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Policy Debate: Is a budget deficit harmful to the economy?

Issues and Background

Research on economic growth assigns importance to the tax structure, marginal tax rates, and the level and composition of government spending, but not to whether spending is financed by taxes or deficits. Deficits are a sign that federal spending is too high, but deficits do not cause many of the economic harms that some analysts are claiming.
~ Alan Reynolds

The adverse consequences of sustained large budget deficits may well be be far larger and occur more suddenly than traditional analysis suggests.... Substantial deficits projected far into the future can cause a substantial shift in market expectations and a related loss of confidence both at home and abroad. The unfavorable dynamic effects that could ensue are largely if not entirely excluded from the conventional analysis of budget deficits. This omission is understandable and appropriate in the context of deficits that are small and temporary; it is increasingly untenable, however, in an environment with deficits that are large and permanent. Substantial ongoing deficits may severely and adversely affect expectations and confidence which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy.
~ Robert E. Rubin, Peter R. Orszag, and Allen Sinai

In the late 1990s, discussion of U.S. fiscal policy often focused on how the budget surplus should be used. The recession of 2001 (and the subsequent "jobless recovery"), the Bush Administration's tax cuts, and rising military and homeland security expenditures have converted the the budget surplus into a large and growing federal budget deficit. The economic effects of this deficit have been the focus of a substantial amount of public policy debate.

During the first administration of George W. Bush, government spending rose rather dramatically while federal income and estate taxes were cut. Advocates of these policy actions believe that this helped make the recession of 2001 relatively shortlived and encouraged an economic expansion during this period. While unemployment did not decline as rapidly as anticipated, advocates of these expansionary macroeconomic policies believe that a more severe and extended recession would have otherwise occurred. Traditional macroeconomists argue that the increase in government spending directly increased aggregate demand while the tax cuts indirectly increase aggregate demand by resulting in an increase in consumption spending. While most economists believe that the growing deficit of the past few years primarily stimulated the economy through an increase in aggregate demand, some economists believe that these tax cuts have also had a substantial impact on aggregate supply. This argument suggests that individuals have more incentive to work and invest when marginal tax rates are reduced.

Opponents of the rising deficit often express concern about the long-run consequences of the deficit. In the late 1990s, government policy was directed at creating a government surplus to help deal with the problems expected for the social security system over the next several decades. As the baby boom generation ages, Social Security expenditures are expected to increase substantially while the proportion of the labor force working is expected to decline. (This topic is discussed more extensively in the debate dealing with the future of Social Security.) If the tax cuts enacted in 2001, 2002, and 2003 are made permanent, the federal budget deficit is projected to grow much more rapidly than GDP for several decades.

One of the main concerns about the rising budget deficit is the crowding-out effect. The demand for loanable funds rises as the federal government increases its borrowing, resulting in an increase in the equilibrium real interest rate. The resultant increase in the interest rate reduces private investment spending and leads to a slower rate of economic growth. This argument suggests that the long-run effects of a growing deficit include substantial decreases in future income and consumption.

Some economists are also concerned that higher borrowing by the government may also directly result in reduced consumption spending. They argue that households recognize that higher current government borrowing results in higher future taxes. If households wish to smooth their consumption spending over time, they must set aside an additional amount of saving today just equal to the amount borrowed (since this is the present value of the future payment stream needed to finance this deficit). This argument was initially made by David Ricardo in the 19th century, and was restated by Robert Barro over a century later as the Ricardian Equivalence Theorem. Under this argument, an increase in government spending that is financed by a deficit results in an offsetting reduction in consumption spending. It should be noted, however, that most economists do not believe that this effect (if it occurs) is likely to fully offset an increase in the deficit.

Another concern with a rising deficit is that it may result in an arbitrary redistribution of income. As the deficit rises, a growing share of taxes must be raised to cover the cost of interest payments on the debt. This results in a redistribution of income from taxpayers to bondholders.

Economists also express concern about the effect of a rising government spending deficit on the U.S. international trade deficit. As noted above, increases in U.S. government borrowing raise equilibrium domestic interest rates. Since this increases the return on U.S. financial assets, the demand for U.S. financial assets increases, leading to an increase in the demand for dollars on foreign exchange markets. As the demand for dollars rises, the dollar appreciates relative to other currencies. This increase in the value of the dollar results in a reduction in U.S. exports and an increase in U.S. imports. Thus, a rising government deficit is expected to result in a growing trade deficit and a reduction in U.S. net exports.

