budget deficit research papers

Page One Economics ®

Making sense of the national debt.

"Blessed are the young for they shall inherit the national debt." 

—Herbert Hoover

We live in a world of scarcity —which means that our wants exceed the resources required to fulfill them. For many of us, a household budget constrains how many goods and services we can buy. But, what if we want to consume more goods and services than our budget allows? We can borrow against future income to fulfill our wants now. 1 This type of spending—when your spending exceeds your income—is called deficit spending. The downside of borrowing money, of course, is that you must repay it with interest, so you will have less money to buy goods and services in the future. 

2018 U.S. Federal Deficit

In 2018 the federal deficit was $779 billion, which means that the U.S. federal government spent $779 billion more than it collected. 

SOURCE: https://datalab.usaspending.gov/americas-finance-guide/ . Data are provided by the U.S. Department of the Treasury and refer to fiscal year 2018.

Governments face the same dilemma. They too can run a deficit, or borrow against future income, to fulfill more of their citizens' wants now (Figure 1). For a variety of reasons, governments may borrow rather than fund spending with current taxes. Deficit spending can be used to invest in infrastructure, education, research and development, and other programs intended to boost future productivity. Because this type of investment can increase productive capacity , it can also increase national income over time. And deficit spending can be used to create demand for goods and services during recessions.  

For the U.S. government, deficit spending has become the norm. In the past 90 years, it has run 76 annual deficits and only 14 annual surpluses. In the past 50 years, it has run only 4 annual surpluses. 2 The accumulation of past deficits and surpluses is the current national debt : Deficits add to the debt, while surpluses subtract from the debt. At the end of the first quarter of 2019, the total national debt, also called total U.S. federal public debt, was $22 trillion and growing. This circumstance raises important questions: How much debt can an economy sustain? What are the long-term risks of high debt levels? 

Who "Owns" the National Debt?

While individuals borrow money from financial institutions, the U.S. federal government borrows by selling U.S. Treasury securities (bills, notes, and bonds) to "the public." For example, when investors purchase newly issued U.S. Treasury securities, they are lending their money to the U.S. government. The purchaser may receive periodic payments and/or a final payment, known as the "face value," at the end of the term. You or someone close to you likely holds U.S. Treasury securities either directly in an investment portfolio or indirectly through a mutual fund or pension account. As such, you, or they, own U.S. government debt. But, as a taxpayer, you are also beholden to pay part of that debt. A majority of the national debt is held by "the public," which includes individuals, corporations, state or local governments, Federal Reserve Banks, and foreign governments. 3 In other words, debt held by the public includes U.S. government debt held by any entity except the U.S. federal government itself (Figure 2). The largest public holders of U.S. government debt are international investors (40 percent), domestic private investors (38 percent), Federal Reserve Banks (15 percent), and state and local governments (6 percent). 4

Fiscal Year 2018 Debt Held by the Public and Intragovernmental Debt

SOURCE: https://www.gao.gov/americas_fiscal_future?t=federal_debt , accessed September 5, 2019.

In addition to owing money to "the public," the U.S. government also owes money to departments within the U.S. government. For example, the Social Security system has run surpluses for many years (the amount collected through the Social Security tax was greater than the benefits paid out) and placed the money in a trust fund. 5 These surpluses were used to purchase U.S. Treasury securities. Forecasts suggest that as the population ages and demographics change, the amount paid in Social Security benefits will exceed the revenues collected through the Social Security tax and the money saved in the trust fund will be needed to fill the gap. In short, some of the $22 trillion in total debt is intragovernmental holdings—money the government owes itself. Of the total national debt, $5.8 trillion is intragovernmental holdings and the remaining $16.2 trillion is debt held by the public. 6 Because debt held by the public represents debt payments external to the government, many economists feel it is a better measure of the debt burden. 

Household and Government Financing Over the Life Cycle 

The life cycle theory of consumption and saving holds that households seek to smooth their consumption of goods and services over the life cycle by borrowing early in life (for college or to buy a home), then saving and paying down debt during their working careers, and finally living on their savings during retirement. Financial advisors often suggest that people try to be debt free before they retire. As such, people are often motivated in their prime working years to pay down their debts and then pay them off entirely before they quit working. Given this mindset, people often assume that government debt must be paid in full at some point. But there are important differences between government debt and household debt.

While people tend to prefer to pay off their debts before they retire (and stop earning income) or die, governments endure indefinitely. In general, governments expect that their economies will continue to grow and that they will continue to collect tax revenue. If governments need to refinance past debts or cover new deficits, they can simply borrow. In effect, governments never need to pay off their debts entirely because the governments will exist indefinitely. 

However, this does not mean that debt is without cost. It is important to understand that debt has an opportuni ty cost . For the 2018 fiscal year, interest payments on the U.S. national debt were $523 billion. 7 This money could have financed other projects if the debt did not exist. And, of course, that $523 billion was simply the interest on the existing debt and did not pay down that debt.

How Much Debt Is Too Much Debt?

Although governments may endure indefinitely, that does not mean they can accumulate unlimited debt. Govern­ments must have the necessary income to finance their debt. Economists use gross domestic product (GDP), the total market value, expressed in dollars, of all final goods and services produced in an economy in a given year, as a measure of national income. Because GDP indicates national income, it also indicates the potential income that can be taxed, and taxes are a primary source of government revenues. In this way, a nation's GDP determines how much debt can be supported, which is similar to how a person's income determines how much debt that person can reasonably take on. Just as individuals can sustain higher debt as their incomes increase, economies can sustain higher debt when the economy grows over time. However, if debt grows at a faster rate than income, eventually the debt might become unsustainable. Econ­omists use the debt-to GDP ratio to measure how sustainable the debt is (Figure 3). Some economists, referred to as "owls," suggest that people's worries about U.S. government debt are overblown (see the boxed insert, "Deficit Hawks, Doves, and…Owls?"). 

Federal Debt Held by the Public as Percent of Gross Domestic Product

Federal debt held by the public has grown faster than GDP, lead ing to a rising debt-to-GDP ratio.

NOTE: Gray bars indicate recessions as determined by the National Bureau of Economic Research (NBER).

SOURCE: U.S. Office of Management and Budget. FRED ® , Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=lKfK, accessed September 5, 2019. 

The Government Accountability Office (GAO) suggests that the U.S government debt is currently on an unsustainable path: The federal debt is projected to grow at a faster rate than GDP for the foreseeable future. A significant portion of the growth in projected debt is to fund social programs such as Medicare and Social Security. Using debt held by the public (instead of total public debt), the debt-to-GDP ratio averaged 46 percent from 1946 to 2018 but reached 77 percent by the end of 2018 (see Figure 3). It is projected to exceed 100 percent within 20 years. 8  

Credit risk is the risk to the lender that the borrower will not repay the loan. It is one component of the interest rate that borrowers pay. Like for all loans, interest rates on Treasury securities reflect risk of default . The higher the risk of default, the higher the interest rate investors will expect: A country perceived as a higher credit risk must pay bond holders higher interest rates than a country perceived as a lower credit risk, all else equal. Thus, when bond yields spike, it might reflect rising risk. 

Economist Herb Stein once said, "If something cannot go on forever, it will stop." In other words, trends that are unsustainable will not continue because the economy will adjust, sometimes in abrupt and jarring ways. While governments never have to entirely pay off debt, there are debt levels that investors might perceive as unsustainable. A solution some countries with high levels of unsustainable debt have tried is printing money. In this scenario, the government borrows money by issuing bonds and then orders the central bank to buy those bonds by creating (printing) money. History has taught us, however, that this type of policy leads to extremely high rates of inflation ( hyperinflation ) and often ends in economic ruin. Some of the better-known examples of such polices are Germany in 1921-23, Zimbabwe in 2007-09, and Venezuela currently. An important protection against this type of policy is to create an independent central bank that is insulated from the political process and has clear objectives (such as a specific target for the inflation rate) so that it can make policy decisions to sustain economic health over the long run rather than respond to political pressures. 9  

Conclusion 

The national debt is high by historical standards—and rising. People often assume that governments must pay off their debts in the same way that individuals do. How­ever, there are important differences: Governments (and their economies) do not retire, and governments do not die (or don't intend to). As long as their debt payments remain sustainable, governments can finance their debt indefinitely. And if a government prints money to solve its debt problem, history warns that hyperinflation and financial ruin will likely result. While debt in itself is not a bad thing, it can become dangerous if it becomes unsustainable.

1 Households could alternately spend out of past savings. 

2 U.S. Office of Management and Budget, "Federal Surplus or Deficit." FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=otZF , accessed September 5, 2019.

3 U.S Department of the Treasury, Bureau of the Fiscal Service. "Frequently Asked Questions about the Public Debt." https://www.treasurydirect.gov/govt/resources/faq/faq_publicdebt.htm#DebtOwner , accessed September 5, 2019.

4 U.S. Government Accountability Office. "America's Fiscal Future: Federal Debt." https://www.gao.gov/americas_fiscal_future?t=federal_debt , accessed September 5, 2019.

5 Social Security Administration. "Trust Fund Data." https://www.ssa.gov/oact/STATS/table4a3.html , accessed September 5, 2019.

6 U.S. Department of the Treasury, Bureau of the Fiscal Service. "Federal Debt Held by the Public." FRED ® , Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=mAfK , accessed September 5, 2019.

7 U.S Department of the Treasury, Bureau of the Fiscal Service. "Interest Expense on the Debt Outstanding." https://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm , accessed September 5, 2019.

8 U.S. Government Accountability Office. "America's Fiscal Future." https://www.gao.gov/americas_fiscal_future?t=fiscal_forecast#projecting_the_future , accessed September 5, 2019.

9 Waller, Christopher. "Independence + Accountability: Why the Fed Is a Well-Designed Central Bank." Federal Reserve Bank of St. Louis Review , September/October 2011, 93 (5), pp.  293-301; https://files.stlouisfed.org/files/htdocs/publications/review/11/09/293-302Waller.pdf .

© 2019, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Default: The failure to promptly pay interest or principal when due. 

