If the borrower repays the loan, the government pays nothing; if the borrower defaults, the government makes the repayment. When the government provides this guarantee, it undertakes a liability contingent on the borrower’s default.Yet this contingent liability is not reflected in the budget deficit, in part because it is not clear what dollar value to attach to it. Measurement Problem 4: The Business Cycle Many changes in the government’s budget deficit occur automatically in response to a fluctuating economy. For example, when the economy goes into a recession, incomes fall, so people pay less in personal income taxes. Profits fall, so corporations pay less in corporate income taxes. More people become eligible for government assistance, such as welfare and unemployment insurance, so government spending rises. Even without any change in the laws governing taxation and spending, the budget deficit increases. These automatic changes in the deficit are not errors in measurement, because the government truly borrows more when a recession depresses tax revenue and boosts government spending.But these changes do make it more difficult to use the deficit to monitor changes in fiscal policy.That is, the deficit can rise or fall either because the government has changed policy or because the economy has changed direction. For some purposes, it would be good to know which is occurring. To solve this problem, the government calculates a cyclically adjusted budget deficit (sometimes called the full-employment budget deficit).The cyclically adjusted deficit is based on estimates of what government spending and tax revenue would be if the economy were operating at its natural rate of output and employment. The cyclically adjusted deficit is a useful measure because it reflects policy changes but not the current stage of the business cycle. Summing Up Economists differ in the importance they place on these measurement problems. Some believe that the problems are so severe that the measured budget deficit is almost meaningless. Most take these measurement problems seriously but still view the measured budget deficit as a useful indicator of fiscal policy. The undisputed lesson is that to evaluate fully what fiscal policy is doing, economists and policymakers must look at more than only the measured budget deficit. And, in fact, they do.The budget documents prepared annually by the Office of Management and Budget contain much detailed information about the government’s finances, including data on capital expenditures and credit programs. 412 | PART V Microeconomic Policy Debates
Worth: Mankiw Economics 5e CHAPTER I5 Government Debt 413 No economic statistic is perfect. Whenever we see a number reported in the media, we need to know what it is measuring and what it is leaving out. This is especially true for data on government debt and budget deficits CASE STUDY Generational Accounting One harsh critic of current measures of the budget deficit is economist Laurence Kotlikoff Kotlikoff argues that the budget deficit is like the fabled emperor who wore no clothes: everyone should plainly see the problem, but no one is willing to admit to it. He writes, " On the conceptual level, the budget deficit is intellec tually bankrupt. On the practical level, there are so many official deficits that"bal- anced budget has lost any true meaning "He sees an"urgent need to switch from an outdated, misleading, and fundamentally noneconomic measure of fiscal li ely the budget deficit, to generational Generational accounting, Kotlikoff's new way to gauge the influence of fiscal policy, is based on the idea that a persons economic well-being depends on his or her lifetime income. (This idea is founded on Modigliani's life-cycle theory of consumer behavior, which we examine in Chapter 16.)When evaluating fiscal policy, therefore, we should not be concerned with taxes or spending in any sin- gle year. Instead, we should look at the taxes paid, and transfers received, by peo- ple over their entire lives. Generational accounts measure the impact of fiscal policy on the lifetime incomes of different generations Generational accounts tell a very different story than the budget deficit about the history of U.S. fiscal policy. In the early 1980s, the U.S. government cut taxes, beginning a long period of large budget deficits. Most commentators claim that older generations benefited at the expense of younger generations during this period, because the young inherited the government debt. Kotlikoff agrees that hese tax cuts raised the burden on the young, but he claims that this standard analysis ignores the impact of many other policy changes. His generational ac- counts show that the young were hit even harder during the 1950s, 1960s, and 1970s. During these years, the government raised Social Security benefits for the elderly and financed the higher spending by taxing the working-age population This policy redistributed income away from the young, even though it did not ffect the budget deficit. During the 1980s, Social Security reforms reversed this trend, benefiting younger generations. Despite Kotlikoff's advocacy, generational accounting is not likely to replace the budget deficit. This alternative system also has flaws. For example, to calculate the total tax burden on different generations, one needs to make assumptions about future policy, which are open to dispute. Nonetheless, generational ac- ounting offers a useful perspective in the debate over fiscal policy 2 Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays, and When, for What We Spend New York: The Free Press, 1992). For an appraisal of the book, see David M. Cutler, Book Review, National Tax Journal 56(March 1993): 61-67. See also the symposium on generational accounting in the winter 1994 issue of the Journal of Economic Perspectives. User LUKBI: Job EFFo1431: 6264_ch15: Pg 413: 28043#/eps at 100sl I Wed,Feb20,20023:28
User LUKBI:Job EFF01431:6264_ch15:Pg 413:28043#/eps at 100% *28043* Wed, Feb 20, 2002 3:28 PM No economic statistic is perfect.Whenever we see a number reported in the media, we need to know what it is measuring and what it is leaving out.This is especially true for data on government debt and budget deficits. CHAPTER 15 Government Debt | 413 CASE STUDY Generational Accounting One harsh critic of current measures of the budget deficit is economist Laurence Kotlikoff. Kotlikoff argues that the budget deficit is like the fabled emperor who wore no clothes: everyone should plainly see the problem, but no one is willing to admit to it. He writes,“On the conceptual level, the budget deficit is intellectually bankrupt. On the practical level, there are so many official deficits that ‘balanced budget’ has lost any true meaning.” He sees an “urgent need to switch from an outdated, misleading, and fundamentally noneconomic measure of fiscal policy, namely the budget deficit, to generational accounting.” Generational accounting, Kotlikoff’s new way to gauge the influence of fiscal policy, is based on the idea that a person’s economic well-being depends on his or her lifetime income. (This idea is founded on Modigliani’s life-cycle theory of consumer behavior, which we examine in Chapter 16.) When evaluating fiscal policy, therefore, we should not be concerned with taxes or spending in any single year. Instead, we should look at the taxes paid, and transfers received, by people over their entire lives. Generational accounts measure the impact of fiscal policy on the lifetime incomes of different generations. Generational accounts tell a very different story than the budget deficit about the history of U.S. fiscal policy. In the early 1980s, the U.S. government cut taxes, beginning a long period of large budget deficits. Most commentators claim that older generations benefited at the expense of younger generations during this period, because the young inherited the government debt. Kotlikoff agrees that these tax cuts raised the burden on the young, but he claims that this standard analysis ignores the impact of many other policy changes. His generational accounts show that the young were hit even harder during the 1950s, 1960s, and 1970s. During these years, the government raised Social Security benefits for the elderly and financed the higher spending by taxing the working-age population. This policy redistributed income away from the young, even though it did not affect the budget deficit. During the 1980s, Social Security reforms reversed this trend, benefiting younger generations. Despite Kotlikoff’s advocacy, generational accounting is not likely to replace the budget deficit.This alternative system also has flaws. For example, to calculate the total tax burden on different generations, one needs to make assumptions about future policy, which are open to dispute. Nonetheless, generational accounting offers a useful perspective in the debate over fiscal policy.2 2 Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays, and When, for What We Spend (New York:The Free Press, 1992). For an appraisal of the book, see David M. Cutler, Book Review, National Tax Journal 56 (March 1993): 61–67. See also the symposium on generational accounting in the Winter 1994 issue of the Journal of Economic Perspectives