With the near-term retirement of the baby-boom generation, the economic consequences of the federal deficit is likely to be an area of much study over the next several years.


Primary Resources and Data

  • Office of Management and Budget
    The Office of Management and Budget formulates budget plans for the Executive branch of government. This web site contains information on current and proposed budgets, and an extensive collection of studies, testimony, and other information dealing with budget-related issues.

  • Congressional Budget Office
    The Congressional Budget Office web site provides information about current and projected government budgets. Studies, reports, and testimony dealing with budget-related issues are available on this web site.

  • Bureau of the Public Debt
    The Bureau of the Public Debt web site provides information on the size of the federal debt. Annual public debt data from 1791-2005 and detailed data from 1987 to the present day is available on this site.

  • The Concord Coalition
    The Concord Coalition is a nonprofit organization that supports a balanced budget and the preservation of Social Security, Medicare, and Medicaid. This web site contains numerous studies, press releases, and other information related to these budget-related issues.

  • Office of Management and Budget, "A Citizen's Guide to the Federal Budget"
    This annual series of budget documents provides a discussion of the U.S. budget and the budget formulation process. Problems associated with budget deficits and the national debt are also examined in these publications.

  • Joint Economic Committee, "Economics of the Federal Debt and the Debt Limit"
    This document, provided by the Joint Economic Committee compares the current status of the U.S. debt/GDP ratio with that existing in earlier times and in other countries. It is observed that the ratio of the U.S. debt to GDP was higher during the 1940s, the 1980s, and the early part of the 1990s. Germany, Japan, and Italy have higher ratios of debt to GDP. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • Questia, "Budget Deficit"
    This online resource provides a bibliography of print materials dealing with the budget deficit. These articles and books are available online to subscribers, but they may also be found in college libraries.

  • Congressional Budget Office, "The Budget and Economic Outlook, Fiscal Years 2007 to 2017"
    The document contains the Congressional Budget Office's projections for the federal budget from 2007 to 2017. It is projected that the deficit will decline during this interval if the tax cuts of 2001 through 2003 are allowed to expire. The deficit will remain relatively large if the tax cuts remain in place (assuming no other change in taxes and spending). It is observed that the long-term deficit is likely to be larger due to projected increases in Social Security and Medicare expenditures. This report notes that Social Security, Medicare, and Medicaid will account for a steadily increasing share of GDP over the next several decades. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • National Budget Simulation
    This website allows visitors to attempt to participate in a simulation in which they are able to examine the effect of changes in government spending and taxation policies on the federal budget deficit.


Different Perspectives in the Debate

  • Committee for Economic Development, Concord Coalition, and Center on Budget and Policy Priorities, "The Developing Crisis -- Deficits Matter"
    This September 29, 2003 statement on the deficit was jointly issued by the Committee for Economic Development, the Concord Coalition, and the Center on Budget and Policy Priorities. It is argued that the government deficit will be harmful to the economy, especially in light of the anticipated increase in Social Security and Medicare expenditures. A cumulative budget deficit of $5 trillion dollars is projected for the years 2003-2013.

  • The Concord Coalition, "Federal Spending Growth Rates: Going Up By Any Measure"
    In this December 22, 2003 Issue Brief, the Concord Coalition raises concerns over the growth rate in Federal spending. It is argued that this growth rate is not sustainable. It is noted that real federal spending grew by 18% between 2001 and 2003. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • Norbert Michel, "Budget, Deficit, Threatens Economic Freedom"
    In this March 12, 2004 Capitalism Magazine article, Norbert Michel argues that the growth in federal spending makes higher taxes necessary. He raises concerns over the distortionary effect of these taxes on labor supply, investment, and savings decisions. He argues for reductions in both spending and taxes.

  • Tom Nugent, "The Great Budget-Deficit Myth"
    Tom Nugent argues, in this February 12, 2003 National Review Online article, that there is little evidence that the growth in the federal budget deficit has negative economic consequences. He notes that, in recent decades, large deficits have co-existed with relatively high rates of economic growth. Nugent suggests that the crowding-out effect need not occur when government borrowing rises since the increase in government spending results in an economic stimulus that raises incomes and increases the demand for bonds. If bond demand rises by as much as bond supply during such an expansion, interest rates would not rise. He notes that during the 1980s the deficit rose while long-term interest rates declined (he appears to be referring to nominal, rather than real interest rates).