Fiat money: A substance or device used as money, having no intrinsic value (no value of its own), or representational value (not representing anything of value, such as gold).

Hyperinflation: A very rapid rise in the overall price level; an extremely high rate of inflation.

Inflation: A general, sustained upward movement of prices for goods and services in an economy.

National debt: The accumulation of budget deficits. Also known as government debt.

Opportunity cost: The value of the next-best alternative when a decision is made; it's what is given up.

Productive capacity: The maximum output an economy can produce with the current level of available resources.

Scarcity: The condition that exists because there are not enough resources to produce everyone's wants.

U.S. Treasury securities: Bonds, notes, bills, and other debt instruments sold by the U.S. government to finance its expenditures.

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The Political Economy of Budget Deficits

• Published: 01 March 1995
• Volume 42 , pages 1–31, ( 1995 )

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• Alberto Alesina &
• Roberto Perotti  

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This paper provides a critical survey of the literature on politico-institutional determinants of the government budget. We organize our discussion around two questions: Why did certain OECD countries, but not others, accumulate large public debts? Why did these fiscal imbalances appear in the last twenty years rather than sooner? We begin by discussing the “tax smoothing” model and conclude that this approach alone cannot provide complete answers to these questions. We then proceed to a discussion of political economy models, which we organize into six groups: (1) models based upon opportunistic policy makers and naive voters with "fiscal illusion"; (2) models of intergenerational redistributions; (3) models of debt as a strategic variable, linking the current government with the next one; (4) models of coalition governments; (5) models of geographically dispersed interests; and (6) models emphasizing the effects of budgetary institutions. We conclude by briefly discussing policy implications.

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Alesina, A., Perotti, R. The Political Economy of Budget Deficits. IMF Econ Rev 42 , 1–31 (1995). https://doi.org/10.2307/3867338

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How to Rein in the National Debt

Key findings.

• The federal government’s debt is $33 trillion and rising; budget deficits are projected to grow substantially over the next decade, reaching $2.7 trillion in 2033, or 6.4 percent of gross domestic product (GDP).
• Debt held by the public will rise steadily from 97 percent of GDP in 2022 to 115 percent in 2033—the highest level on record.
• Now is the time for lawmakers to focus on long-term fiscal sustainability, as further delay will only make an eventual fiscal reckoning that much harder and more painful. Congressional leaders should follow through on convening a fiscal commission to deal with the long-term budgetary challenges facing the country.
• International experiences of successful debt reductions suggest gradual, spending-focused policies. Any serious debt reduction effort must acknowledge the need to rein in the largest mandatory spending programs, Social Security and Medicare, which constitute a growing share of the budget and are the primary drivers of long-run deficits.
• If lawmakers consider tax A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. increases in a debt reduction effort, they should focus on less distortionary taxes, such as consumption taxes, or tax reforms that rationalize tax expenditures and broaden the tax base The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .

Table of Contents

Introduction, u.s. federal debt in context, how other countries successfully reduced debt and deficits, how the debt ceiling deal affects the u.s. budget, options for reform.

At the time of this writing, the federal government’s debt is $33 trillion and rising. [1] Earlier this year, after a protracted negotiation and just days before the federal government was expected to become unable to pay its obligations, President Biden and House Speaker McCarthy reached a deal to suspend the debt ceiling until January 1, 2025, as part of the Fiscal Responsibility Act (FRA) of 2023. [2] The deal imposes temporary caps on certain types of government spending, reducing projected budget deficits by about $1.5 trillion over the next decade. [3]

Even after the FRA, the latest forecast from the Congressional Budget Office (CBO) indicates that federal budget deficits will grow substantially over the next decade and with it the national debt. Through 2033, deficits will total $18.8 trillion, reaching an annual budget deficit of $2.7 trillion in 2033, or 6.4 percent of gross domestic product (GDP), as spending growth outpaces revenue growth. [4] Debt held by the public will rise steadily from 97 percent of GDP in 2022 to 115 percent in 2033—the highest level on record.

These forecasts and other concerns about the sustainability of the federal debt led Fitch Ratings to downgrade U.S. debt from AAA to AA+ on August 1, noting “expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.” [5] Fitch expects the deficit to reach 6.3 percent of GDP this year and rise from there due to weak economic growth and an interest burden that will grow to 10 percent of revenue by 2025.

According to the latest monthly budget review from the CBO, the deficit in the first 10 months of FY 2023 is $1.6 trillion, more than twice the deficit over the same period last year. [6] Spending is up 10 percent, driven in part by the rising costs of Social Security, Medicare, interest on the debt, and Pres. Biden’s new income-driven repayment plan for student loans. At the same time, tax collections are down 10 percent, due in part to lower capital gains tax A capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. collections as the stock and housing markets have deflated.

Excluding the effects of President Biden’s student loan cancellation policy (which the Supreme Court struck down in June and is distinct from the administration’s income-driven repayment plan), budget experts are forecasting a doubling of the deficit this year, from $1 trillion (or 4 percent of GDP) last year to $2 trillion (or about 8 percent of GDP) this year. Economist Jason Furman and other experts note such a growing deficit pattern is essentially unprecedented in U.S. history outside of major crises and economic downturns. [7]

The current track of ever-increasing budget deficits, interest costs, and debt is not sustainable. In this paper, we discuss how the U.S. debt burden compares to the burdens in other countries and how other countries have successfully reduced their debt in the past. We then analyze the FRA and discuss how lawmakers could build on FRA’s reforms to stabilize the U.S. fiscal trajectory.

According to the International Monetary Fund’s (IMF) measure of central government debt, the U.S. federal government is among the most indebted governments in the world. [8] As of 2021 (the latest available data), federal debt reached 115 percent of GDP, ranking 16 th highest out of 164 countries for which the IMF has data. Japan tops the ranking with central government debt of 221 percent of GDP, followed by Greece , Sudan, Eritrea, and Singapore. Not long ago, the U.S. was among the least indebted countries. In 2001, U.S. federal debt was 42 percent of GDP, lower than debt levels found in 100 other countries.

As illustrated in the nearby chart, using historical data from the White House Office of Management and Budget (OMB), [9] U.S. debt surged upward in two stages over the last 20 years, first after the financial crisis in 2008 and then after the COVID-19 pandemic [10] that began in 2020. [11] Gross federal debt climbed to a record high of 128 percent of GDP in 2020 before falling to 123 percent in 2022. The recent downtick was primarily due to a surge in inflation Inflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “ hidden tax ,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. as well as real economic growth coming out of the pandemic, factors that temporarily reduced debt burdens in many countries. [12]

Debt is forecasted to reach unprecedented levels in the coming years. The CBO projects debt held by the public as a share of GDP will climb from 97 percent in 2022 to 115 percent in 2033—reaching the highest level on record by 2029—before climbing further to 180.6 percent by 2053. [13] The increase is mainly due to population aging and the rising costs of Social Security and Medicare and assumes no major economic calamities or changes in federal laws will occur. [14]

And yet, the problem may be even worse. Mark Warshawsky and other researchers at the American Enterprise Institute (AEI) see rising health-care costs and interest rates contributing to even higher levels of debt. [15] They forecast debt held by the public will grow to 136 percent in 2032 and 264 percent in 2052. Like the CBO forecast, theirs assumes no banking crisis, war, pandemic, or other emergency that might cause a major economic downturn and spike in deficits. As it is, the AEI researchers forecast annual deficits to reach 7 percent of GDP by 2030 and escalate rapidly thereafter in an unprecedented and unsustainable path, around the same time that the Social Security and Medicare trust funds are expected to be depleted.

All of this may seem far off, but the costs of high debt levels are upon us now. They are most clearly visible in the form of high inflation, high interest rates, and slowing economic growth. [16] As John Cochrane, [17] Eric Leeper, [18] Tom Sargent, [19] and other economists [20] have described, the extraordinary surge of federal spending during the pandemic—exceeding $5 trillion through early 2021, or 27 percent of GDP—kicked off a 40-year high in inflation. [21]

That is because the increased spending was not financed by tax increases; it was financed by debt purchased by the Federal Reserve through money creation. [22] To combat high inflation, the Federal Reserve has raised interest rates to the highest levels in more than 20 years. That brute force method of slowing the economy through higher borrowing costs has thus far led to heavy losses for investors, a collapse in home sales, and several bank failures, among other signs of distress, with more pain to come as debt of various types is rolled over at higher interest rates. [23]

High interest rates are also putting pressure on the federal budget, causing interest payments on the debt to crowd out other federal priorities and limiting the federal government’s ability to respond to future crises. According to the CBO, the federal government’s net interest cost will exceed $1 trillion annually by 2029, eclipsing the defense budget.

The financial stress and instability of high interest rates are spreading around the globe, leading the IMF [24] to recommend fiscal restraint as a less economically damaging way to reduce inflation and debt. [25]

As U.S. lawmakers consider options to address the underlying gap between spending and revenue going forward, they should draw on international experiences of fiscal consolidation. [26] International experience cautions against tax-based fiscal consolidations, but modest tax increases may be part of a successful debt reduction package. [27] Overall, a rough guideline that emerges is that deficit reduction efforts should primarily be focused on spending reduction, with 60 percent or more of a plan’s savings coming from spending cuts and 40 percent or less from revenue increases. Further, the types of spending cuts and tax reforms that are part of a fiscal consolidation also matter.

In a recent survey of studies on the experience of countries around the world dealing with fiscal deficits and debt, the IMF outlines factors that contribute to sustained improvements in deficits and debt-to-GDP levels. [28] Reductions in social spending, as opposed to public investment, tend to produce more lasting fiscal improvements, as do less distortionary tax increases—including higher consumption, property, excise, and environmental taxes as well as reductions in tax expenditures.

Other factors important for success include the public’s perception that the government will actually fulfill its commitments and that the adjustment will be gradual, not “front-loaded” with large structural policy changes.

