Chapter4Solutions

Solutions and Activities to CHAPTER 4 TOOLS OF BUDGET ANALYSIS Questions and Problems 1. We say that a variable is cyclical if it increases with economic booms and declines with economic recessions. We say that a variable is countercyclical if the opposite is true. Which elements of the U.S. federal budget are cyclical and which are counter- cyclical? (To get a sense of the main elements of the budget, visit www.whitehouse. gov/omb/budget/fy2004/pdf/hist.pdf, Tables 2 (for revenues) and 3 (for expenditures). For fun, you could also check out Nathan Newman and Anders Schneiderman’s Na- tional Budget Simulator at www.budgetsim.org/nbs/shortbudget04.html, where you can experiment with what might happen to the federal budget under various taxation and spending scenarios. Cyclical revenue categories include the personal income tax and the corporate income tax, both of which tend to move with the economy: during a downturn, individuals and cor- porations will have lower tax burdens, and during boom times their tax burdens will in- crease. Revenue from excise and other taxes on consumption (such as import taxes and gift taxes) will also increase during particularly prosperous (high-consumption) times and de- crease during downturns in the economy. One main expenditure category that is countercyclical is human services, which includes some income-support payments. During a recession, as more people are unemployed, these payments are likely to increase. Payments to bail out struggling companies or to honor in- surance commitments (Federal Depository Insurance for banks, for example) will also tend to increase during bad economic times. 2. How have the major federal laws to promote balanced budgets lost their effectiveness over time? It is difficult to comply with balanced budget rules, and policy makers have been cre- ative in their efforts to skirt them. Exceptions for “emergencies” have been broadly inter- preted. All budgeting processes rely on estimates about future events, and those estimates are likely to vary. Policy makers can choose to rely on optimistic forecasts in order to ap- pear to have a balanced budget. This is particularly problematic in states that have ex ante, or before-the-fact, balanced budget rules. If a budget must really balance even in hindsight (ex post), some of this rosy-picture bias can be avoided. Another problem is that predictions about future policies are not binding. A budget that assumes policy changes many years in the future can appear to be balanced today, but future policy makers may change or negate those assumptions. 3. Suggest one way in which generational imbalances might be understated, and one way in which they might be overstated. Calculated generational imbalances suggest that our current deficit will be balanced on the backs of future generations, to their detriment. These imbalances might be understated, Copyright © Worth Publishers 1 Jonathan Gruber / Finance and Public Policy in which case they will be even worse than anticipated for the next generation, if assump- tions about continued growth are too optimistic; if the actual interest rate is less than the as- sumed rate of 3.6%; or if future policies entail higher expenditures than anticipated. The imbalances might be overstated if assumptions about continued growth are too pes- simistic; if the actual interest rate is greater than the assumed rate; if the quality of life of fu- ture generations (possibly including their economic productivity) is enhanced by expenditures made today; or if demographic shifts or policy changes result in lower expen- ditures than anticipated. 4. What is the intuition behind the notion of Ricardian equivalence? How might you look for evidence to test the suggestion that people account for future generations’ tax burdens by saving more today? According to the theory of Ricardian equivalence, when there is a deficit, the current generation realizes it is paying less in taxes than is being spent by the government, and that will result in a heavier tax burden on future generations. To reduce this intergenerational in- equity, the generation that benefits from deficit spending saves enough that their children in- herit the means to pay higher taxes later. If this theory were accurate, increased private savings would offset increased government borrowing. To investigate whether private sav- ings increase at times of high budget deficits, you could look at changes in savings rates over time, and check to see if savings increase when (or shortly after) higher deficits are in- curred. 