Relationship between federal budget and fiscal policy

relationship between federal budget and fiscal policy

Federal Budget & Fiscal Policy Legislative activity on the federal budget generally takes place between the months of February and September, although . Fiscal Policy. In this module we will dive into fiscal policy. Fiscal policy is one of two policy tools for managing the economy (the other is monetary policy). Between and , the deficit of the U.S. federal government . federal budget, national debt, deficit, gdp, monetary policy, fiscal policy.

Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal.

The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the s for fiscal stimulus.

Fiscal policy

The same general argument has been repeated by some neoclassical economists up to the present. In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income.

When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return.

To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases.

This causes the currency to appreciate, reducing the cost of imports and making exports from that country more expensive to foreigners. Consequently, exports decrease and imports increase, reducing demand from net exports. Some economists oppose the discretionary use of fiscal stimulus because of the inside lag the time lag involved in implementing itwhich is almost inevitably long because of the substantial legislative effort involved.

Further, the outside lag between the time of implementation and the time that most of the effects of the stimulus are felt could mean that the stimulus hits an already-recovering economy and exacerbates the ensuing boom rather than stimulating the economy when it needs it.

Some economists are concerned about potential inflationary effects driven by increased demand engendered by a fiscal stimulus. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.

However, much of this research uses data from the period when disability levels were still declining, and it remains an open question how the recent stabilization in old-age disability, discussed in Chapter 4will affect future health expenditures.

A far more important source of uncertainty concerns the expected rate of growth of health spending holding health status constant.

For more than four decades, health spending growth has exceeded GDP growth. As shown in Tableexcess cost growth—defined as the difference between age-adjusted per capita health spending growth and per capita GDP growth—averaged 2 percent from to and 1. As a result, the share of health spending in GDP increased from 8 percent in to 16 percent in Most analysts believe that this rapid rise in spending in large part reflects the increasing value that our society has been placing on health care as we become richer, which has fueled the demand for new medical technologies and services Smith, Newhouse, and Freeland, But health spending cannot continue to rise in excess of GDP forever, and it is likely that the growth in demand for health services will slow over time as expenditures on health increasingly crowd out spending on other goods and services.

Many researchers believe that there is a considerable amount of inefficiency in our health system, and so part of the slowdown in spending could come from efficiency improvements.

In addition, greater financial pressures on providers will likely lead to a slowdown in the rate of adoption of new technologies. The Congressional Budget Office CBO and the Centers for Medicare and Medicaid Services CMS both assume that excess cost growth in health spending will decline over time, although their assumptions about the rate of decline differ, particularly for Medicare.

However, the health reform measures enacted in the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act ofcollectively known as the Affordable Care Act, or ACA included provisions to lower the annual updates to provider payment rates and to cap annual Medicare growth.

According to the Trustees' projections, with these payment changes, average excess cost growth for Medicare spending under the ACA will be close to zero over the long-run projection period; that is, most of the increase in Medicare spending in the Trustees baseline projection is the result of demographic change rather than health care cost growth.

For these reasons, both the CBO and CMS present alternative Medicare projections in which Medicare payments to providers are higher than those allowed under current law. In addition, it is widely believed that Medicare's payment system for physicians, the Sustainable Growth Rate SGR system, will eventually be amended, as the administration and Congress have repeatedly stepped in to postpone the cuts to physician payments required under this system. The impact of these varying assumptions, along with an estimate of how Medicare spending would rise under the assumption of no decline in excess cost growth, are depicted in Figure Under the Trustees current-law projection, Medicare expenditure rises from 3.

Under the CBO alternative which is similar to the Trustees alternativeMedicare spending in reaches 7. The anticipated slowdown in health spending is important to these projections; under the assumption of no slowdown in excess cost growth, Medicare spending reaches over 10 percent of GDP by Alternative projections of Medicare spending, — Medicaid and Other Health Programs Medicaid, a program that is financed in part by the federal government and in part by the states, is not an old-age program, yet it plays an important part in financing the long-term care needs of the elderly.

Infor example, Medicaid financed about one-third of long-term care services for the elderly O'Brien,and in these services represented 14 percent of Medicaid expenditures Centers for Medicare and Medicaid Services, a. Table shows the distribution of Medicaid spending by age in Per capita Medicaid spending is highest for those 75—84 and over 85, a reflection of the increased utilization and high cost of nursing home care. As noted in Chapter 3increases in life expectancy are projected to significantly increase the share of people aged 85 and older.

