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Gross Domestic Product

Ratio of Public Debt to

War II
Tax cuts
1993 Budget
0.50 2001“2003
World Tax cuts
War I
and Economic Report of the President.


1915 1925 1935 1945 1955 1965 1975 1985 1995 2007

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Chapter 15 305
Budget Deficits in the Short and Long Run

At that point, the government took decisive actions to reduce the budget deficit. The
ratio of debt to GDP then fell for years. But President Bush™s large tax cuts reversed the
trend for a few years after 2001. Lately, the ratio of debt to GDP has been falling mod-
estly again.

We have observed that the federal government ran extremely large budget deficits from the
early 1980s until the mid 1990s, and then again for a few years in this decade. As Figure 4
shows, the budget deficit ballooned from $79 billion in fiscal year 1981 to $208 billion by
fiscal year 1983”setting a record that was subsequently eclipsed several times. As late as
fiscal year 1995, the deficit was still $164 billion. These are enormous, even mind-boggling,
numbers. But what do they mean? How should we interpret them?

The Structural Deficit or Surplus
First, it is important to understand that the same fiscal program can lead to a deficit or a
surplus, depending on the state of the economy. Failure to appreciate this point has led
many people to assume that a larger deficit always signifies a more expansionary fiscal
policy”which is not the case.
Think, for example, about what happens to the budget during a recession. As GDP
falls, the government™s major sources of tax revenue”income taxes, corporate taxes, and
payroll taxes”all shrink because firms and people pay lower taxes when they earn less.
Similarly, some types of government spending, notably transfer payments such as unem-
ployment benefits, rise when GDP falls because more people are out of work. Recall that
the deficit is the difference between government expenditures, which are either purchases
or transfer payments, and tax receipts:
Deficit 5 G 1 Transfers 2 Taxes 5 G 2 (Taxes 2 Transfers) 5 G 2 T

F I GU R E 4
SOURCE: Economic Report of the President (Washington, D.C.: U.S. Government Printing Office; 2008).

Official Fiscal-Year
Budget Deficits,




Federal Budget Deficit

™98 ™99 ™00 ™01
™81 ™82 ™83 ™84 ™85 ™86 ™87 ™88 ™89 ™90 ™91 ™92 ™93 ™94 ™95 ™96 ™97 ™02 ™03 ™04 ™05 ™06 ™07
“50 Fiscal Year


“150 Surpluses





NOTE: Amounts are in billions of dollars.

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Licensed to:
Part 3
306 Fiscal and Monetary Policy

Because a falling GDP leads to higher transfer
payments and lower tax receipts,
The deficit rises in a recession and falls in a
Spending and Tax Receipts