5. From 1962 to 1965, federal spending on non-defense-related education and training rose from $9.6 billion to $19.5 billion, while from 2001 to 2004, it rose from $178.4 bil- lion to $217.5 billion. Given that the Consumer Price Index (in January) was 30.0 in 1962, 31.2 in 1965, 175.1 in 2001, and 185.2 in 2004, which period saw the larger in- crease in education and training spending? Despite the large nominal numbers in the early part of this millennium, the real increase during the 1960s was greater, as illustrated in the accompanying table: 6. Why does the Congressional Budget Office construct a cyclically adjusted budget deficit for the purposes of monitoring federal income and outlays? A number of factors can cause short-run fluctuations in tax collections and expenditures; for example, an economic downturn can temporarily reduce tax collections while increasing expenditures on income-support programs. These fluctuations have only short-term effects on the budget, however, and, given the nature of business cycles, they will be offset by eco- nomic growth cycles, when tax revenues are temporarily high and social expenditures low. Removing these ups and downs from the deficit calculation provides a better long-term pic- ture of revenues and expenditures. 7. What is the distinction between cash and capital assets? What are the arguments for treating them differently in public budgeting? What are the arguments against doing so? Cash assets are nondurable goods that yield immediate benefits, while capital assets are durable goods that are expected to yield a stream of benefits over a longer time period. Cash CHAPTER 4 / Tools of Budget Analysis - 2 - Copyright © Worth Publishers Jonathan Gruber / Finance and Public Policy 1962 1965 Difference 2002 2004 Difference Nominal $9.6b $19.5b $9.9b $178.4b $217.5b $39.1b CPI 30.0 31.2 175.1 185.2 Real (divide by CPI) $3.2m $5.25m $3.05m $10.2m $11.74m $1.54m e accounting is appropriate for nondurable goods because it does not take into account the benefits that accrue over time, nor does it allow for the depreciation of the items acquired. Treating the two types of assets differently in public budgeting allows explicit accounting for the time horizon over which benefits will accrue. When done correctly, capital account- ing can more accurately reflect the value of the things that government buys and builds. On the other hand, cash accounting is more transparent and so offers fewer opportunities for creative accounting. 8. Why is it important to use the present discounted value of future revenues or expendi- tures when making public budgeting or investment decisions? Financial institutions pay their depositors interest and consumers pay their credit card is- suers interest because having money now is worth more than having the same amount of money sometime in the future. The same is true of the government: revenues that are col- lected in the future are not worth as much as the same amount of money today; similarly, the money for expenses that are not incurred today can earn interest until the time it is actu- ally spent. Discounting future revenues and expenditures to their present value takes this into account. 9. Table 4-1 shows the remarkable difference across generations in their likely net tax payments to the federal government. What is responsible for these large intergenera- tional differences? The generational accounting used to generate Table 4-1 assumes that our current deficit will be paid for by future generations. Specifically, this accounting sets current plus future tax payments equal to the current debt plus future government consumption. Future tax pay- ments will need to be sufficient to pay off the current deficit as well as to pay for the com- mitments the government has made to the current generation, including the commitment to make Social Security and Medicare payments when that generation retires. The baby boom generation will require high government expenditures when they retire. Those commitments plus current deficit spending (which benefits the current generation) mean that future tax payments will have to be high to keep this account in balance. Thus the tax burden of future generations will be greater than the benefits they are predicted to receive. 10. Is it necessarily inequitable for future generations to face higher taxes as a result of benefits that accrue to those living today? Explain. There are some reasons why the apparent intergenerational inequity might not be as bad as it seems. First, many of the expenditures made today will yield benefits far into the fu- ture. Because future generations will benefit from these current expenditures, it is not unrea- sonable to ask them to shoulder some of the costs. Second, the historical trend is for future generations to live better lives (measured on some dimensions) than their parents’ genera- tion. Technological advances constantly improve productivity and increase real incomes. Therefore, future generations may be better able to shoulder this debt than is the current generation. 