  • Congressional Budget Office, "The Long-term Budget Outlook"
    In this December 2003 study, the Congressional Budget Office provides projections of future budgets under alternative scenarios. The analysis presented in this report indicates that current spending levels cannot be supported in the future without unprecedented tax levels and negative economic consequences.

  • Martin Mühleisen, "Overview: Returning Deficits and the Need for Fiscal Reform"
    This document is an online chapter from the IMF study entitled U.S. Fiscal Policies and Priorities for Long-Run Sustainability, edited by Martin Mühleisen and Christopher Towe. Concerns are raised about the crowding-out effect that may result from the the budget deficit if these trends are not reversed. Mühleisen suggests that spending reforms begin in the immediate future.

  • Stephen Moore, "Putting Taxpayers First: A Federal Budget Plan to Benefit the Next Generation of American Taxpayers"
    Stephen Moore provides a proposal for budget reform in this January 13, 2004 IPI Policy report. He argues that the rapid increase in government spending that has occurred in recent years will have negative effects on economic growth. Moore argues that many government spending programs are inefficient and/or have outlived their usefulness. He suggests that there is a need for more careful evaluation of the effectiveness of government spending programs. Moore notes that government spending increased dramatically during the first term of President George W. Bush. He argues that there is a need for a balanced budget amendment to help restrain wasteful spending.

  • Thomas Laubach, "New Evidence on the Interest Rate Effects of Budget Deficits and Debt"
    In this May 2003 Federal Reserve Board Working Paper, Thomas Laubach investigates the magnitude of the crowding out effect of the government deficit. His estimates suggest that a one percentage-point increase in the projected deficit-to-GDP ratio results in a 0.25 percentage point increase in long-term interest rates. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • Robert E. Rubin, Peter R. Orszag, and Allen Sinai, "Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray"
    Robert E. Rubin, Peter R. Orszag, and Allen Sinai discuss the long-run costs of sustained budget deficits in this January 4, 2004 paper. They argue that the U.S. is on the path to unsustainable deficits. They argue that such deficits have long-run costs beyond the crowding-out effect since they adversely affect expectations and result in a loss of consumer and producer confidence. This will, in turn, result in higher interest rates, a reduction in real wealth, and lower consumption and investment spending. Rubin, Orszag, and Sinai present projections of the budget deficit based on alternative growth rates and alternative policy changes. They argue that substantial reform should be implemented to reduce the long-term projected deficits. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • William G. Gale and Peter Orszag, "The Economic Effects of Long-Term Fiscal Discipline"
    In this April 24, 2003 Urban Institute / Brookings Institution study, William Gale and Peter Orszag examine evidence concerning the economic effect of long-term changes in the budget deficit (or surplus). A summary of the empirical evidence suggests that when the long-term budget deficit increases by 1% of GDP, real interest rates rise by 0.5 to 1.0 percentage points. Gale and Orszag observe that some Republican economists have recently claimed that there is little or no evidence that changes in the deficit have an effect on the interest rate even though their own studies have indicated such an effect. Gale and Orszag suggest that there will be a substantial long-run cost associated with maintaining the tax cuts enacted between 2001 and 2003. They argue that these costs should be taking into account when budgetary policy is formulated. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • February 25, 2004 Testimony of Alan Greenspan
    Alan Greenspan, in this testimony before the House Budget Committee, warns that continued growth in the federal budget deficit will have adverse economic consequences. He argues that running a deficit during the recession and the subsequent slow recovery was a reasonable policy. As the economy continues to expand, however, he argues that there must be more serious effort to restrain spending. He raises particular concerns about the combination of a budget deficit with the coming Social Security shortfalls. Greenspan believes that if steps are not taken to reduce the deficit, government borrowing will crowd out private investment spending, resulting in a slower rate of economic growth.

  • Alan Greenspan, "March 2, 2005 Testimony before the House Budget Committee"
    Alan Greenspan expands upon his concerns over the budget deficit in this March 2, 2005 testimony. He argues that Congress must be willing to make difficult choices over spending priorities and must be willing to restrain spending to substantial crowding out is to be avoided.

  • November 3, 2005 Testimony of Alan Greenspan
    Alan Greenspan reiterates his concerns over the long-run deficit in this November 3, 2005 testimony As the economy continues to expand, however, he argues that there must be more serious effort to restrain spending. He raises particular concerns about the combination of a continuing budget deficit with the coming Social Security shortfalls. Greenspan believes that if steps are not taken to reduce the deficit, unsustainable growth will occur in the budget deficit.

