It's true that if you advise politicians on economic policy in the U.S. today, you spend your time in a cross between inquiry and combat. You are always on the periphery of harsh partisan warfare that has nothing to do with substance.
Macroeconomic Issues and Policy
(Part D)
by
Charles Lamson
The Effects of Spending cuts on the Deficit
Suppose the terms of a balanced budget amendment or some other deficit-reduction measure dictate that the deficit must be cut by $20 billion. By how much must government spending be cut to achieve this goal? You might be tempted to think the spending cuts should add up to the amount the deficit is to be cut---$20 billion. [This is what the Gramm-Rudman-Hollings Bill (GRH) (GRH set a target for for reducing the federal deficit by a set amount each year. Figure 5 shows the deficit was to decline by $36 billion per year between 1987 and 1991, with a deficit of zero slated for 1991.) dictated: If the deficit needed to be cut by a certain amount, automatic spending cuts were to be equal to this amount.] This seems reasonable. If you decrease your personal spending by $100 over a year, your personal deficit will fall by the full $100 of your spending cut.  However, the government is not an individual household. A cut in government spending shifts the aggregate demand (AD) curve to the left and results in a decrease in aggregate output (income) (Y) and a contraction in the economy. When the economy contracts, both the taxable income of households and the profit of firms fall. This means revenue from the personal income tax and the corporate profits tax will fall. How do these events affect the size of the deficit? To estimate the response of the deficit to changes in government spending, we need to go through two steps. First, we must decide how much a $1 change in government spending will change GDP. That means we need to know the size of the government spending multiplier. [The government spending multiplier measures the increase (or decrease) in GDP (Y) brought about by a $1 increase (or decrease) in government spending.] Based on empirical evidence, a reasonable value for the government spending multiplier seems to be around 1.4 after 1 year, and this is the value we will use (Case & Fair, 2004). A $1 billion decrease in government spending lowers GDP by about $1.4 billion after one year. Next we must see what happens to the deficit when GDP changes. We have just noted that when GDP falls---the economy contracts---taxable income and corporate profits fall, so tax revenues fall. In addition, some categories of government expenditures tend to rise when the economy contracts. For example, unemployment insurance benefits (a transfer payment) rise as the economy contracts because more people become unemployed and eligible for benefits. Both the decrease in tax revenues and the rise in government expenditures cause the deficit to increase.  The deficit tends to rise when GDP Falls, and tends to fall when GDP Rises. Assume the deficit response index (DRI) is -.22. That is, for every $1 billion decrease in GDP, the deficit rises by $.22 billion. This number is seen as close to what is true in practice (Case & Fair, 2004). We can now use the multiplier and the DRI to answer the question that began this post. Suppose government spending is reduced by $20 billion, the exact amount of the necessary deficit reduction. This will lower GDP by 1.4 x $20 billion, or $28 billion, if the value of the multiplier is 1.4. A $28 billion fall in GDP will increase the deficit by .22 x $28 billion, or $6.2 billion, if the value of the DRI is -.22. Because we initially cut government spending (and therefore lowered the deficit from this source) by $20 billion, the net effect of the spending cut is to lower the deficit by $20 billion - $6.2 billion = $13.8 billion. A $20 billion government spending cut does not lower the deficit by $20 billion. To lower the deficit by $20 billion, we need to cut government spending by about $30 billion. By using 1.4 as the value of the government spending multiplier and -.22 as the value of the DRI, we see that a spending cut of $30 billion lowers GDP by 1.4 x $30 billion, or $42 billion. This raises the deficit by .22 x $42 billion, or $9.2 billion. The net effect on the deficit is -$30 billion (from the government spending cut) + $9.2 billion, which is -$20.8 billion (slightly larger than the necessary $20 billion reduction). This means the spending cut must be nearly 50 percent larger than the deficit reduction we wish to achieve. Congress would have had trouble achieving the deficit targets under the GRH legislation even if it had allowed GRH's automatic spending cuts to take place, which it did not. Because in 1986, the U.S. Supreme Court declared part of the GRH bill unconstitutional. In effect the court said the Congress would have to approve the "automatic" spending cuts before they could take place. The law was changed in 1986 to meet the Supreme Court ruling and again in 1987, when new targets were established. The new targets had the deficit reaching zero in 1993 instead of 1991. The targets were changed again in 1991, when the year to achieve a zero deficit was changed from 1993 to 1996. Monetary Policy to the Rescue? Was Congress so poorly informed about macroeconomics that it would pass legislation that could not possibly work? In other words, are there any conditions under which it would be reasonable to assume that a spending cut needs to be only as large as the desired reduction in the deficit? If the government spending multiplier is zero, government spending cuts will not contract the economy, and the cut in the deficit will be equal to the cut in government spending.  