Additional research further supports the idea that fiscal consolidations based on spending cuts have had fewer negative effects on GDP than tax increases. Looking at 16 OECD countries over a 30-year period, Alberto Alesina and his coauthors found that, on average, spending cuts were associated with mild recessions and in some cases no downturns at all, while almost all fiscal reforms based on tax increases were followed by “prolonged and deep recessions.” [29] Fiscal adjustments based on tax increases reduced investment and business confidence. By contrast, business confidence rebounded almost immediately after a fiscal adjustment based on spending reforms.

In a follow-up paper, Alesina and his coauthors showed that cuts in transfer spending had milder negative effects on economic growth, nearing zero, compared to cuts in government consumption and investment, though both have relatively little impact on growth compared to tax increases. [30]

Examining fiscal adjustments from a sample of 26 countries from 1995 to 2018, a Mercatus Center analysis found that successful consolidations, defined as one where the debt-to-GDP ratio declines by at least 5 percentage points in the three years after the plan is implemented, were more spending-focused than tax-focused. [31] More than half (53 percent) of expenditure-based fiscal consolidations, defined as those in which spending cuts represent 60 percent or more of deficit reduction, were successful. In contrast, only 38 percent of tax-based fiscal consolidations (defined as those in which tax increases represent 60 percent or more of deficit reduction) were successful. Balanced fiscal consolidations, however, had the highest success rate at 55 percent. Among the successful fiscal consolidations, on average, 60 percent of the deficit reduction came from spending cuts, whereas among the unsuccessful fiscal consolidations, 74 percent of the deficit reduction came from tax increases.

A European Central Bank analysis arrived at a similar conclusion: EU countries that pursued spending-based consolidations had higher growth rates five years following a fiscal consolidation announcement than those that pursued tax-based ones. [32] While part of the difference in economic performance can be explained by better follow-through for revenue-based plans, the bulk of the difference was due to the composition of consolidations, with revenue having large, negative effects compared to nearly zero for spending.

When it comes to designing tax changes, raising a dollar of revenue through different taxes has different effects on the economy. A more harmful tax increase can shrink the economy, yielding less revenue from other taxes. Harm the economy too much and the solution may prove counterproductive, reducing the likelihood of successful debt stabilization.

In a study of 17 OECD countries over a 30-year period, Norman Gemmell and other academics showed that reducing deficits by raising distortionary taxes, such as income taxes, consistently reduced economic growth, while raising less distortionary taxes, such as consumption taxes, was more growth-enhancing. [33] They found small positive growth effects from deficit-financed “productive” spending, such as infrastructure, implying that cutting such spending could hurt growth. Negative growth effects from cutting productive spending would take longer to materialize, while negative effects of tax increases would be more immediate. Deficit-financed “nonproductive” spending, such as transfers, was shown to have a negative effect on long-run economic growth, suggesting that cutting them would boost growth.

In all, the experience with successful fiscal consolidations suggests adjustments should be gradual and focused on spending, with careful consideration of the growth effects of selected policies. If tax increases are included in a package, [34] it is most effective to focus on less distortionary taxes, such as consumption taxes, or tax reforms that rationalize tax expenditures [35] and broaden the tax base. [36]

Among other changes, the debt ceiling deal enacted in June (FRA) limits discretionary spending over the next two years, expedites permitting for pipelines and other energy infrastructure, and expands work requirements for food and income assistance programs. [37]

Specifically, the deal caps discretionary spending (except for certain funding including emergencies and overseas contingencies) at $1.59 trillion in FY 2024 and $1.61 trillion in FY 2025, roughly flat relative to this year’s $1.63 trillion. It caps defense spending at $886 billion in FY 2024 and $895 billion in FY 2025 and non-defense discretionary spending at $704 billion in FY 2024 and $711 billion in FY 2025.

The deal also contains a mechanism to enforce a better budget process by further reducing the budget caps by 1 percent if Congress fails to enact all 12 appropriations bills by January 2024. Additionally, the deal specifies certain unenforceable spending limits beyond FY 2025.

Outside of the spending caps, the deal makes several other changes with relatively small effects on the budget. The deal rescinds about $11 billion in unspent pandemic relief funds, codifies the already-expected end of the pause in student loan payments, and claws back about a quarter of the $80 billion in additional IRS funding authorized by last year’s Inflation Reduction Act. The deal also tightens work requirements and eligibility rules for the Supplemental Nutrition Assistance Program (SNAP) and Temporary Assistance to Needy Families (TANF), speeds the permitting process for energy and infrastructure projects by limiting environmental reviews, and requires cost estimates for administrative actions through 2024.

In total, the CBO estimates the FRA will reduce deficits by $1.5 trillion from 2023 to 2033, including a substantial reduction in interest payments on the debt of $188 billion. [38]

The FRA rightly focuses on reducing spending, which is what most successful fiscal consolidations have done. But while the spending reductions are substantial, they pale in comparison to total federal spending of about $6.4 trillion this year and $79 trillion projected over the next decade, or projected deficits of about $19 trillion over the next decade. [39]

The current CBO forecast indicates spending this year will be about 24.2 percent of GDP and average 23.6 percent of GDP over the next decade, compared to an average of 21 percent over the last 50 years. To bring spending closer into alignment with historic norms would require cuts several times larger than what the FRA enacted. Just to stabilize the debt at its current share of the economy would require about $7.5 trillion in deficit reduction over the next 10 years, inclusive of reduced interest costs.

The problem is that the FRA does not address the largest part of the budget and the source of growing fiscal imbalances, which is mandatory spending, including major entitlement programs such as Social Security and Medicare. [40] Under current law, mandatory spending is set to grow from 14.3 percent of GDP next year to 15.3 percent in 2033, while discretionary spending (the part of the budget addressed by the FRA) will shrink from 6.6 percent to 5.6 percent over the same period. [41] Discretionary spending was already on a downward trajectory before the FRA; in May, the CBO forecasted it would fall from 6.5 percent of GDP in 2024 to 6.0 percent in 2033. [42]

By leaving mandatory spending on autopilot, the FRA fails to address the core driver of long-term deficits and fails to grapple with the weakening finances of the Social Security and Medicare trust funds, which are projected to be insolvent within a decade. [43]

To address the more challenging parts of the budget, especially the unsustainable growth in mandatory spending, lawmakers should follow up on the debt ceiling agreement with a focus on long-term fiscal sustainability.

A Fiscal Commission and Other Reforms to the Budget Process

In the aftermath of the FRA, Speaker McCarthy indicated he would seek to convene a fiscal commission to grapple with long-term budgetary challenges, a meaningful next step to improve the process of budget reform. [44] The 2010 Simpson-Bowles Commission was the last time a fiscal commission was assembled, and it can offer some lessons going forward. [45]

First, perhaps now more than ever, convening a fiscal commission makes eminent sense. A commission comprised of budgetary experts selected on a bipartisan basis would provide a space for tough budget decisions outside of the political pressures that make real discussion of budgetary alternatives and trade-offs impossible. The commission should aim for specific targets, such as stabilizing debt as a share of GDP at or below current levels, and engage and solicit input from citizens and outside experts to form a set of recommendations.

Second, as noted by Dave Walker and others, for a fiscal commission to be successful, it needs to be statutory, so the administration and members of Congress have buy-in to the process. [46] The recommendations of the commission should be put to an up or down vote in Congress. All of this, of course, assumes elected officials first acknowledge the scale of the problem, are willing to engage with solutions, and then follow through with action.

As a longer-term process reform, Dave Walker and others, including the late Nobel laureate economist James Buchanan, have also recommended a constitutional amendment to enforce fiscal sustainability. [47] The amendment could take many forms. Buchanan recommended an amendment that limits estimated spending to estimated tax revenues, with the ability to waive this requirement in extraordinary situations via separate approval by three-fourths of the House of Representatives and the Senate. [48]

Several countries have had success controlling debt through a similar constitutional rule. For instance, since 2003, Switzerland ’s “debt brake,” which limits spending to revenues over the business cycle, has led to the stabilization of gross government debt at just over 40 percent of GDP. [49] As with a fiscal commission, the effectiveness of such an amendment depends on a wide consensus among the public and policymakers. [50] The Swiss debt brake, for example, was approved by 85 percent of its public. While this seems a remote possibility currently in the U.S., an amendment process could gain traction as the growing U.S. debt becomes more problematic.

Spending Reforms

Turning to reforms of particular spending programs, lawmakers should focus on controlling the growth of the largest mandatory spending programs: Social Security and Medicare. Together, the two programs will grow from 8.2 percent of GDP this year to 10.1 percent of GDP in 2033, while the rest of the budget shrinks from 15.9 percent to 14.4 percent, according to the CBO’s latest forecast. [51] Over the long run, essentially all of the deficit is due to Social Security, Medicare, and associated interest costs. [52]

The demographic factors contributing to the growth of these old-age programs are not uniquely American, as populations are aging rapidly in several countries, [53] especially in Japan and across Europe . There too, pressure is rising on programs that promise benefits for an expanding pool of retirees financed by taxes on a shrinking pool of workers. [54] Economist Eric Leeper describes this dynamic as creating a kind of “insidious” inflationary pressure, as the budgetary imbalance and associated risks grow somewhat imperceptibly over time and the looming policy uncertainty creates costly maneuvering. [55]

Social Security and traditional Medicare (Part A) are both funded by payroll taxes on a “pay-as-you-go basis.” That is, current payroll taxes paid by today’s workers fund payments to today’s retirees. Unlike discretionary spending, which must be voted on by Congress every year during the appropriations process, current law mandates Social Security and Medicare spending. Mandatory spending in its entirety represents more than two-thirds of the current U.S. budget. [56]

An aging U.S. population and a declining worker-per-retiree ratio (now only 3 to 1) have contributed to the cost of financing Social Security and Medicare. Under current law, Medicare’s Hospital Insurance Trust Fund will be insolvent by 2031, and Social Security’s

Old Age, Survivors, and Disability Insurance (OASDI) Trust Fund by 2033. [57] Without reforms, Social Security benefits would be automatically reduced across the board by 20 percent, and Medicare hospital insurance payments would be cut by 11 percent. Absent any reforms, the 2023 Trustees Report shows that a significant payroll tax hike of 4.2 percent would be required to close the current funding gap for OASDI and Medicare. [58]

Given the dire outlook, policymakers must reform the programs to ensure their long-run stability. A brief, non-exhaustive review of various proposals over the past decade to reform Social Security and Medicare illustrates the possibility of tackling the issue with a measured and bipartisan approach.