11. Table 6.1 from the 2004 federal budget’s historical tables (www.whitehouse.gov/omb/ budget/fy2004/pdf/hist.pdf) shows how the main categories of federal outlays have changed from 1940 to 2008 (projected). Where have the biggest changes over time oc- curred? Where are the biggest changes from 2004 to 2008 projected to occur? The budget totals have increased enormously; outlays as a percent of GDP have in- creased by less (from approximately 10% immediately preceding World War II, to a high of 43.7% five years later in 1944, to approximately 20% in recent decades). Defense spending was very high during and immediately following World War II: in 1945 almost 90% of fed- eral outlays were for defense. Briefly during the mid-1950s defense spending accounted for CHAPTER 4 / Tools of Budget Analysis - 3 - Copyright © Worth Publishers Jonathan Gruber / Finance and Public Policy more than 50% of all federal outlays. By the mid-1990s that percentage had fallen to less than 20% of total outlays, where it remains today. Interest payments increased until 2000, then fell briefly. They are now back on the rise, and are expected to increase from 2004 to 2008. Grants to state and local governments have also increased and are also predicted to in- crease further. Payments to individuals, both indirectly in the form of grants to state and local governments and directly, have accounted for an increasing share of the federal budget: in 1940 only 17.5% of the budget went to these items; that share fell to as low as 2% during World War II, then increased and remained in the 20–30% range from the late 1940s until the early 1970s (with a brief dip during the Korean War). In the 1970s payments to individuals surpassed defense expenditures and, as a share of the budget, have increased to more than 60% of outlays. By 2008, this category is predicted to represent 63.1% of the budget. It is difficult to compare numbers over such a long period of time that vary so much in magnitude. Comparing the distribution of outlays can make it somewhat easier to see how some categories fare relative to others. 12. Consider a one-year project that costs $300,000, provides an income of $70,000 a year for five years, and costs $30,000 to dispose of at the very end of the fifth year. As- sume that the first payment comes at the start of the year after the project is under- taken. Should the project be undertaken at a 0% discount rate? How about 2%? 5%? 10%? To answer these questions, calculate the present discounted value as P/(1 + r)t where P is the dollar value, r is the discount rate, and t is the number of years until it is realized. Enter costs as negative numbers. This formula yields the following calculations: Only when the flow of benefits is not discounted at all and when it is discounted at the low rate of 2% does this project make economic sense. When the stream of benefits faces a higher discount rate (5% and 10%) the project is no longer economically justified. Note: The icon indicates a question that requires students to apply the empirical economics principles discussed in Chapter 3 and the Empirical Evidence boxes. CHAPTER 4 / Tools of Budget Analysis - 4 - Copyright © Worth Publishers Jonathan Gruber / Finance and Public Policy r = 0% r = 2% r = 5% r = 10% Initial Cost –$300,000 –$300,000 –$300,000 –$300,000 Disposal Cost –30,000 –27,171.92 –23,505.78 –18,627.64 Benefit, year 1 +70,000 +68,627.45 +66,666.67 +63,636.36 Benefit, year 2 +70,000 +67,281.81 +63,492.06 +57,851.24 Benefit, year 3 +70,000 +65,962.56 +60,468.63 +52,592.04 Benefit, year 4 +70,000 +64,669.18 +57,589.17 +47,810.94 Benefit, year 5 +70,000 +63,401.16 +54,846.83 +43,464.49 Net Benefits $20,000 $2,771.26 –$20,441.37 –$53,271.47 e Advanced Questions 13. Several public interest watchdog groups point out “pork” in the federal budget— spending that they claim would have little or no national benefit but would benefit a small number of people in a geographically concentrated area. Why are these types of spending more likely to occur in the federal budgeting process than they would if they were each voted on individually? Possible explanations include the following: It is easier to “hide” pork in large, multi-issue bills, where relatively small items may escape scrutiny. These bills might contain a bit of pork for everyone, encouraging “logrolling” among representatives who have a very strong interest in benefiting their local constituents and see expenditures in other districts as having a minimal negative impact on the budget as a whole. Special interest groups and lobbyists may push hard for their own pieces of the pork, while there is often little organized opposition to these items. 14. How do you think population growth affects the degree of “generational balance” in government finance? Relying on a growing population to pay off current imbalances is like a pyramid scheme. A smaller early generation can run up a big bill for government services with the expectation that the burden will be spread among more people in the generation that fol- lows. If this growth slows or stops, though, the imbalance will worsen as fewer and fewer people try to pay off the debts of prior generations. 