Could the government spending multiplier ever be zero? Before the GRH bill was passed some argued it could. The argument went as follows: If households and firms are worried about the large government deficits and hold back on consumption and investment because of these worries, the passage of GRH might make them more optimistic and induce them to consume and invest more. This increased consumption and investment would offset the effects of the decreased government spending, and the net result would be a multiplier effect of zero. Another argument in favor of the GRH bill centered on the fed and monetary policy. We know that an expansionary monetary policy shifts the AD curve to the right. Because a cut in government spending shifts the AD curve to the left, the Fed could respond to the spending cut enough to shift the AD curve back (to the right) to its original position, preventing any change in aggregate output (income). Some argue the Fed would behave in this way after the passage of the GRH bill because it would see that Congress finally "got its house in order." How large would the interest rate cuts have to be to completely offset the decrease in government spending (G), thus resulting in a multiplier of zero? Studies at the time of the original GRH bill showed the decrease in the interest rate that would be necessary to have the multiplier be zero---that is, for a government spending cut to have no effect on aggregate output (income)---is quite large. The Fed would have had to engage in extreme behavior with respect to interest rate changes for the multiplier to be zero. A zero multiplier can come about through renewed optimism on the part of households and firms or through very aggressive behavior on the part of the Fed, but because neither of these situations is very plausible, the multiplier is likely to be greater than zero. Thus, it is likely that to lower the deficit by a certain amount, the cut in government spending must be larger than that amount.  Economic Stability and Deficit-Reduction So, lowering the deficit by a given amount is likely to require a government spending decrease larger than this amount. However, this is not the only point to learn from our analysis of deficit targeting. We will now show how deficit targeting can adversely affect the way the economy responds to a variety of stimuli. In a world with no GRH, no balanced-budget amendment, no similar deficit-targeting measure, the Congress and the president make decisions each year about how much to spend and how much to tax. The federal government deficit is a result of these decisions and the state of the economy. However, with GRH or a balanced-budget amendment, the size of the deficit is set in advance. Taxes and government spending must be adjusted to produce the required deficit. In this situation, the deficit is no longer a consequence of the tax and spending decisions. Instead, the taxes and spending become a consequence of the deficit decision. What difference does it make whether Congress chooses a target deficit and adjusts government spending and taxes to achieve this target or decides how much to spend and tax and lets the deficit adjust itself? The difference may be substantial. Consider a leftward shift of the AD curve caused by some negative demand shock. A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports. We know that a leftward shift of the AD curve lowers aggregate output (income), which causes the government deficit to increase. In a world without deficit targeting, the increase in the deficit during contractions provides an automatic stabilizer for the economy. The contraction-induced decrease in tax revenues and increase in transfer payments tend to reduce the fall in the after-tax income and consumer spending due to the negative demand shock. Thus, the decrease in aggregate output (income) caused by the negative demand shock is lessened somewhat by the growth of the deficit [Figure 6(a)].   In a world with deficit targeting, the deficit is not allowed to rise. Some combination of tax increases and government spending cuts would be needed to offset what would have otherwise been an increase in the deficit. We know that increases in taxes or cuts in spending are contractionary in themselves. The contraction in the economy will therefore be larger than it would have been without deficit targeting, because the initial effect of the negative demand shock is worsened by the rise in taxes or the cut in government spending required to keep the deficit from rising. As Figure 6(b) shows, deficit targeting acts as an automatic destabilizer. It requires taxes to be raised and government spending to be cut during a contraction. This reinforces, instead of counteracts, the shock that started the contraction.
Summary It is clear that GRH legislation, balanced-budget amendments, and similar deficit-targeting measures have some undesirable macroeconomic consequences. Deficit targeting requires cuts in spending or increases in taxes at times when the economy is already experiencing problems. This does not mean Congress should ignore deficits when they arise. Instead, it means that locking the economy into spending cuts during periods of negative demand shocks, as deficit targeting measures do, is not a very good way to manage the economy. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 586-588* end |
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