Social Security Reforms

In 2010, President Obama established the National Commission on Fiscal Responsibility and Reform to develop a plan to reduce the deficit. The bipartisan commission produced what became known as the Simpson-Bowles plan—named after then-Senators Alan Simpson (R-WY) and Erskine Bowles (D-NC)—which proposed significant changes to Social Security to ensure its fiscal sustainability. [59] Although the plan was never enacted, many of its recommendations can be found in other proposals , and for this reason, it is worth reviewing in full.

Simpson-Bowles would have slowed benefit growth for high-income earners, making Social Security more progressive. Currently, benefits are calculated using a three-bracket system, where higher earners receive a lower share of their lifetime earnings than lower earners. The plan would have gradually phased in a four-bracket structure of replacement rates starting in 2017, reducing the share of lifetime benefits for higher earners even further.

Additionally, the plan would have gradually raised the retirement age. Under current law, the normal retirement age is 67, but retirees can begin collecting benefits as early as 62. Simpson-Bowles would have indexed both the normal and early retirement ages to life expectancy, making the normal retirement age 68 by 2050.

Currently, all Social Security benefits are adjusted for inflation using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The plan would have switched to chained CPI for cost-of-living adjustments (COLAs) instead. The standard CPI typically overstates inflation as it doesn’t account for consumers’ ability to switch to cheaper substitutes for goods, whereas the chained CPI better captures these consumption dynamics. [60] Switching to the chained CPI would slow benefit growth and therefore reduce the overall cost of the program.

On the revenue side, the plan would have gradually raised the payroll tax A payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. cap. Currently, wages and salaries above $160,200 do not face the payroll tax for Social Security. [61] As a result, the tax applies to about 83 percent of all wages earned. Simpson-Bowles would have raised the cap to ensure that 90 percent of all wages were covered by 2050.

Another more recent proposal by Senator Bill Cassidy (R-LA) would attempt to shore up Social Security by borrowing $1.5 trillion and placing it in a diversified investment fund that would be used to replenish the Social Security trust fund. [62] Cassidy characterizes the proposal as a bridge between President Bill Clinton’s proposal to invest part of the trust fund in stocks, and President George W. Bush’s proposal to partially privatize Social Security. However, the plan does not include private accounts, a key feature in successful pension reforms implemented in several countries, [63] including Sweden [64] and Australia . [65] Lawmakers should look to their experiences [66] for guidance on this promising direction for reform. [67]

Medicare Reforms

Currently, physicians who serve patients under traditional Medicare are reimbursed under a fee-for-service system, where they are compensated for the quantity of services they provide rather than the quality. This leads to physicians often providing unnecessary treatments or tests that do little to improve health outcomes for their patients, driving up the costs of Medicare. Proposals to reform fee-for-service have included switching to a system of bundled payments, where physicians are reimbursed based on a fixed price for specific medical episodes. [68] The Center for Medicare and Medicaid Services began experimenting with such a system [69] for hip and knee replacements in 2016, and announced further expansions for other types of care, but expanding it even more broadly could help keep costs down. [70]

Alternatively, reforms could go even further by switching to a system of capitation, where physicians are paid a set amount per patient, regardless of how much care is provided. Currently, Medicare Advantage (Medicare Part C) functions this way. [71] Under Medicare Advantage, recipients select among a variety of mostly managed care plans and private insurers receive a fixed payment through Medicare to cover the medical expenses. This incentivizes doctors to serve their patients in the most efficient way possible.

Other proposals call for simply increasing premiums. Premiums for Medicare Part B (which covers outpatient care) currently only cover about 25 percent of the program’s outlays. [72] The CBO estimated that increasing the basic premium to cover 35 percent of the outlays would reduce the deficit by $406 billion from 2023 to 2032.

Similarly, reforming cost sharing would reduce health-care overutilization and lower expenditures. Under the current system, Medicare patients face a high deductible when admitted to a hospital, but no cap on out-of-pocket expenses. As a result, 90 percent of patients acquire additional private coverage known as Medigap. [73] These plans are often expensive because the government is picking up the tab, and only a few plans are available, leading patients to consume more health care than necessary. The Committee for a Responsible Federal Budget (CFRB) offered a proposal that would implement an out-of-pocket cap and a higher deductible for non-hospital services, reducing the need to purchase additional coverage. [74]

One of the more ambitious plans to reform Medicare is to transition to a “premium support” model. Such a system was proposed by Senators Ron Wyden (D-OR) and Paul Ryan (R-WI) and the Bipartisan Policy Center (BPC) in 2011. [75] The Ryan-Wyden plan would have allowed traditional Medicare plans to compete with private insurance plans in a competitive bidding process, and then the government would have provided vouchers to seniors to purchase coverage. [76] The value of the vouchers would have grown at a rate of GDP plus one percent, and the expectation was that allowing private insurers to compete would help lower costs. To keep costs down even further, the BPC plan would have required Medicare beneficiaries earning above 150 percent of the poverty level to pay higher premiums if spending exceeded the growth limit.

Finally, numerous proposals have been offered to reduce the price of drugs purchased through Medicare. While some of these policies can actually harm innovation in the pharmaceutical sector (e.g., the Inflation Reduction Act’s price controls on specific drugs), [77] more modest reforms could encourage physicians to prescribe cheaper generics. [78] Under Medicare B, doctors purchase drugs for their patients and then get reimbursed based on the average sales price of the drug (net of all rebates and discounts), plus 6 percent of the drug cost. This incentivizes physicians to recommend more expensive, branded drugs since they will receive a larger reimbursement.

One proposed reform from the CFRB would implement “clinically comparable drug pricing,” where physicians would be reimbursed based on a weighted average sales price for clinically similar classes of drugs. [79] This would remove the incentive for physicians to recommend more expensive drugs, as they would incur all the additional costs of purchasing a drug above that weighted average sales price.

Tax Reforms

As discussed above, the experiences of countries around the world caution against raising particularly distortive taxes to reduce debt. However, modest tax increases with minimal harm to the economy can contribute to debt stabilization.

To illustrate, we have simulated the following three potential tax increases that differ considerably in their effects on the U.S. economy and the federal debt burden:

• Increasing the federal gas tax A gas tax is commonly used to describe the variety of taxes levied on gasoline at both the federal and state levels, to provide funds for highway repair and maintenance, as well as for other government infrastructure projects. These taxes are levied in a few ways, including per-gallon excise taxes , excise taxes imposed on wholesalers, and general sales taxes that apply to the purchase of gasoline. by $0.35 and indexing it for inflation
• Broadening the individual income tax base by eliminating the exclusion for employer-sponsored health insurance (ESI)
• Raising the top individual income tax An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment . Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rate to 50 percent above $400,000 for single filers and $450,000 for joint filers, and raising the corporate tax rate to 28 percent

As shown in the table and chart below, all three options would raise substantial revenue, in excess of $3 trillion over 10 years in the case of eliminating the ESI exclusion. Both the higher gas tax and the elimination of the ESI exclusion result in relatively minor economic trade-offs for the revenue raised. In contrast, higher marginal income tax rates come at a steep cost: GDP would be reduced by about 1.3 percent over the long run due to decreased incentives to work, save and invest.

As a result, a less economically harmful option like eliminating the ESI exclusion results in a much more powerful reduction in long-run debt as a share of GDP—double the impact on the debt ratio over the long run and less than half the impact on GDP, as compared to raising income tax rates.

However, all three of these revenue options demonstrate that even with substantially higher tax revenues, debt-to-GDP would still continue to grow unsustainably—exceeding 200 percent of GDP by 2064—demonstrating that spending needs to be the primary focus to successfully reduce debt.

That brings us to the options currently on the table. Unfortunately, President Biden’s plan to reduce the deficit, as described in his most recent budget, depends entirely on net revenue increases from raising economically damaging taxes—an approach inconsistent with successful efforts to reduce debt. [80]

The Biden administration’s estimates of nearly $3 trillion in deficit reduction under the budget are highly uncertain, particularly as they depend on a novel set of tax increases. On a conventional basis, Tax Foundation estimates the President’s budget plan would reduce the 10-year deficit by $2.5 trillion. Because the plan would reduce GDP by 1.3 percent, the deficit reduction drops to $1.9 trillion over 10 years on a dynamic basis.

By 2033, publicly held debt as a share of GDP will reach 115 percent under the baseline. [81] Pres. Biden’s budget would reduce it to 108.4 percent conventionally or 110.6 percent dynamically. In the long run (by 2064), the plan would reduce debt-to-GDP from 231.8 percent under the baseline to 207.0 percent conventionally or 214.6 percent dynamically.

The smaller improvement on a dynamic basis highlights the importance of minimizing the economic costs of tax hikes and instead seeking efficient sources of revenue.

For example, in contrast to Biden’s proposals, Tax Foundation’s Tax Reform Plan for Growth and Opportunity proposes replacing the current corporate income tax A corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses , with income reportable under the individual income tax . with a distributed profits tax A distributed profits tax is a business-level tax levied on companies when they distribute profits to shareholders, including through dividends and net share repurchases (stock buybacks). and the current individual income tax with a much broader based flat tax An income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. , and reforming estate and capital gains taxes at death. [82] Base broadeners in the plan help offset the costs of the reforms, including eliminating most tax expenditures: the exclusion for employer-sponsored health insurance, all itemized deductions, and many tax credits.

The plan is approximately revenue neutral in the long run, and it raises about $522 billion over the 10-year budget window. Because it raises revenue more efficiently, it increases long-run GDP by 2.5 percent and reduces long-run debt-to-GDP by 9.2 percentage points on a dynamic basis to 222.6 percent.