T = Taxes “ Transfers boom, even with no change in fiscal policy.
Figure 5 depicts this relationship between
GDP and the budget deficit. The government™s
fiscal program is summarized by the blue and
brick-colored lines. The horizontal blue line la-
beled G indicates that federal purchases of
goods and services are approximately unaf-
fected by GDP. The rising brick-colored line la-
beled T (for taxes minus transfers) indicates
that taxes rise and transfer payments fall as
Y1 Y2 Y3 GDP rises. Notice that the same fiscal policy
Gross Domestic Product (that is, the same two lines) leads to a large
deficit if GDP is Y1, a balanced budget if GDP
F I GU R E 5 is Y2, or a surplus if GDP is as high as Y3. Clearly, the deficit itself is not a good measure of
The Effect of the the government™s fiscal policy.
Economy on the Budget
To seek a better measure, economists pay more attention to what is called the structural
budget deficit or surplus. This hypothetical measure replaces both the spending and
The structural budget
taxes in the actual budget by estimates of how much the government would be spending
deficit or surplus is the
and receiving, given current tax rates and expenditure rules, if the economy were
hypothetical deficit or sur-
operating at some fixed, high-employment level. For example, if the high-employment
plus we would have under
benchmark in Figure 5 was Y2, although actual GDP was only Y1, the structural deficit
current fiscal policies if the
economy were operating would be zero even though the actual deficit would be AB.
near full employment. Because it is based on the spending and taxing the government would be doing at some
fixed level of GDP, rather than on actual expenditures and receipts, the structural deficit
does not depend on the state of the economy. It changes only when policy changes, not
when GDP changes. For that reason, most economists view it as a better measure of the
thrust of fiscal policy than the actual deficit.
This new concept helps us understand the changing nature of the large budget deficits of
the 1980s, the stunning turn to surpluses in the late 1990s, and the rapid swing back to large
deficits since 2001. The first two columns of data in Table 1 show both the actual surplus and
the structural surplus every other year since 1981. (Most of the numbers are negative, indi-
cating deficits.) Because of recessions in 1983 and 1991, the actual deficit was far larger than
the structural deficit in those years. But the difference between the two was negligible in
1987 and small in 1995, when the economy was near full em-
ployment, and then changed sign (the structural deficit was
larger than the actual deficit) in 1997“2001). By 2007, the two
Alternative Budget Concepts, 1981“2007
measures were quite close again.
Total Structural On-Budget Off-Budget Four interesting facts stand out when we compare the numbers
Fiscal Surplus Surplus Surplus Surplus in the first and second columns. First, even though the official
Year (1) (2) (3) (4)
deficit was smaller in fiscal 1995 than in fiscal 1983, the structural
1981 279 217 274 25 deficit was larger in 1995”despite years of budget “stringency.”
1983 0
2208 2112 2208 Second, the structural deficit rose between 1989 and 1993. It was
1985 2212 2179 2222 110
this trend toward larger structural deficits that alarmed keen
1987 2150 2156 2168 118
students of the federal budget. Third, the stunning $381 billion
SOURCE: Congressional Budget Office

1989 2153 2117 2205 152
swing in the budget deficit from 1993 to 1999 (from a deficit of
1991 2269 2150 2321 152
1993 2255 2193 2300 145 $255 billion to a surplus of $126 billion) far exceeds the change in
1995 2164 2146 2226 162 the structural deficit, which fell by “only” $192 billion. This last
1997 222 280 2103 181
number, which is still impressive, is a better indicator of how
1999 1126 21 12 1124
much fiscal policy changed during the period. Fourth, the swing
2001 1128 1105 232 1160
from a moderate-sized structural surplus in 2001 to a large struc-
2003 2378 2276 2538 1160
2005 2318 2237 2494 1176 tural deficit in 2003 was both rapid and huge”$381 billion in just
2007 2162 2166 2344 1182 two years. Fortunately, both the actual and the structural deficit
have come down dramatically since then.
NOTE: Amounts in billions of dollars.

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Chapter 15 307
Budget Deficits in the Short and Long Run

On-Budget versus Off-Budget Surpluses
When you read about the budget in the newspapers, you may see references to the
“off-budget” surplus or deficit and the “on-budget” surplus or deficit. What do those
terms mean?
Because Social Security benefits are financed by an earmarked revenue source”the
payroll tax”Social Security and a few minor items have traditionally been segregated in
the federal fiscal accounts. Specifically, both Social Security expenditures and the payroll
tax receipts that finance them are treated as off-budget items, whereas most other expen-
ditures and receipts are classified as on-budget. Thus:
Overall budget deficit 5 Off-budget deficit 1 On-budget deficit
Because the Social Security System has been running sizable surpluses in recent years,
the difference between the overall and on-budget deficits has been substantial. For exam-
ple, in fiscal year 2007, the overall budget showed a $162 billion deficit (column 1). But this
was composed of a whopping $344 billion on-budget deficit (column 3) less a $182 billion
Social Security surplus (column 4). Some people claim that such a large discrepancy must
mean that the Social Security surplus is “hiding” the “true” deficit. That™s a matter of se-
mantics. Nothing is really hidden; the facts are as given in Table 1. But you need to inter-
pret the facts correctly. If you are interested in knowing how much the federal government
must borrow each year, the total deficit (column 1) gives the number you want.

Conclusion: What Happened after 1981?
Table 1 helps us understand the remarkable ups and downs of the federal budget deficit
since the early 1980s. Column 1 shows the overall surplus (if positive) or deficit (if nega-
tive) every other year from 1981 to 2007, and column 2 shows the corresponding structural


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