Video Transcript: Lesson 32
Okay, continuing along with Unit 11, let's discuss why governments run deficits. It is evident during periods of war the debt is higher, right? So, what underlies this relationship between wars and deficits? War is certainly expensive. Take, for example the conflicts in Iraq and Afghanistan. Congress has already appropriated about a trillion dollars for these wars, and the Congressional Budget Office study projected the conflicts would eventually cost the United States about 2.4 trillion. When the government purchases increase due to a war, a government can either increase taxes to pay for the war or issue government debt. Remember that when the government runs a deficit to pay for a war, it is borrowing from the general public. The government's intertemporal budget constraint reminds us that since government debt is ultimately paid for by taxes in the future, the choice is really between taxing households now or taxing them later. History tells us that deficits have been the method of choice. Governments have chosen to tax future generations to pay for current wars. There are two arguments in favor of this policy: right, fairness. Number one, any gains from winning a war will be shared by future generations. Hence, the cost should be shared as well. The government should finance the war with debt so that the future generations will repay some of the obligations. To take an extreme case, suppose a country is fighting for its right to exist. If it wins the war, future generations will also benefit. Number two, tax smoothing. A good fiscal policy is one where tax rates are relatively constant in the face of a rapid increasing in spending. Each, such as a war, the best policy is one that pays for the spending increase over many periods of time, not just in one year. So taxation is expensive to the economy because it distorts economic decision decisions such as saving and labor supply. The amount people want to work depends on their real wage after taxes. So if tax rates are increased to finance government spending, this reduce reduces the benefit from working. Put differently, increase income taxes increase the price of consumption relative to leisure. So the higher the taxes, the price of consumption is higher because taxes are up and leisure will be less expensive, and I'll be willing to spend my time in leisure versus consumption because the taxes are higher. The fact that people work less when taxes increase is a distortionary effect of taxation. Instead of bunching all of this distortionary taxation into a short amount of time, such as a year, it is more efficient for the government to spread the taxation over many years. This is called tax smoothing. So, by running a budget deficit, the government imposes relatively small distortions over many years, rather than imposing a large distortion over a single year. So, they want to spread out that obligation, pay it back over time, and make it less expensive year over year, even though it may be paid back in a longer period of time, 30 to 50 years. Similar arguments apply to other cases in which governments engage in substantial spending. Imagine that the government is considering putting a large amount of resources into cancer research. The discovery of a successful cancer treatment would, of
course, benefit many citizens in that generation. Because households would share the gains in the future, the cost should be shared as well. By running a deficit, the government is able to distribute the costs across generations of citizens in parallel with the benefits from the perspective of both fairness and efficiency, there are some gains to deficit spending. Now, more generally, we might want to make a distinction among different types of government purchases, just as we do among private purchases. We know that the national accounts distinguish consumption purchases. Speaking broadly here, things from which we get short-run benefits such as food or movies, etc. From investment purchases, things that bring long-term benefits such as factories and machinery. So we have to make a decision on what are we spending this money on, and how will the effects be felt most broadly and efficiently. Likewise, we might want to distinguish between government consumption, such as wages of employees at the Department of Motor Vehicles, from government investment, such as spending on cancer research. We could then argue that it makes more sense to borrow to finance government investment rather than government. Consumption. We want the government to be able to use the cash wisely, and we would rather them invest back into the social fabric than have them continue to consume our tax dollars, bloating the bureaucracy inside the government. Although a very nice idea and principle. This approach to the government accounts often founders on the practicalities of the politics of implementation. First, it is not at all clear how to classify many government expenditures. Was a launch of the space shuttle consumption or investment? What about the wages of teachers in the public schools? What about the money spent on national parks? Second, politicians would have a strong incentive to classify expenditures as investment rather than consumption, just to defer the payment. Another benefit of deficits is that they can play a role in economic stabilization. In the short run, the level of economic activity can deviate from the potential GDP. As a consequence, aggregate expenditures play a role in determining the level of output. Fiscal policy influences the level of aggregate expenditures. Changes in government purchases directly affect aggregate expenditures because they are a component of spending, and changes in taxes indirectly affect aggregate demand throughout the effect of consumption; therefore, deficit spending can help stabilize the economy. The more we have, the more cash we have out there, the more that they run a deficit and able to redistribute that revenue back into the economy can potentially give individual households the capacity to consume more, and therefore through a deficit, they are able to spur the economy and make it make it grow that way too. So there's varying policies and principles on how to run government deficits, and it's basically on the opinion of. In summary, there are several arguments for allowing governments to run deficits. We would foresee these benefits if we were able to adopt a balanced budget amendment. One of the arguments for deficits is funding wars.
This is an explicit exception, and the only such exception written in the bill that we discussed earlier, but we conclude by noting that there is a further, much less benign reason for government deficits. They may benefit politicians even if they do not benefit the country as a whole. Deficits allow politicians to provide benefits to constituents today and leave the bill to future generations. If politicians and voters care more about current benefits than future costs, then they have a strong incentive to incur large deficits and let future generations worry about the consequences. To me, that seems unfair, but that's how governments at times choose to run their finances, so we're kind of subjected to the policies of whoever is controlling the purse at the time inside the government.