In lieu of a fundamental overhaul of the tax system, lawmakers may consider permanence for all or part of the expiring Tax Cuts and Jobs Act (TCJA) provisions. An across-the-board extension of the individual income tax expirations would be pro-growth but would significantly reduce revenue. Alternatively, lawmakers could build on the TCJA’s reforms to further broaden the base by, for example, using the options outlined in Tax Foundation’s Plan for Growth and Opportunity [83] and curtailing new green energy tax credits. [84]

Other reforms, such as permanent expensing for capital investments and R&D, would also enhance the efficiency of the tax system. [85] On a conventional and dynamic basis, such changes would reduce revenue in the short term, but, over the long run, the fading revenue cost and permanent economic benefit would be enough to slightly reduce deficits and the debt-to-GDP ratio.

Lifting the debt ceiling probably relieved some pressure on U.S. lawmakers to reduce the nation’s growing debt, at least until the debt ceiling returns in early 2025. Until then, other events are likely to remind lawmakers of the seriousness of the problem, including the recent downgrade of U.S. debt and the apparent doubling of the deficit over the last year. Now is the time for lawmakers to focus on long-term fiscal sustainability, as further delay will only make an eventual fiscal reckoning that much harder and more painful.

House Speaker McCarthy should follow through on his idea to convene a fiscal commission to deal with the long-term budgetary challenges facing the country. Any fiscal commission or other serious debt reduction effort must acknowledge the need to rein in the largest mandatory spending programs, Social Security and Medicare, which constitute a growing share of the budget and are the primary drivers of long-run deficits. The programs are unsustainable and are statutorily scheduled for a major reduction in benefits within the decade absent reforms.

Tax increases and tax reform should also be on the table. Lawmakers must not lose sight of the incentive effects of various possible reforms, both because of the demonstrable effects on the larger economy and standards of living, and because the effects in turn affect the sustainability of the debt reduction. Though it may not be politically popular to raise the gas tax or broaden the tax base, to the extent that a comprehensive deficit reduction package includes modest tax increases, such options are the most advisable on economic grounds. Ultimately, a better-designed tax system should be a goal of any fiscal consolidation package, noting that the majority of deficit savings should come from spending reforms.

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[2] The debt limit, the nation’s debt, and the annual federal budget deficits are distinct but related issues. Annual budget deficits are the difference between how much revenue the nation brings in, primarily through taxes, and how much it spends. The nation’s debt reflects the accumulation of past budget deficits—spending promises that have already been made but not yet paid for. Congress limits the amount of debt that the Treasury can issue to pay obligations, and if it hits that limit, it must rely on cash balances and extraordinary measures to manage the debt in the interim until Congress suspends or raises the limit.

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• Published: 20 August 2019

Twin deficit hypothesis and reverse causality: a case study of China

• Umer Jeelanie Banday 1 &
• Ranjan Aneja 1  

Palgrave Communications volume  5 , Article number:  93 ( 2019 ) Cite this article

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A Correction to this article was published on 01 October 2019

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This paper analyses the causal relationship between budget deficit and current account deficit for the Chinese economy using time series data over the period of 1985–2016. We initially analyzed the theoretical framework obtained from the Keynesian spending equation and empirically test the hypothesis using autoregressive distributed lag (ARDL) bounds testing and the Zivot and Andrew (ZA) structural break for testing the twin deficits hypothesis. The results of ARDL bound testing approach gives evidence in support of long-run relationship among the variables, validating the Keynesian hypothesis for the Chinese economy. The result of Granger causality test accepts the twin deficit hypothesis. Our results suggest that the negative shock to the budget deficit reduces current account balance and positive shock to the budget deficit increases current account balance. However, higher effect growth shocks and extensive fluctuation in interest rate and exchange rate lead to divergence of the deficits. The interest rate and inflation stability should, therefore, be the target variable for policy makers.

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Introduction.

Fiscal and monetary strategies, when executed lucidly, assume a conclusive part in general macroeconomic stability. The macroeconomic theory which assumes an ideal connection between budget (or fiscal) deficit and trade balance is known as twin deficit hypothesis. The growing literature on twin deficit hypothesis (TDH) has been theoretically and empirically researched by researchers like Kim and Roubini ( 2008 ), Darrat ( 1998 ), Miller and Russek ( 1989 ), Lau and Tang ( 2009 ), Abbas et al. ( 2011 ), Bernheim and Bagwell ( 1988 ), Lee et al. ( 2008 ), Corestti and Muller ( 2006 ), Altintas and Taban ( 2011 ), and Banday and Aneja ( 2016 ).

A study by Tang and Lau ( 2011 ) found that a 1% increase in budget deficit causes 0.43% increase in current account deficit in the US from 1973 to 2008. After the currency crises and Asian financial crises, various countries simultaneously experienced budget deficit and current account deficit. Lau and Tang ( 2009 ) confirmed the twin deficits hypothesis for Cambodia based on cointegration and Granger causality testing. Banday and Aneja ( 2016 ) and Basu and Datta ( 2005 ) confirmed the twin deficits hypothesis for India by applying cointegration and Granger causality testing. Kulkarni and Erickson ( 2011 ) found that, in India and Pakistan trade deficit was driven by the budget deficit. Thomas Laubach ( 2003 ) found that for every one percentage increase in the deficit to GDP ratio, long-term interest rates increase by roughly 25 basis points. The recent study by Engen and Hubbard ( 2004 ) found that when debt increased by 1% of GDP, interest rate would go up by two basis points. China needs to take care of lower interest rate rather than higher interest rate especially on home loans which is very low in real estate market and has created a serious trouble in the economy.

The literature identifies that the FDI “crowding in effect” as an important source of China’s current account surpluses. In fact, the World Developmental Report (1985) demonstrated that a country can promote growth using FDI and technology transfers. China employed such strategies to a remarkable effect on foreign exchange reserves which increased from US$ 155 billion in 1999 to US$ 3.8 trillion by the end of 2013. Since then, there has been a sharp decline in the capital account surplus. The data from the State Administration of Foreign Exchange (SAFE) showed that in 2015, China recorded a deficit of US$142.4 billion on the capital and financial account. However, it posted a current account surplus of US$ 330.6 billion.

However, majority of the countries are facing both budget deficit and current account deficit. The increasing budget deficit alongside with current account deficit has been an imperative issue for policy makers in China. Besides, given the importance on free trade, decentralization and development there is a need to understand the association between budget deficit and trade imbalance in Chinese economy. Few researchers like Burney et al. ( 1992 ), Banday and Aneja ( 2015 ), Lau and Tang ( 2009 ), Corsetti and Müller ( 2006 ) and Ghatak and Ghatak ( 1996 ) have emphasized the issue emerged because of growing budget deficit and its relationship with macroeconomic factors likes interest rate, exchange rate, inflation, and consumption.

In the economic literature there are two distinct theories that show the linkage between budget deficit and current account deficit. The first theory is based on the traditional Keynesian approach, which postulates that current account deficit has a positive relationship with budget deficit. This means that an increase in budget deficit will lead to a current account deficit and a budget surplus will have a positive impact on the current account deficit. The increase in budget deficit will lead to domestic absorption and, thus, increase domestic income, which will lead to an increase in imports and widen the current account deficit. The twin deficits hypothesis is based on the Mundell-Fleming model (Fleming, 1962 ; Mundell, 1963 ), which asserts that an increase in budget deficit will cause an upward shift in interest rate and exchange rate. The increase in interest rates makes it attractive for foreign investors to invest in the domestic market. This increases the domestic demand and leads to an appreciation of the currency, which in turn causes imports to be cheaper and exports costlier. However, the appreciation of domestic currency will increase imports and lead to a current account deficit (Leachman and Francis, 2002 ; Salvatore, 2006 ). Conversely, the Ricardian Equivalence Hypothesis (REH) disagrees with the Keynesian approach. It states that, in a setting of an open economy, there is no correlation between the budget and current account deficits and hence the former would not cause the latter. In other words, a change in governmental tax structure will not have any impact on real interest rate, investments or consumption (Barro, 1989 ; and Neaime, 2008 ). The assumption here is that consumption patterns of consumers will be based on the life cycle model, formulated by Modigliani and Ando in 1957 , which suggests that current consumption depends on the expected lifetime income, rather than on the current income as proposed by the Keynesian model. Furthermore, the permanent income hypothesis developed by Milton Friedman in 1957, states that private consumption will increase only with a permanent increase in income. This means that a temporary rise in income fueled by tax cuts or deficit-financed public spending will increase private savings rather than spending (Barro, 1989 , p. 39; Hashemzadeh and Wilson, 2006 ). As private savings rise, the need for a foreign capital inflow declines. In this situation a current account deficit will not occur (Khalid and Guan, 1999 , p. 390).

This paper attempts to find out how strong is the relationship between budget and current account deficits in China? Addressing this question is relevant for both policy and academic perspectives. Policymakers would like to know to what extent fiscal adjustment contributes to addressing external disequilibria, especially in the case of increasing external and fiscal imbalances. Secondly, we examined the effects of budget deficit on the current account in the multivariate framework, and also have derived the general relationship among those variables. The study is based on ARDL model to investigate twin deficit hypothesis for china both in short-run and long-run. Further, we analyze the direction of causality if such a relationship exists. We utilize econometric methods for example, ARDL bound testing approach and Granger causality test to achieve these goals. In section “Theoretical Background and Literature Review” we explore the theoretical foundation of the twin deficits hypothesis. Section “Macroeconomics Aspects of the Chinese Economy” will give Macroeconomics Aspects of the Chinese Economy. Section “Data and Empirical results” describes data and empirical results. Section “Results and Discussion” provides empirical results and section “Conclusions”, provides conclusion to the study.

Theoretical background and literature review

The theoretical relationship between budget deficit and current account deficit can be represented by the national income accounting identity:

where IM stand for imports, EX for exports, S p for private savings, I for real investments, G for government expenditure, T for taxes, and TR for transfer payments. When IM is greater than EX, the country has current account deficit. From the right-hand side of the equation, when (G + TR − T) is greater than 0, the country is running a budget deficit. The difference between budget deficit and current account deficit must equal the private savings and investments which are shown below.

