Do Deficits Matter?

Do Deficits Matter?

by Daniel Shaviro


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Do deficits matter? Yes and no, says Daniel Shaviro in this political and economic study. Yes, because fiscal policy affects generational distribution, national saving, and the level of government spending. And no, because the deficit is an inaccurate measure with little economic content. This book provides an invaluable guide for anyone wanting to know exactly what is at stake for Americans in this ongoing debate.

"[An] excellent, comprehensive, and illuminating book. Its analysis, deftly integrating considerations of economics, law, politics, and philosophy, brings the issues of 'balanced budgets,' national saving, and intergenerational equity out of the area of religious crusades and into an arena of reason. . . . A magnificent, judicious, and balanced treatment. It should be read and studied not just by specialists in fiscal policy but by all those in the economic and political community."—Robert Eisner, Journal of Economic Literature

"Shaviro's history, economics, and political analysis are right on the mark. For all readers."—Library Journal

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Product Details

ISBN-13: 9780226751139
Publisher: University of Chicago Press
Publication date: 11/22/1999
Edition description: 1
Pages: 345
Product dimensions: 6.00(w) x 9.00(h) x 0.80(d)
Lexile: 1550L (what's this?)

About the Author

Daniel Shaviro is a professor of law at New York University Law School. He is the author of Making Sense of Social Security Reform and Do Deficits Matter?, both published by the University of Chicago Press.

Read an Excerpt

Do Deficits Matter?

By Daniel Shaviro

University of Chicago Press

Copyright © 2003

University of Chicago
All right reserved.

ISBN: 0-226-75112-0

Chapter One

Few topics in American politics are more discussed and less understood than the
federal budget deficit. We frequently hear that deficit reduction is vital to
our prosperity, but we rarely hear why this might be so. The deficit is blamed
for all manner of economic ills, ranging from high interest rates to
unemployment to the trade deficit to the low rate of national saving to low
productivity growth-whichever seems most crucial at the moment-but little
attention is paid to why it might have any of these effects.

The near unanimity in public discourse about the evil of deficits might seem to
suggest that economists are similarly unanimous. In fact, however, they disagree
fundamentally about whether deficits matter, and, if so, then why. They have
been debating these issues for more than two centuries, with consensus
occasionally emerging but not persisting. Over the past twenty-five years, the
deficit debate among economists has grown increasingly discordant, reflecting
the issue's increased prominence, the growing size of reported deficits, and the
collapse of 1960s Keynesianism.

Despite the scope and intensity of this debate, no one has ever published a
serious,comprehensive study of budget deficits' economic and political
significance. Economists generally do not focus on more than one or two of the
main issues that we will see deficits pose, nor do they explore the
relationships between the issues. They also mainly ignore the question of how
deficits affect the level of federal spending, although this is a key part of
the national political debate. Moreover, their work is often marred by
partisanship of the Left or the Right, or by the impulse to stake out a public
stance like a campaigning politician-often as the foundation of one's academic
career-and then to stick to it at all costs, ignoring or disparaging all
contrary arguments and evidence.

For the first time in two centuries of deficit debate, this book unifies the
varied strands of the economic and political science literature, and draws
definite, balanced, and inter-related conclusions regarding all of the main
issues that budget deficits present. The journey has many stages, and will take
us in a number of different directions. I therefore offer the following summary
of my analysis and conclusions.

1) Purely as a descriptive matter, why do Americans care so much about budget
The United States has a history of unusual concern about federal
(although not state) budget deficits, going back to the earliest days after
adoption of the Constitution. Other industrialized nations generally have not
shown similar levels of concern, even when they have had comparable or greater
budget deficits (or outstanding national debt) relative to their economies.

Our deficit fixation results in part from equating government debt with an
individual's or household's debts, which generally could not grow for decades at
a time without raising a serious prospect of default. In addition, deficits are
a deeply rooted symbol in American history, the meaning of which has changed
over time, but that continually relates to distrust of the national government.
The historical lineage from Thomas Jefferson's denunciations of the deficit to
those of H. Ross Perot should alert us to the cultural conditioning that needs
to be left to one side for purposes of clear analysis.

2) Are the national government's debts properly analogized to those of an
individual or household?
People often exaggerate the analogy, although it is not
wholly misplaced. The main distinction is that the federal government, with its
power to raise taxes and print money, faces less default risk than would a
household that regularly spent more than it took in. In addition, our debt is
mainly internal: owed by American taxpayers to American bondholders (two groups
that overlap).

