Deficits and the case for balance
Mankiw's three fiscal debates: spending or tax cuts in recessions, balancing the budget, and taxing to encourage saving, with each side's case.
FinanceThe economy behind your investmentsAbout 7 min: 4 reading, 3 practiceUpdated
General education, not financial advice.
- Set out the case for fighting recessions with spending and with tax cuts
- Weigh the arguments for and against balancing the budget
- Explain the debate over reforming taxes to encourage saving
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The economy behind your investments: lesson 12 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 23
What it is
The other three of Mankiw's six debates concern fiscal policy. As before, these are the sides' arguments as he sets them out, not this site's view.
1. Fight recessions with spending increases or tax cuts?
- Spending: since Keynes, economists have seen recessions as a shortage of aggregate demand. Monetary policy is the first line of defence, but in 2008–2009 the Fed cut its target rate to almost zero and could go no lower. Government purchases add directly to demand, so each dollar of spending raises demand by more than an equal tax cut, some of which households save.
- Tax cuts: tax cuts raise demand and can also raise supply, by improving incentives to work and invest. Tax cuts under Presidents Kennedy (passed 1964) and Reagan (1981) were followed by strong growth. Spending financed by borrowing means higher future taxes, which people may anticipate by spending less now; and quickly chosen spending projects may be wasteful.
2. Should the government balance its budget?
For: In Mankiw's figures, US federal debt rose from 710 billion dollars in 1980 to 7.6 trillion in 2009, about 25,000 dollars per person. Debt shifts the bill to future taxpayers. Deficits also reduce national saving, raise interest rates and crowd out investment, leaving future generations with less capital and lower incomes. Deficits make sense in wars and recessions, but not otherwise.
Against: The burden is often exaggerated. A person earning 50,000 dollars a year for 40 years earns 2 million over a lifetime, so a 25,000 share of the debt is about 1% of lifetime resources. A deficit should be judged alongside the rest of fiscal policy: cutting education to balance the budget could leave future generations worse off. Other policies, such as raising pension benefits financed by higher payroll taxes, also shift income between generations without adding to the debt. And debt should be judged against national income: as long as it grows more slowly than income, it can keep growing without limit.
Quick check
Tap an answer to check it.
A person earns 40,000 a year for 40 years, and their share of the national debt is 32,000. What share of their lifetime income is this?
- That compares the debt with one year's income
- Lifetime income is 1.6 million; 32,000 is 2% of it
Show answer
2%. 32,000 ÷ (40,000 × 40) = 32,000 ÷ 1,600,000 = 2%.
Why it matters
3. Should taxes be reformed to encourage saving?
For: Saving finances investment, which raises productivity and incomes, and people respond to incentives. But taxes on interest and dividends reduce the reward for saving. Mankiw's example: 1,000 dollars saved at 25 and invested at 10% for 45 years grows to about 72,900 without tax; with a 40% tax on interest, the after-tax return is 6%, and it grows to only about 13,800, about 80% less. Some capital income is taxed twice (once as company profit, again as dividends). Many economists favour a consumption tax, under which saved income is not taxed until it is spent.
Against: Tax policy should also be fair. Higher-income households save more, so tax breaks for saving mostly favour the rich and may shift the burden to the poor. It isn't even clear such breaks raise saving: a higher return makes saving more rewarding (the substitution effect) but also means people need to save less to reach a goal (the income effect), and some studies suggest the two roughly cancel. A more direct way to raise national saving is to raise public saving by cutting the budget deficit.
Mankiw closes by warning that policies promising benefits with no costs deserve suspicion.
Worked example
Checking Mankiw's saving figures with compound interest:
- Without tax: 1,000 × 1.10⁴⁵ ≈ 72,900.
- With a 40% tax on interest, the after-tax rate is 10% × 0.6 = 6%: 1,000 × 1.06⁴⁵ ≈ 13,800.
- Reduction: 1 − 13,800 ÷ 72,900 ≈ 81%, "about 80%".
A 40% tax on each year's interest removes about four-fifths of the final gain, because it reduces the return that compounds every year.
Common mistake
Taking the size of the national debt alone as proof of a problem, or dismissing it entirely. Both sides in Mankiw's debate look at more than the headline number: what the borrowing paid for, how the debt compares with income, and who bears the cost.
Key terms
- budget deficit
- government spending greater than tax revenue
- government debt
- the total of past borrowing not yet repaid
- consumption tax
- a tax on spending rather than income, so saved income is not taxed until spent
- substitution effect
- here, a higher return makes saving more rewarding, encouraging it
- income effect
- here, a higher return means less saving is needed to reach a goal, discouraging it
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| budget deficit | government spending greater than tax revenue |
| government debt | the total of past borrowing not yet repaid |
| consumption tax | a tax on spending rather than income, so saved income is not taxed until spent |
| substitution effect | here, a higher return makes saving more rewarding, encouraging it |
| income effect | here, a higher return means less saving is needed to reach a goal, discouraging it |
Practice
Work it through
Using Mankiw's US figures for 2009: federal debt of 7.6 trillion dollars, about 25,000 per person.
- 7,600,000 ÷ 25,000 = 304 million (approximately)
- 25,000 ÷ 2,000,000 × 100
Quick quiz
Tap an answer to check it.
Why do supporters of spending say it is more powerful than an equal tax cut?
- Tax cuts raise demand, but less directly
Show answer
Spending adds directly to demand, while households save part of a tax cut. The first round of a tax cut is partly saved.
Why might a tax break for saving not raise saving, according to its critics?
- People do save; the question is whether they save more
Show answer
The income effect may offset the substitution effect. A higher return means less saving is needed to reach a goal.
On which occasions does the case for balancing the budget, in Mankiw's account, accept deficits?
- Mankiw's examples are war and recession
Show answer
In wars and recessions. Borrowing spreads temporary costs over time.
Sort it
Which group does this belong to?
Debt shifts the bill to future taxpayers
The burden on future generationsShow answer
For a balanced budget. The burden on future generations
A person's share of the debt is about 1% of lifetime income
The burden is smallShow answer
Against a balanced budget. The burden is small
Deficits crowd out investment
Less capital for the futureShow answer
For a balanced budget. Less capital for the future
Cutting education to balance the budget could hurt future generations
Look at the whole of fiscal policyShow answer
Against a balanced budget. Look at the whole of fiscal policy
In short
- Spending or tax cuts? Spending works directly on demand; tax cuts also improve incentives and supply.
- Balance the budget? For: debt burdens the future and crowds out investment. Against: the burden is small relative to lifetime income; look at the whole of fiscal policy.
- Tax reform for saving? For: taxes heavily reduce the reward for saving. Against: favours the rich and may not raise saving.
- Be wary of proposals that sound too good to be true.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
In Mankiw's example, what does 1,000 dollars saved at 10% for 45 years become, before and after a 40% tax on interest?
Show answer
About 72,900 before tax and about 13,800 after.
What is a consumption tax?
Show answer
A tax on spending, so income that is saved isn't taxed until it is spent.
How much was US federal debt in 1980 and 2009, in Mankiw's figures?
Show answer
710 billion dollars in 1980 and 7.6 trillion in 2009.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 23.
- On this site: Fiscal policy and the multiplier and Rules or discretion.
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