In the literature, various studies attempt to find the relationship between budget deficit and current account deficit for different countries or groups of countries using various methods depending upon the sample size and pre-testing of the data. The researchers have generally focused on the U.S economy because of its simultaneous budget and current account deficit since 1980s (Miller and Russek, 1989 ; Darrat, 1998 ; Tallman and Rosensweig, 1991 ; Bahmani-Oskooee, 1992 ). However, researchers from different countries have studied twin deficit hypothesis and obtained different results for different countries (Like India, U.S and Brazil) ((Bernheim, 1988 ; Holmes, 2011 ; Salvatore, 2006 ; Mukhtar et al. 2007 ; Kulkarni and Erickson, 2011 ; Banday and Aneja, 2016 ; Ganchev, 2010 ; Lau and Tang, 2009 ; Rosensweig and Tallman, 1993 ; Fidrmuc, 2002 ; Khalid and Guan, 1999 )). These studies do not support the REH but rather accept the Keynesian traditional theory, finding that budget deficit does have an impact on current account deficit in the long run. There are studies that support the Ricardian equivalence theorem which denies any correlation between budget deficit and current account deficit (Feldstein, 1992 ; Abell, 1990 ; Kaufmann et al. 2002 ; Enders and Lee, 1990 ; Kim, 1995 ; Boucher, 1991 ; Nazier and Essam, 2012 ; Khalid, 1996 ; Modigliani and Sterling, 1986 ; Ratha, 2012 ; Kim and Roubini, 2008 ; Algieri, 2013 ; Rafiq, 2010 ). These contradictory results may be due to differences in the sample period and the methods of measuring variables, which use different econometric techniques.

Khalid ( 1996 ) researched 21 developing countries from the period of 1960–1988, taking three variables into consideration: real private consumption, real per capita gross domestic product (GDP) as a proxy of real disposable income and real per capita government consumption expenditure as a proxy of real public consumption. This was done using Johansen cointegration (1988) and full information maximum likelihood (FIML) for parameter estimates. The model gives us restricted and unrestricted parameter estimations when restricted parameters are used, meaning that parameter estimation is non-linear when testing the REH for the sample countries. The results did not reject the REH for twelve of the countries, but the remaining five countries do diverge from the REH. The rejection of Ricardian equivalence in the latter group of countries demonstrates lack of substitutability between government spending and private consumption. Ghatak and Ghatak ( 1996 ) studied variables such as private consumption, government expenditure, income, taxes, private wealth, government bonds, government deficits, investments, government spending and interest on bonds to test the Ricardian Equivalence hypothesis for India for the period from 1950 to 1986. The study employed multi-cointegration analysis and rational expectation estimation, and both the tests rejected the REH, finding evidence that tax cuts induce consumption. Thus, the results invalidate the REH for India.

Ganchev ( 2010 ) rejected the Ricardian equivalence theorem for the Bulgarian economy using monthly time series data for the period 2000–2010. The long-run results of the vector error correlation model (VECM) showed evidence of the structural gap theory, which states that fiscal deficit influences current account deficit. However, vector autoregression (VAR) results did not show any evidence of a short-run relationship between budget deficit and current account deficit. The study, therefore, found that fiscal policy should not be used, in the Bulgarian economy, as a substitute for monetary policies in maintaining the internal equilibrium.

Nazier and Essam ( 2012 ) studied the Egyptian economic data from 1992 to 2010. The data included five variables: GDP, government budget deficit (as primary deficit), current account deficit, real lending interest rate (RIR) and real exchange rate (RER). The study used structural vector autoregression (SVAR) analysis, which also gave an impulse response function (IRF) to capture the impact of budget deficit on current account deficit and real exchange rate. The findings support the twin divergence hypothesis. This contradicts the theoretical framework, which finds that a shock given to a budget deficit leads to an improvement in the current account deficit and exchange rate. Sobrino ( 2013 ) investigated the causality between budget deficit and current account deficit for the small open economy of Peru for the period 1980–2012 using the Granger causality and Wald tests, generalized variance decomposition and the generalized impulse-response function. The study found no evidence of a causal relationship between budget deficit and current account in the short run.

Goyal and Kumar ( 2018 ) investigates the connection between the current account and budget deficit, and the exchange rate, in a structural vector autoregression for India over the period 1996Q2 to 2015 Q4. The impact of oil stuns and the differential effect of consumption and venture propose compositional impacts and supply stuns rule the conduct of India's CAD, directing the total request channel. Ricardian hypothesis is not supported.

Afonso et al. ( 2018 ) studied 193 countries over the period of 1980–2016 using fixed effect model and system GMM model. The results find the existence of fiscal policy reduces the effect of budget deficit on current account deficit. When there is an absence of fiscal policy rule twin deficit hypothesis exists.

Bhat and Sharma ( 2018 ) examines the association between current account deficit and budget deficit for India over the period of 1970–1971 to 2015–2016 using ARDL model. The results accepts Keynesian proposition and rejects Ricardian equivalence theorem. The results find long-run relationship between current account deficit and budget deficit. Rajasekar and Deo ( 2016 ) find the long-run relationship and bidirectional causality between the two deficits in India. Garg and Prabheesh ( 2017 ) investigate the twin deficit for India by using ARDL model and confirm the twin deficit hypothesis. Badinger et al. ( 2017 ) investigated the role of fiscal rules in the relationship between fiscal and external balances for 73 countries over the period of 1985–2012. Their results confirm the twin deficits hypothesis. Litsios and Pilbeam ( 2017 ) investigates Greece, Portugal and Spain using ARDL model. The empirical results suggest negative relationship between saving and current account deficit in all three countries.

It is clear that the research so far has not yielded any concrete evidence regarding the causal relationship between budget deficit and current account deficit. As such there is a disagreement on the causality between the two deficits. In this paper we test the theory with the support of autoregressive distributed lag (ARDL) bounds testing approach using data for the emerging country China.

Macroeconomics aspects of the Chinese economy

The Chinese economy has experienced an unparalleled growth rate over the past few decades, with increases in exports, investments and free market reforms from 1979 and an annual GDP growth rate of 10%. The Chinese economy has emerged as the world’s largest economy in terms of purchasing power parity, manufacturing and foreign exchange reserves.

In 2008, the global economic crisis badly affected the Chinese economy, resulting in a decline in exports, imports and foreign direct investments (FDI) inflow and millions of workers losing their jobs. It is visible from the Fig. 1 that China’s current account surplus has dropped significantly from its boom during 2007–2008 financial crises. After the financial crisis, China’s exports fell by 25.7% in February 2009. Further, the exclusive demand for Chinese goods in the international market pushed up current account surplus to 11% of the GDP in 2007, in a global economy (Schmidt and Heilmann, 2010 ). It is said that China responded to the 2008 crisis with a greater fiscal stimulus in terms of tax reduction, infrastructure and subsidies when compared to the Organization for Economic Co-operation and Development (OECD) countries (Herd et al., 2011 ; Morrison, 2011 ).

Behavior of Macroeconomic variables. Overview of Budget Deficit (BD), Current Account Balance (CAB), Interest Rate (INT), Inflation (INF), Money Supply (MS) and Real effective Exchange Rate (REER) from 1985 to 2017. Source: Compiled based on data taken from the World Bank. BD and CAB are expressed as percentage of GDP

However, we draw an important inference from the Fig. 1 , when the budget deficit was lowest (−0.41% of GDP in 2008), the current account surplus increased to 9.23% of the GDP. The negative shock to the budget deficit reduces current account surplus and positive shock to the budget deficit increases current account surplus.

The deprecation of the exchange rate is directly related to the elasticity of demand which improves the exports of the country and finally enhances current account surplus. However, the negative shift in the current account is due to structural and cyclical forces. The cyclic forces can be seen from the trade prospective: the increasing prices of Chinese imports like oil and semiconductors, pulls the current account balance downwards. However, the structural shift can be seen from the financial side, which affects Chinese saving and investments. The investments got reduced to 40% and household savings has reduced from 50% to 40% of GDP.

Data and empirical results

For undertaking the empirical analysis, we use the World Bank data for the following variables. The study covers the period from 1985–2016 and is based secondary data.

Current account deficit (CAD) indicates the value of goods, services and investments imported in comparison with exports on the basis of percentage of the GDP

Budget deficit (BD) indicates the financial health in which expenditure exceeds revenue as a percentage of the GDP

Deposit interest rate (DIR) as a proxy of interest rate (INT) the amount charged by lender to a borrower on the basis of percentage of principals

Inflation (INF) is measured on the basis of consumer price index which reflects annual percentage change in the cost of goods and services

Broad money (MS) a measure of the money supply that indicates the amount of liquidity in the economy. It includes currency, coins, institutional money market funds and other liquid assets based on annual growth rate and real effective exchange rate (REER)

The basic model to find out the relationship among BD, CAD, INF, INT, REER, and MS is as follows:

where INF is inflation and DIR is direct interest rate.

Based on Fig. 2 we will estimate the two models in which CAD and BD is dependent variables and others are independent variables which is as below:

Relationship of the dependent variables (CAD and BD) with other macroeconomic variables

To estimate the above models we have employed various econometric techniques to achieve the objective of the study are as below:

Unit root test to check stationarity of the variables.

ARDL bound testing for long-run and short-run relationship among the variables.

Granger causality to check the causal relationship among the variables.

Empirical results

Unit root test.

As we are using time series data, it is important to check the properties of the data; otherwise, the results of non-stationary variables may be spurious (Granger and Newbold, 1974 ). To assess the integration and unit root among the variables, numerous unit root tests were performed. Apart from applying the unit root test with one structural break (Zivot and Andrews, 1992 ), we also employed a traditional Augmented Dickey-Fuller (ADF) unit root test ( 1981 ) and Phillips-Perron test (PP 1988 ).