Thus, population aging may increase the demands on Medicaid. For example, assuming that relative Medicaid spending by age remains constant at the levels, projected changes in the age distribution of the population would raise Medicaid spending by about 10 percent by and 15 percent by Medicaid expenditure growth is also affected by excess cost growth in health spending Table as well by the recently enacted health reform, which expanded eligibility for the program.

Taking into account the expected slowdown in health spending growth, the aging of the population, and the effects of the recently enacted health reform, the CBO projects Figure that federal spending for Medicaid and other non-Medicare health programs the much smaller Children's Health Insurance program and the future outlays for health insurance subsidies under health reform will rise from about 2 percent of GDP in to 3.

First, since states finance roughly 40 percent of Medicaid spending, on average, rapid increases in Medicaid expenditures are also likely to put pressure on state budgets as well. Second, although states are subject to balanced budget requirements in their operating funds and so typically don't have substantial amounts of debt outstanding, they do have implicit debt in the form of unfunded liabilities for the pension and retiree health benefits of state workers Munnell et al.

There has been much less attention paid to long-term budget projections for the state and local sector than to the federal government sector. One exception is the Government Accountability Office GAOwhich reports its projections for state and local expenditures and revenues through Government Accountability Office, The GAO examines both the impact of health care cost growth and the liabilities for state and local pension and retiree health benefits, assuming that these benefits are fully paid as scheduled.

According to these projections, without policy changes, state and local government operating budgets are likely to be under increasing stress over time. Byfor example, the GAO's base case shows an imbalance between revenues and expenditures of about 1. Much of this rise is attributable to rapidly increasing excess cost growth the GAO assumes slightly faster growth of excess health cost growth for Medicaid and retiree health insurance than does the CBO.

The Outlook for Fiscal Policy - Aging and the Macroeconomy - NCBI Bookshelf

While not strictly comparable to the CBO projections, the GAO projections show that, even with the assumed slowdown in health spending, expenditure and revenue adjustments will need to be made in the state and local sector as well. While not all of these adjustments are directly attributable to demographic change, they are an important component of the overall fiscal outlook for the U. Auerbach and Gale present a detailed analysis of alternative trajectories of total federal spending, revenues, and debt under a variety of assumptions about fiscal policy.

Figure presents two such scenarios for noninterest expenditure and revenues. The more optimistic scenario uses the Medicare Trustees projections for Medicare spending and assumes that taxes will rise to about 21 percent of GDP over the long term, 3 percentage points above the 18 percent average recorded from to In addition, it assumes that savings from the Budget Control Act of will materialize.

relationship between federal budget and fiscal policy

Auerbach and Gale Under the optimistic scenario, noninterest expenditures fall from 22 percent to roughly 20 percent of GDP by as the economy recovers and then rise slowly thereafter, to about 22 percent by and 23 percent by Under the more pessimistic scenario, noninterest outlays rise faster, reaching almost 26 percent by With tax revenues of 21 percent and 18 percent of GDP, respectively, the primary deficit that is, the deficit excluding interest payments on the national debt reaches 2 percent of GDP by under the optimistic scenario and almost 8 percent in the pessimistic scenario.

Figure shows the deficit projections implied by these two sets of expenditure and revenue projections, including projected interest payments. In both scenarios, the deficit declines sharply over the next few years relative to GDP as the economy recovers, and then begins to climb. In the optimistic scenario, the deficit falls to close to 1 percent of GDP over the next decade and then increases only gradually over time, reaching 4 percent of GDP by and almost 8 percent of GDP by Even under this positive scenario, future adjustments will still be necessary.

In the pessimistic scenario, the deficit hovers around 5 percent of GDP for much for the next decade but climbs sharply thereafter, reaching over 10 percent of GDP by and over 20 percent of GDP by The sharp acceleration in the future deficits under the pessimistic scenario reflects the combination of continued rapid growth in health expenditures as well as rapidly rising interest payments from continued large deficits. Committee calculations based on Auerbach and Gale Figure shows the implied debt: GDP ratios under these two sets of projections.

Under the most optimistic set of assumptions, the debt: GDP ratio falls over the next 15 years and then begins to climb sharply, reaching percent of GDP by Under the more pessimistic set of projections, the debt: GDP ratio cannot continue to rise indefinitely; at some point, investors would become uncertain of full repayment or worry about repayment in greatly inflated dollars and start demanding a risk premium 13 on U. At that point, rising interest payments on the debt would trigger even larger deficits, potentially resulting in an unsustainable deficit spiral.

Although there is uncertainty as to exactly what level of debt will elicit such a reaction, it is clear that fiscal policy adjustments will need to be made eventually. In particular, even throughit is unlikely that the pessimistic scenario could actually unfold, as it is unlikely that investors would be willing to continue to finance the projected deficits.