While the prospect of involuntary default is remote in the United States at
present, we face a problem that is a lesser version of it: that of policy
, or our ability to meet current commitments that are not quite as
definite as the pledge to honor government bonds. Current fiscal policy is
likely to prove hard to sustain-not only because of the growing national debt,
but because of the expected long-term insolvency of Social Security and
Medicare. Fiscal policy changes may result in disappointing expectations that
our present fiscal policy encourages people to hold. Yet more and more people
realize that our fiscal policy must and will change. The main problem posed by
policy unsustainability is the shock and dislocation that result when
expectations must change too fast.

3) What issues do federal budget deficits raise, apart from concern about
default and policy sustainability?
The first issue is generational equity, or
concern about unduly benefiting current generations at the expense of future
generations. The second issue is what macroeconomic effects deficits generally
have. At one time, they were lauded by Keynesians as the cure for recession or
even significant unemployment, based on the claim that they increased current
consumer spending and thereby stimulated the economy. Today, the same causal
claim leads many to condemn deficits as a cause of the low rate of national
saving. The third issue concerns their effects on the size of the national
. Some supporters of limited government identify deficit spending as a
major cause of undesirable government growth, and therefore advocate the
adoption of a balanced budget amendment to the U.S. Constitution.

Each concern rests on a common causal claim: that deficit spending reduces the
perceived (whether or not the actual) cost of government spending to current
consumers and voters, thus inducing them to feel wealthier. They therefore
consume more, leave less for subsequent generations, and accept a higher level
of government spending than they would have otherwise. Before discussing the
accuracy and significance of this causal claim, we must look more carefully at
how deficits are defined and measured.

4) Is the budget deficit a meaningful economic measure? The budget deficit would
seem most likely to have these claimed effects if it were a meaningful economic
measure. Unfortunately, it is not-although there is a meaningful underlying
phenomenon, which it mismeasures, about which the above claims can be made.

The budget deficit's main shortcoming is that it is calculated on the basis of
cash flow, rather than economic accrual. Suppose that an individual kept his
books under the rules that the federal government uses to measure the budget
deficit. If he managed to buy a million dollar home for only a thousand dollars,
he would seem to have acted imprudently, since, in the year of purchase, he
would have increased his deficit. This transaction would be treated identically
to losing a thousand dollars at the racetrack. If he instead sold a million
dollar home for a thousand dollars, or agreed to pay someone a million dollars
next year in exchange for a thousand dollars today (assuming that this was not
classified as a loan), he would have accomplished deficit reduction, at least
under some versions of the measure, and thus would seem to have acted prudently.

While inaccuracies of this kind may have mattered little at one time in American
history, that time has passed. Today, a cash flow measure creates systematic,
not just random, mismeasurement, for three main reasons. First, it encourages
ignoring the approach of unfunded future spending commitments, as under Social
Security and Medicare. Second, it encourages legislative responses that, over
the long term, are meaningless or even make the government's fiscal posture
worse. "Smoke and mirrors" policy changes, or those that reduce deficits in the
short term while increasing them for "out years" beyond the estimating window,
have been a feature of all major deficit reduction initiatives in Washington.
Third, to the extent that fiscal policy affects economic behavior via its impact
on perceived wealth, the long-term elements of such policy that the deficit
ignores may matter. Unless people are highly myopic, their expectations
regarding how much the government will pay or take from them in the future
should affect their current behavior.

5) How could we better describe the underlying fiscal policy that deficits
Given the deficit's economic inaccuracy as a cash flow measure, we
need a new vocabulary to describe the underlying phenomenon of having spending
accrue before taxes. I will use the term tax lag to describe a fiscal policy
(such as our present one) in which, over the long term, (a) tax revenues will be
inadequate to pay for government spending absent a policy change and/or (b)
younger generations and future generations will end up paying for government
spending on behalf of older individuals and current generations. The word lag is
appropriate because, over the long term, no government spending is free; it all
must and will be paid for by someone. Even if the national debt is never repaid,
taxpayers bear it economically over time by perpetually paying interest on the
debt. Nor would defaulting on our debt obligations eliminate the cost of paying
for government spending. Default would merely shift the cost from taxpayers to
bondholders-functioning, in effect, as a one-time tax on the latter.