To ascertain the order of integration, we first applied the ADF and PP unit root tests. The results of the unit root test suggest that the RER and INF series is integrated of order zero I(0), and other variables are integrated of order I(1). The Zivot and Andrews (ZA) unit root test begins with three models based on Perron ( 1989 ). The ZA model is as follows:

From the above equations, DU t ( λ ) = 1, if t  >  Tλ , 0 otherwise: DT t ( λ ) =  t  − T λ if t  > T λ , 0 otherwise. The null hypothesis for Eqs. 4 – 6 is α  = 0, which implies that ( Yt ) contains a unit root with drift and excludes any structural breakpoints. When α  < 0 it simply means that the series having trend-stationary process with a structural break that happens at an unknown point of time. DT t is a dummy variable which implies that shift appears at time TB, where DT t  = 1 and DT t  =  t  − TB if t  > TB; 0 otherwise. The ZA test (1992) suggests that small sample size distribution can deviate, eventually forming asymptotic distribution. The results of the unit root tests are given below.

The first step in ascertaining the order of integration is to perform ADF and PP unit root tests. Table 1 , above, provides the results of the ADF and PP tests, which suggest that four out of six variables are non-stationary at level and two variable is stationary at level. However, it is important to check the structural breaks and their implications, and the ADF and PP tests are unable to find the structural break in the data series. To avoid this obstacle, we applied a ZA (1992) test with one break, the results of which are given in Table 2 . The structural break test reveals four breaks in Model A. The first, in 1992, may be due to inflation caused by privatization; the second, in 1994 may be due to higher inflation which caused the consumer price index to shot up by 27.5% and imposition of a 17% value-added tax on goods; the third, in 2003, may be due to a 48% decline in state owned enterprises at the same time as a reduction on trade barriers, tariffs and regulations was put in place and the banking system was reformed; the fourth, in 2008, is probably due to the global financial crisis

The ZA test with one structural break gives different results, as all six variables are non-stationary at a 1% level.

ARDL bounds testing approach

We applied the ARDL bounds testing approach to check the cointegration long-run relationship by comparing F -statistics against the critical values for the sample size from 1985 to 2016. The bounds testing framework has an advantage over the cointegration test developed by Pesaran et al. ( 2001 ), in that the bounds testing approach can be applied to variables when that have different orders of integration. Thus, it is inappropriate to apply a Johansen test of cointegration, and we applied ARDL bounds testing to determine the long-run and short-run relationships. The F -statistics are compared with the top and bottom critical values, and if the F -statistics are greater than the top critical values, it means there is a cointegrating relationship among the variables Table 3 .

All values are calculated by using Microfit which defines bounds test critical values as “ k ” which denotes the number of non-deterministic regressors in the long-run relationship, while critical values are taken from Pesaran et al. ( 2001 ). The critical value changes as ‘ k ’ changes. The null hypothesis of the ARDL bound test is Ho: no relationship. We accept the null hypothesis when F is less than the critical value for I(0) regressors and we reject null hypothesis when F is greater than critical value for I(1) regressors. For t-statistics we accept the null hypothesis when t is greater than the critical value and reject the null hypothesis when t is less than the critical value.

As seen in Table 4 , the calculated F -statistic F  = 9.439 is higher than the upper bound critical value 3.99 at the 5% level. The results over the period of 1985 to 2016 suggest that there is a long run relationship among the variables and the null-hypothesis of no cointegration is rejected meaning acceptance of traditional Keynesian approach for China. The bounds test results conclude that there is strong cointegration relationship among budget deficit, current account deficit, interest rate, exchange rate, inflation and money supply. Since the F-statistic was greater than the upper bound critical value, we performed a diagnostic testing based on auto-correlation, normality and heteroskedasticity, the results of which were insignificant based on the respective P -values. The Fig. 3 gives the results of CUSUM and CUSUMSQ tests which check the stability of the coefficient of the regression model. The CUSUM test is based on the sum of recursive residuals, and the CUSUMSQ test is based on the sum of the squared recursive residual. Both the graphs are stable, and the sum does not touch the red lines. Hence there were no issue of serial corelation, Heteroscedasticity and normaility in this model see Table 5 .

CUSUM and CUSUMSQ stability tests. Plot of cumulative sum of recursive residuals and plot of cumulative sum of squares of recursive residuals

Long-run and short-run relationship

After discovering the cointegrating relationship among the variables, it is important to determine the long-run and short-run relationships using the ARDL model.

The above Eqs. 7 , 8 of the ARDL model capture the short and long-run relationship among the variables. The model is based on Schwarz Bayesian Criteria (SBC) optimized over 20,000 replications. The lagged error correction term (ECM) is estimated from the ARDL model. The coefficient ECM t −1 should be negative and significant to yield the evidence of a long run relationship and speed of equilibrium (Banerjee et al. 1993). The results of Eqs. 7 , 8 are provided in Table 6 . The results find a strong long-run relationship among the variables for the period from 1985 to 2016.

At 5% level of significance the long-term estimates of the ARDL model find evidence of the twin deficits hypothesis for China, as all the variables are found to be significant at this level. Thus, our study upholds the empirical validity of the Keynesian proposition for China, while rejecting the Ricardian equivalence hypothesis.

The short-run results are significant; the coefficients of BD, CAD, INF, and INT are significant at a 5% level. This shows that a small change in the budget deficit has a significant impact on the current account deficit; similarly most of the macroeconomic variableshave a significant impact on the current account deficit. As we found evidence of a long-run relationship, we calculated the lagged ECM from the long-run equations. The negative (−0.95348) ECM coefficient and the high speed of adjustment brought equilibrium to the economy, with the exogenous shocks and endogenous shocks restoring it after a long period.

The Chinese economy is one of the most integrated economies in the world and has emerged as a powerful actor in the global economy. The pace of growth in china’s economy has accelerated since the decades in which there was a higher export promotion due to market liquidity and flexible governmental policies. In the early 1990s, it was reported in the Chinese print media that although the Chinese economy was expanding rapidly, the deficits still existed. These were called ‘hard deficits’ primarily because they were financed by expanding money supply and hence exerted inflationary pressure on the economy (People’s Daily, March 28, 1993). Deficit financing may also increase interest rates because once the monetary accommodation of the deficit is ruled out, the government has to incentivize consumers and firms to buy more government bonds. If the purchase of government bonds does not increase in direct proportion to the rise in deficit, government must borrow more money. This, in turn, crowds out private investment. Such a reduction in the private sector's demand for capital has been summarized by Douglas Holtz–Eakin, the director of the U.S Congressional Budget Office, as a “modestly negative” effect of the tax cut or budget deficits on long - term economic growth.

This study finds that a higher interest rate significantly affects the budget deficit and current account deficit in both the short-run and long-run. Chinese banks are increasing interest rates on home loans that had previously been very low; however, because of its economic bubble, especially in the real estate market, this is creating serious trouble in the economy. This is similar to the American bubble, in which most people were unable to repay loans, creating a financial crisis. Still, China must work within the existing bubble, even though it creates a lack of investments and can cause trouble for economies worldwide. The debt bubble is due to the elimination of loan quotas for banks in an attempt to increase small business. These companies are still struggling to repay that debt, which is almost half the amount of GDP of both private and public debt (The Economist, 2015).

While empirical research shows a statistically significant relationship between higher budget deficits and long-term interest rates, there are differences on the magnitude of the impact. Chinese needs to take care of lower interest rate rather than higher interest rate especially on home loans which was very low; in real estate market which has created a serious trouble in the economy.

It is also important to note that the concept of the deficit includes both hard and soft deficits. The “hard” part of the deficit, being financed by printing money, is inflationary. The “soft” part, being financed by the government's domestic and foreign debts, is non-inflationary. However, they are not reported by the Chinese government.

Moreover, hard deficits and consequent inflation increases capital inflows (to prevent interest rates from rising) and causes current account deficit. In China, deficits occurred as a result of overestimating revenues or underestimating expenditures (Shen and Chen, 1981 ) and contributed to the development of bottle-necks in sectors such as energy, transportation, and communications sectors that are of vital importance for the long-term growth of China. However, given the reluctance of the non-government investors to venture into such low pay-back sectors, the Chinese government’s policy to balance budgets by cutting its capital expenditure can severely restrict the development of these sectors (Luo, 1990 , and Colm and Young, 1968 ).

However, the natural explanation for the external surplus is that the economy follows an export-driven growth model by increasing FDI inflows. In the rising tide of economies, China’s demographic boom has created an economic miracle, allowing them to invest in education and skilled workers that will accordingly benefit the economy.

During the global financial crisis of 2008, the Chinese government combined active fiscal policy and loose monetary policy and introduced a stimulus package of $580 billion (around 20% of China’s GDP) for 2009 and 2010. The package partially offset the drop-in exports and its effect on the economy, so that the economic growth of China remained well above international averages. During this period (2008–2009) the current account surplus, as a percentage of GDP was at its highest and the budget deficit was at its lowest point of the entire decade. Our findings suggest that a strong long-run and short-run relationship exists among the variables. The empirical findings support the Keynesian proposition for Chinese economy.

Granger causality

In this section we attempt to estimate the causality from X t to Y t and vice versa. We apply Granger causality to check the robustness of our results and to detect the nature of the causal relationship among the variables based on Eqs. 9 , 10 .

Table 7 describes the results of Granger causality test. The reverse causality holds in light of the fact that budget deficit cause Granger to the current account deficit. For all the variables, the reverse causality from budget deficit to macro variables and current account deficit to macro variables holds at 5% level of significance. Thus, the results of Granger causality gives us more evidences in support of the Keynesian proposition for China in the light of above data. The reverse causality was not apparent because Chinese economy is one of the most integrated economies with higher capital outflows, export-led growth and export promotion due to market liquidity and flexible governmental policies. While the capital inflow determines a tight fiscal policy to avoid overheating of economy (see author Castillo and Barco ( 2008 ) and Rossini et al. ( 2008 ).

Results and discussion

The ambiguous verdict on the twin deficits hypothesis based on two competing theories: the Keynesian preposition and the Ricardian Equivalence theorem. In this paper we investigated the link between budget deficit and current account deficit with an emphasis on the impact of macro-variables shock on current account balance and budget deficit in the Chinese economy over the period 1985–2016.