One response to population aging would be to attempt to smooth the required adjustments over time in order to minimize the size of the adjustment in any given year. Because population aging is projected to be permanent, however, spreading the adjustments equally over time would require the government to build up a large stock of assets and to use the earnings on those assets to help finance part of future government spending. Alternatively, the government could smooth through the adjustments over a more finite period.

For example, Table presents calculations based on Auerbach and Gale showing the size of the adjustments required in order for the debt: GDP ratio in to be the same as it was in For example, under the more optimistic scenario, which already includes higher revenues and lower health spending growth than the historical averages, an immediate and permanent change to tax revenues or expenditures equal to just over 1 percent of GDP would leave the debt: GDP ratio in the same as it is today; under this scenario, the debt: GDP ratio would decline to 44 percent over roughly the next two decades years, and then it would start to climb again, reaching 68 percent in Alternatively, if the adjustment were delayed untila 1.

Under the pessimistic scenario, which assumes significantly lower tax revenues and higher health expenditures, the required adjustments are significantly larger. These changes will have important macroeconomic consequences, but there is no natural baseline against which to measure these macroeconomic effects because the status quo trajectory is not a feasible one—it would lead to an exploding and unsustainable level of national debt.

Thus, we can only compare the effects of different feasible paths, especially their relative effects on capital accumulation and labor supply, both in the aggregate and across generations.

To estimate these effects, several attributes of budget adjustments will be relevant, including those described in the next seven subsections. How Quickly the Changes Are Implemented Under both the optimistic and pessimistic scenarios, annual deficits are projected to grow over time as a share of GDP, even when debt service costs are excluded. Thus, as mentioned above, if the adjustment process targets the rate of debt accumulation, the magnitude of deficit cuts will grow over time as a share of GDP.

A different policy that would lessen the magnitude of the required deficit cuts over time would be to make larger immediate adjustments to taxes and spending policies that could temporarily lower the debt: This would have the effect of smoothing the adjustments across more cohorts.

According to Auerbach andthere is a predictable reaction function of government spending to the deficit: Thus, policies that would significantly lower deficits ahead of the baby boom retirement, while possibly economically attractive, might prove politically unsustainable. On the other hand, waiting too long to announce and implement policy changes is a risky strategy. As noted above, it is impossible to predict the level of debt at which investors might lose confidence in the ability or willingness of the United States to fully repay its debts.

This loss of confidence could occur quite suddenly, and it might lead to a period of financial crisis or a situation in which policy adjustments would have to be quite large and immediate, which could have deleterious effects on short-term macroeconomic performance National Research Council and National Academy of Public Administration, When Changes Are Announced or Anticipated Changes that are implemented in the future may nonetheless be announced or anticipated many years before.

If announcements of future policies are credible or if expectations reflect an accurate assessment of the policies that eventually will be undertaken, then these policies can affect behavior long before their implementation.

An example is the phased increase in the Social Security full retirement age, which was enacted in but implemented over a long period beginning several years after enactment.

Fiscal policy - Wikipedia

To the extent individuals are forward looking, this change in policy would have boosted private saving in the years prior to its implementation, as people increased their saving in anticipation of lower future Social Security benefits.

But many marginal tax rates are implicit, as in the case of the means-testing of social insurance benefits. But the point also applies to universal old-age entitlement programs. For example, the share of Social Security benefits subject to the income tax depends on retirees' other income, which imposes an implicit marginal tax rate in addition to the explicit one on that other income.

Similarly Medicare Part B premiums are now income-based, which also imposes a tax on such income. Note that implicit marginal tax rates on income may be imposed through the tax system as in the case of Social Security benefit taxation or through the expenditure system as in the case of Medicare premiums, which are classified in the budget as offsetting receipts that reduce expenditures.

This fact highlights an important point: Macroeconomic effects will depend on the distribution and structure of budget changes but not directly on whether these changes are recorded on the tax side or the expenditure side. Though this distinction sometimes appears paramount in political discussions, it is of little relevance for economic analysis except to the extent that the underlying behavioral effects of tax or expenditure changes may systematically differ.

The Intergenerational Distribution of Policy Changes The intergenerational distribution of policy changes will relate to the first point above, because changes that are delayed are likely to affect younger generations.

But two policies of the same magnitude implemented at the same time may have different distributional effects among generations.

relationship between federal budget and fiscal policy

For example, an immediate, permanent cut in Social Security benefits will affect older generations more than an immediate, permanent increase in Social Security taxes with the same budget result. Similarly, a consumption tax would affect older generations more than an increase in the income tax.