  • Ben Bernanke, "Economic and Financial Developments in 2006"
    In this July 19, 2006 report, Ben Bernanke notes that the federal deficit has been declining. He observes that this "has reduced its drain on national saving." Bernanke expresses concern, though, with the low level of net national savings.

  • Alice M. Rivlin and Isabel V. Sawhill, "Restoring Fiscal Sanity: How to Balance the Budget"
    Alice M. Rivlin and Isabel V. Sawhill edit this January 2004 Brookings Institution collection of studies that analyze the consequences of long-term budget deficits. Suggestions for remedial action are also provided. Social Security, national defense, and other budgetary issues are discussed extensively in the papers included in this collection. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • Brookings Institution, "Do Budget Deficits Matter?"
    This website contains a transcript of a March 11, 2003 Brookings Institution Forum on the budget deficit. Participants in the forum were Alice M Rivlin, Eric M. Engen, William G. Gale, Rudolph G. Penner, and Charles L. Schultze. This forum provide a solid discussion of the economic arguments against large long-term deficits. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • Brian M. Riedl, "Most New Spending Since 2001 Unrelated to the War on Terrorism"
    Brian M. Riedl discusses the sources of growth in federal spending between September 11, 2001 and November 2003. His analysis indicates that 55% of the growth in the federal budget is unrelated to homeland security and military programs. During this time interval, nondefense expenditures rose by 15 percent. Riedl observes that federal spending per household equaled $20,300 in 2003, the highest level of federal spending since World War II.

  • Brian M. Riedl, "$20,000 per Household: The Highest Level of Federal Spending Since World War II"
    Brian M. Riedl, in this December 3, 2003 Heritage Foundation Backgrounder provides a detailed discussion of the rapid growth of federal spending from 2001 to 2003. He notes that in 2003 federal spending per household ($20,300) exceeds federal taxes per household ($16,780) by $3,520. Riedl argues that this must ultimately be paid through higher future taxes.

  • Brian M. Riedl, "Omnibus Spending Bill Hikes Discretionary Spending by 9 Percent in 2004"
    In this December 16. 2003 Heritage Foundation article, Brian M. Riedl discusses the growth in discretionary fiscal spending. He notes that discretionary fiscal spending increased by 13% and 12% in the 2002 and 2003 fiscal years, and is projected to increase by 9% in 2004.

  • Rudolph Penner, "Are Current Budgets More Worrisome Than Those of the 1980s?"
    In this November 2003 Urban Institute report, Rudolph Penner examines the consequences of a large and growing federal budget deficit. He raises concern that there seems to be little political pressure to restrain deficit spending. Penner argues that this rather large increase in the deficit is particularly troubling in light of the large demands that will soon be placed on the Social Security system as the baby-boom generation reaches retirement age. Concerns are raised about the potential crowding-out effect associated with high deficit spending. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • Mike Bradley, "Federal Budget Deficits: Concerns & Realities"
    In this online article, Mike Bradley argues that there is little evidence indicating that the federal budget deficit has generated negative consequences for the U.S. economy. He notes that the deficit has been a substantially higher share of GDP in the past. Bradley argues that there is no evidence indicating that the deficit has resulted in higher interest rates and less private investment spending.

  • J. Bradford DeLong, "The Budget Deficit"
    This January 30, 1998 Federal reserve Bank of San Francisco document provides a nice description of the economic concerns associated with budget deficits. A very nice intuitive discussion of the crowding-out effect is provided in this article.

  • Bruce Bartlett, "Interest Rates, Tax Cuts, and Budget Deficits"
    Bruce Bartlett discusses several studies that analyze the economics effect of the deficit. He argues that recent research casts doubt upon the crowding-out effect of deficit finance.

  • Federal Reserve Bank of St. Louis, "Die another Day? Budget Deficits and Interest Rates"
    This December 12, 2003 Federal Reserve Bank of St. Louis report summarizes research indicating that interest rates are affected by expected growth rates, but are not significantly affected by government budget deficits. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

  • President George W. Bush, "A Blueprint For New Beginnings"
    This February 2001 document summarizes President's Bush's economic plan for the next 10 years. He proposes to use some of the surplus to cut taxes while also raising spending on education and reducing the debt. This document contains a reasonably detailed statement of this plan.