15. How might large federal deficits affect future economic growth? How would your an- swer change if foreign confidence in the ability of the United States to repay its debts erodes? Deficits compete with private borrowing for loanable funds. When the government bor- rows more money, fewer funds are available for private investment. Private investors may not be able to get the capital they need, or may have to pay a higher rate of interest to obtain those funds (because government demand has bid up rates). This will tend to curtail invest- ment in assets that improve economic productivity. This is the basic theory of crowding out. However, if those higher interest rates attract more savings (because savers earn a higher re- turn on their savings), then both types of borrowers will be able to obtain funds, but at a higher interest rate. This market equilibration works best when there are many potential in- vestors, domestically and internationally. If international investors/savers lose faith in the United States’ ability to repay its debt, then the number of investors will be reduced. As the supply of loanable funds shrinks, interest rates will climb higher and private investment will again be crowded out. 16. What is meant by dynamic scoring of the budget? Why does dynamic scoring poten- tially lead to more realistic estimates of the “true” effective size of a budget deficit? What are some methodological issues involved in dynamic scoring? (Note that you can read more about dynamic budget scoring in the Council of Economic Advisers’ Economic Report of the President. In 2004, this was found in Chapter 5. The Council of Economic Advisers’ Web site is www.whitehouse.gov/cea, and at the time of this writing the Economic Report of the President could be found at www.gpoaccess.gov/ eop/index.html.) Dynamic scoring allows budget predictions to incorporate changes in the economy in re- sponse to policy. Tax increases and tax cuts have direct effects on revenue collections, and they also have indirect effects on collections because they can affect economic growth. For CHAPTER 4 / Tools of Budget Analysis - 5 - Copyright © Worth Publishers Jonathan Gruber / Finance and Public Policy example, some argue that a tax cut will actually increase tax revenue because workers will have an incentive to work more when they are taxed less. If done correctly, dynamic scoring can improve estimates by accounting for ripple effects of policy changes. Most people agree that policy changes do not happen in a vacuum; when one aspect of the economy changes, other variables change in response. However, the magnitude of those changes is not pre- cisely known, so predictions can vary. This might encourage policy makers to overstate or understate the effects of a policy. 17. You are trying to decide which of two projects (if any) to undertake. Project A would cost $1 million immediately and would provide benefits of $500,000 per year for the next five years. Project B would cost $1.5 million immediately and would provide ben- efits of $500,000 per year for three years and $1 million per year in years four and five. Under which range of discount rates would you prefer to undertake project A over project B? Under which range of discount rates would you prefer to undertake project B over project A? Under which range of discount rates would you choose to under- take neither project? Project A returns benefits of $500,000 each year for five years and has a lower immedi- ate cost (by $500,000); project B has the same stream of benefits for the first three years, but returns $1 million in benefits in the fourth and fifth years. At a discount rate of 20%, project A returns higher net benefits. When the interest rate is greater than approximately 16.75%, project A’s net benefits just exceed those of project B. At a discount rate of 10%, project B is preferred. Project B will be preferred when the PDV of the higher future benefit exceeds the $500,000 higher initial cost. A lower discount rate yields a higher PDV of future benefits, so project B will be preferred at lower discount rates. At interest rates greater than 30%, project B will return negative net benefits; at interest rates greater than 40%, even project A will return negative net benefits. See the following table. CHAPTER 4 / Tools of Budget Analysis - 6 - Copyright © Worth Publishers Jonathan Gruber / Finance and Public Policy Project A No discounting Year PDV at 10% PDV at 15% PDV at 20% PDV at 16.75% PDV at 31% PDV at 41% Discount factor 1.1 1.15 1.2 1.1675 1.31 1.41 Current cost –$1,000,000 –$1,000,000 –$1,000,000 –$1,000,000 –$1,000,000 –$1,000,000 –$1,000,000 Benefits, year 1 500,000.00 1 454,545.45 434,782.61 416,666.67 428,265.52 381,679.39 354,609.93 Benefits, year 2 500,000.00 2 413,223.14 378,071.83 347,222.22 366,822.72 291,358.31 251,496.40 Benefits, year 3 500,000.00 3 375,657.40 328,758.12 289,351.85 314,195.05 222,410.93 178,366.24 Benefits, year 4 500,000.00 4 341,506.73 285,876