When I use the term tax lag, the reader should keep in mind that I am describing
the relative timing of taxes and spending, rather than anything absolute about
taxation. I could just as easily refer to spending acceleration. Tax lag can be
reduced through policy changes either on the tax side or on the spending side of
the federal budget. On the tax side, one can increase the extent to which future
necessary taxes are specified and/or increase taxes on current generations and
older individuals. On the spending side, one can reduce planned present or
future spending, in particular that on behalf of current generations and older

The most intuitively obvious way to measure changes in tax lag would be through
what I call the economic accrual budget deficit (as distinct from the cash flow
budget deficit that we currently use). This measure-which I mean only as a
thought experiment-would focus on economic accrual over time, rather than cash
flow, by taking account of expected future revenues and outlays at their
interest-adjusted present value. Suppose that at the beginning of the fiscal
year, the national debt stood at $2 trillion, and the present value of all
expected future budget deficits stood at $3 trillion. Tax lag would therefore
total $5 trillion in present value terms at the start of the year. (This would
be the "economic accrual national debt.") Next, suppose that during the fiscal
year, there was a $100 billion cash-flow budget deficit, and the present value
of all expected future deficits rose by $150 billion. The economic accrual
budget deficit would equal the sum of these two amounts, or $250 billion, as the
present value of our tax lag would have increased by that amount to $5.25
trillion in the course of the fiscal year.

The measure, as I have described it thus far, would still be too cash
flow-oriented in a critical respect. It would fail to distinguish between
expenditures that create durable government assets, and those that are
immediately consumed. Recall my earlier point that spending a thousand dollars
to buy a house is quite different from spending that amount at the racetrack. To
the extent feasible, one would want to adjust the economic accrual budget
deficit to use standard principles of accrual accounting for government
expenditures. At a minimum, expenditures that created lasting government assets
would be deducted over their estimated useful lives, rather than in the year of
the expenditure. One might also want to consider adjusting for fluctuations in
the value of government assets (at least those plausibly held for sale, if not,
say, the Lincoln Memorial), and ignoring government asset sales that merely
convert property to cash.

Yet, even if one could make these adjustments, another problem would arise.
Suppose that Congress in 1998 enacted a head tax of $50,000 per year, to apply
starting in 2050 to each adult American, and remain in force as long as needed
to pay off all public debt and eliminate all funding shortfalls in Social
Security and Medicare. This enactment probably would not alter one's view of our
current fiscal policy, whether because it seemed frivolous or because the bottom
line, the fact that taxes ultimately will pay for today's spending, was already
implicit. This suggests two problems with the economic accrual budget deficit.
The more trivial one is that the set of tax and payment rules currently on the
books is less important, for some purposes, than the set of rules that actually,
credibly constitute our current policy. The more fundamental problem is that
what really matters about taxes and spending, at least distributionally, is who
pays for and receives them. A tax on younger generations in fifty years may be
quite different than a tax on us today, even if the taxes have the same present

Responding to these problems in measuring tax lag, the economist Laurence
Kotlikoff has proposed a new measurement system to replace the cash flow budget
deficit that, while less intuitive than the economic accrual budget deficit,
provides more meaningful information. He calls it generational accounting. Its
most important innovation, beyond employing principles of economic accrual, is
that it compares expected taxes to expected outlays by age group, rather than
providing a single overall measure of tax lag. Generational accounting involves
computing the estimated lifetime net tax payment and lifetime net tax rate for
the average member of an age group-those born, say, in 1930, 1960, 1990, or the
future-assuming the continuation of current policy (except that future
generations are deemed to make up all the long-term revenue shortfalls). The
lifetime net tax payment is the excess of taxes paid over transfers received,
computed on a lifetime basis in present value terms from birth. The lifetime net
tax rate is the lifetime net tax payment, divided by estimated lifetime income.

Generational accounting thus directly addresses which age groups win and lose
under fiscal policy, and sheds light on such policy's likely sustainability.
According to Kotlikoff, lifetime net tax rates have been rising throughout the
twentieth century, and now stand at astronomical levels for future
generations-more than 84 percent under current policy, according to his most
recent data.

Unfortunately, any long-term economic accrual measure involves conceptual and
computational difficulty.


Excerpted from Do Deficits Matter?
by Daniel Shaviro
Copyright © 2003
by University of Chicago.
Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Table of Contents

1. Introduction
2. Reasons for the Perceived Importance of Budget Deficits
3. The Debate among Economists from the 1770s through the 1970s
4. The Modern Deficit Debate
5. Tax Lag and Generational Equity
6. Macroeconomic Issues Raised by Tax Lag and Budget Deficits
7. Issues of Government Size and Structure
8. Conclusion

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