  • The Bush Administration FY 2003 Budget
    While this budget message focuses on the antiterrorist campaign and homeland security, it also discusses a plan to restore a balanced budget by 2005.

  • The Bush Administration FY 2004 Budget
    This budget message continues a focus on the antiterrorist campaign and homeland security. Projections of a balanced budget in the short term are no longer present.

  • The Bush Administration FY 2005 Budget
    This budget message continues an emphasis on national defense and homeland security. Issues of economic security are also addressed. A goal of cutting the deficit in half within 5 years is stated in the President's budget message.

  • The Bush Administration FY 2006 Budget
    This budget message suggests that the deficit will continue to decline in response to economic growth.

  • The Bush Administration FY 2007 Budget
    This budget message suggests again that the deficit is expected to continue to decline in response to economic growth.

  • House Budget Committee (Republican page)
    This page provides information about the Republican viewpoint on the President's budget proposals.

  • House Budget Committee (Democratic page)
    On this page, you will find a Democratic perspective on the budget.

  • House Budget Committee Democrats, "Fuzzy Budget Math and the Facts"
    The House Budget Committee Democrats argue that the Bush tax cut has eliminated the surplus in the federal budget and is cutting into the social security and Medicare Trust Funds. They believe that such a policy is not desirable and contradicts early claims by the Bush administration that only a portion of the surplus would be used to fund tax cuts.

  • Senate Budget Committee (Republican page)
    This page contains information that generally supports Republican plans for tax cuts.

  • The Heritage Foundation, "Research: Federal Budget and Spending"
    On this website, the Heritage Foundation provides links to its online articles and studies dealing with the federal budget deficit. The Heritage Foundation provides a conservative viewpoint concerning the effects of the deficit. A common theme is that the economy would function more efficiently if government spending were restrained.

  • Alison Fraser, "Walker’s Warning: Nation’s Top Accountant Worried About Financial Future"
    Alison Fraser, in this December 21, 2004 online article, describes problems with the federal accounting and budgetary processes. She observes that 10 of 23 federal agencies had deficiencies in their prior year's audit reports. Fraser also notes that the federal government could not account for $24 billion in spending. She argues that the federal government's accounting processes need to be improved so that budgetary decision may be based on accurate information.

  • Brian M. Riedl, "A Budget Agenda for the 109th Congress"
    Brian M. Riedl, in this December 15, 2004 Heritage Foundation Backgrounder, argues that Congress needs to restrain spending if the budget deficit is to be controlled. He notes that federal spending had increased by 23% in 3 years and the first wave of baby-boom workers becomes eligible for retirement in 2008. He argues that reform of the budgetary process is needed to help keep spending in check. Riedl also argues that spending on entitlement programs (particularly Social Security and Medicare) must be reduced.

  • Robert Greenstein, David Kamin, Richard Kogan, and Joel Friedman, "Is Domestic Spending Exploding? An Assessment of Claims by the Heritage Foundation and Others"
    This February 1, 2004 Center on Budget and Policy Priorities document suggests that conservative opponents have overstated the magnitude of the increase in spending during the first administration of George W. Bush. The authors note that while federal spending has increased, spending as a share of GDP is not as large as it was during the years 1975 through 1996. They note that much of the increase was in the areas of national defense and homeland security. Specific concerns are also raised about the methodology used by the Heritage Foundation in creating their "talking points" about the deficit. The authors express concern about the growth in the deficit, but believe that the long-run problems are likely to be the result of tax cuts, not spending increases.

  • Lee Price and Max Sawicki, "The Budget Arithmetic Test: Repairing Federal Fiscal Policy"
    Lee Price and Max Sawicki examine the causes of the growing deficit in this October 13, 2004 EPI briefing paper. They suggest that public discussion of this issue has generally placed to much importance on the costs of an unbalanced budget, overestimated the benefits of tax cuts, and underestimated the benefits from public spending. Price and Sawicki argue that tax increases should be considered and efforts should be made to reduce the rate of growth in health care costs.

  • Alan Reynolds, "Deficits, Interest Rates, and Taxes: Myths and Realities"
    Alan Reynolds discusses the economic impact of budget deficits in this June 29, 2004 Cato Institute article. He argues that empirical evidence does not support the crowding-out arguments generally used by economists. He cites research that suggests that higher marginal tax rates would be likely to reduce economic growth. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

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