The conclusion of this study is based on ARDL bound testing approach. The model is based on Schwarz Bayesian Criteria (SBC) optimized over 20,000 replications. With this data and analysis, we conclude that there is a long-run and short-run relationship among the variables. We accept the Keynesian hypothesis, which means we did not find evidence in support of the Ricardian Equivalence theorem in the Chinese economy. This was surprising because higher governmental expenditure and flexible governmental policies could have pushed up the current account deficit. We further applied Granger causality test the results concluded that there is a strong inverse causal relationship between budget deficit and current account deficit meaning that Keynesian preposition is more plausible than Ricardian Equivalence theorem in the light of above data. Our results are consistent with Banday and Aneja, ( 2019 ); Banday and Aneja, ( 2016 ); Ganchev, 2010 ; Bhat and Sharma ( 2018 ); Badinger et al. ( 2017 ), and Afonso et al. ( 2018 ).

The findings of the Granger causality test revealed that there exists bidirectional causality running from budget deficit to current account balance and vice versa in China. A similar movement of the budget deficit and the current account balance is the thing that one would expect when there are cyclic shocks to output. Detailed empirical findings highlight that the interest rate bubble and higher inflated housing prices are becoming a challenge for the Chinese economy, as they are now nearing the prices of the US bubble before the financial crisis popped it. If the US increases interest rates, the money will flow out of the Chinese market, which could cause a similar crisis in China. It will be a challenge for the monetary authority to bring stability in China where inflation, interest rate bubble and exchange rate volatility are of primary concern. Expenditure reduction for low payback sectors, such as energy and communication, could also be a worry in the future. Rising inflation can significantly increase the inflow of capital due to an increase in domestic demand; this can lead to a current account deficit, as it is now more than half of the GDP. The indebtedness in the economy is at its peak, and this can crush the financial cycle and cause financial crisis.

Conclusions

The cointegration investigation confirms the presence of a long-run relationship between the variables. The results propose that there is a positive connection between the current account deficit and fiscal deficit. Our outcomes show that increase in money supply and the devaluation of the exchange rate increases current account balance. The effects of the current account deficit and the exchange rate have been taken as exogenous. A long-run stationary association between the fiscal deficit, current account deficit, interest rate, inflation, money supply, and the exchange rate has been found for China. Granger causality tests reveal bidirectional causality running from budget deficit to current account balance and macroeconomic variables to budget deficit and current account balance.

A genuine answer for the issue of budget deficit and current account deficit lies with a coherent package comprising of both fiscal and monetary approaches. It must concentrate on stable interest rate, inflation target and monetary position will supplement the budget-cut policies. The findings of the paper will be helpful for future empirical models, which attempt to further highlight the transmission mechanism.

Data availability

For undertaking the empirical analysis, we use the World Bank data for the following variables. The study covers the period from 1985 to 2016 and is based on secondary data which are available at: https://data.worldbank.org/country/china .

Change history

01 october 2019.

An amendment to this paper has been published and can be accessed via a link at the top of the paper.

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Banday, U.J., Aneja, R. Twin deficit hypothesis and reverse causality: a case study of China. Palgrave Commun 5 , 93 (2019). https://doi.org/10.1057/s41599-019-0304-z

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Government Budgets, Debt and Deficits Research Paper

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This research paper describes the economics of government budgets, with particular attention to government borrowing in the United States at the federal, state, and local levels. The next section provides definitions and describes some principles of federal, state, and local budgeting. The third section focuses on major issues pertaining to federal government borrowing. The final section is a summary.

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Get 10% off with 24start discount code, definitions and principles of government budgeting, preliminaries.

Equity and efficiency are crucial concepts in economics, so it is useful to begin by defining these terms. Two principles guide evaluations of the effect economic policies have on equity. The benefit principle is the viewpoint that it is equitable for citizens who benefit from government services to pay for them. The ability-to-pay principle is the viewpoint that it is equitable for a citizen’s tax liabilities to be correlated with the citizen’s economic resources. It follows that taxpayers with equal abilities to pay should be taxed equally (horizontal equity) and that tax liability should increase as ability to pay increases (vertical equity). Resources are allocated efficiently if and only if they are used where they have the highest social value.

Operating and Capital Budgets

State and local governments report operating budgets and capital budgets. In general terms, an operating budget is an enumeration of (a) expenditures on current operations and (b) the revenue inflows required to finance those operations (current operations take place each period). Typical expenditures on current operations include purchases of services and of tangible items. Services are commodities that cannot be stored, for example, state employee salaries and interest payments on government debt. Tangibles are items that are used up each period, for example, stationery and gasoline. Revenue inflows collected in 2009 include tax and fee collections that are used to pay for 2009 operating expenditures.

Capital budgets enumerate (a) planned spending on purchases and repairs of capital assets and (b) the means of financing capital assets. In contrast to current operations, capital assets are used for many periods (examples are roads, school buildings, and water treatment plants). Because capital purchased in the current period produces services in the future, capital, like houses, often is financed with borrowed funds. Governments borrow by selling bonds, which are repaid over many periods, when the services produced by capital are enjoyed. A legal obligation requiring future expenditures is a financial liability. Thus, a capital budget is an enumeration of expenditures on capital assets and newly incurred liabilities in a given period. In contrast to most state and local governments, the federal government does not report a capital budget.

A fiscal year is a 12-month period covered by an operating budget. The U.S. federal government’s fiscal year begins on October 1 of each calendar year and ends on September 30 of the following calendar year. Before the beginning of a fiscal year, governments formulate planned operating budgets, which show planned expenditures and expected tax and fee revenues. However, some operating expenditures are difficult to plan for (e.g., disaster assistance), and tax and fee revenues are difficult to predict (e.g., sales tax revenue). Thus, within any fiscal year, actual expenditures may differ from plans, and actual tax and fee revenue may fall short of predictions. In all cases except Vermont, U.S. state governments are constitutionally required to adjust their operating budgets so that by the end of each fiscal year, actual expenditures do not exceed tax and fee revenue. Economists call this restriction the government’s current budget constraint. Note that if expenditures equal tax and fee revenue, the state budget is said to be balanced.

Although the national government also must satisfy a current budget constraint, the restriction is much less severe than that faced by subnational governments. This is true because national governments, generally, are not required to balance their operating budgets. Thus, national governments can borrow to finance operating expenditures. The national current budget constraint states simply that in a fiscal year, government expenditures cannot exceed the sum of borrowed funds plus tax and fee revenue. Additionally, many national governments can issue money, which can be used to finance expenditures. Of course, there is a limit to money finance because money creation tends to cause inflation. U.S. law precludes the federal government from directly issuing money to finance expenditures. However, if the U.S. Federal Reserve Bank (the Fed) buys U.S. Treasury bonds, the money stock increases. This is a form of indirect money finance. However, U.S. law precludes the federal government from compelling the Fed to buy Treasury bonds. For most of its history the Fed appears not to have engaged in indirect money finance.

Governments’ current budget constraints restrict expenditure and revenue choices within a fiscal year. Governments, like individual consumers and businesses, also face a constraint that extends into future periods, namely, the intertemporal budget constraint (IBC). IBC dictates that the sum of current and all future expenditures plus currently outstanding debt cannot exceed current plus all future tax and fee revenue (outstanding debt is debt that has not yet been paid off). Here, future expenditures/ revenues are measured in “present value terms.” (Note that the present value of a dollar to be received in a future period is the dollar adjusted downward by the opportunity cost incurred by not having the dollar for a period. The opportunity cost is the rate of return that could have been earned if the dollar were invested during the period.)

There seems to be a great deal of public confusion about IBC, so it is important to be clear about what restrictions it does and does not impose. In general, the IBC imposes the condition that any increase in expenditure implies an increase in current taxes or future tax liabilities equal in present value to the expenditure. By way of a false analogy, IBC sometimes is taken to mean that governments must repay principal on their debts. This is incorrect. To see why, first note the economic incentives that motivate creditors to lend. Creditors are willing to forgo consuming their wealth for some period of time if they are compensated with a market rate of return on the loans. Second, because individual consumers, sadly, live only finite periods of time, they must repay debt principal before they or their estates expire. Creditors will demand that the principal is repaid. For if creditors were not repaid the principal, they would suffer a large opportunity cost, namely, the opportunity to continue to earn the market rate of return.

However, the same cannot be said for governments and successful business firms because their “lifespans” effectively extend into the indefinite future: They are not finite. As a result, if a government reliably pays the market rate of return on its outstanding debt, and creditors believe the government will continue to do so, the government can satisfy its creditors by servicing its debts forever; it is not required to repay the principal on the debt.

IBC may seem to be a weak restriction on government choices. Nonetheless, IBC does place an important restriction on government debt policy: The government cannot sustain a policy that would cause debt to grow faster than the economy in the long run. If the debt did grow faster, it would outrun the economy’s ability to generate the revenue that must be collected to pay the market rate of interest on the debt. In this case, creditors eventually would stop making loans to the government, and the policy must terminate. Is recent U.S. debt policy sustainable?

Why Report Budgets?

The U.S. government reports a budget each fiscal year in accord with Section 9, Article 1, of the U.S. Constitution, which states that “a regular statement of accounting of receipts and expenditures of all public money shall be published from time to time.” The states have stringent constitutional provisions, requiring construction of budgets, and states impose similar requirements on their local governments.

But what is the value added of a government budget? Government budgets have two major purposes. First, budgets provide information the public needs to evaluate the costs and benefits of public goods and services. This information is fundamental in democracies. Underlying the relations between a democratic government and its citizens is an assumption that government activities are sanctioned by a social contract in which citizens relinquish some freedom in return for public goods and services. Without a budget, this evaluation would be more difficult than it is.

Second, budgets indicate whether governments’ expenditure and revenue decisions are financially responsible. Without a budget, it is harder to know if fiscal policy satisfies the government’s budget constraints, and it would be difficult, if not impossible, for the public and the government itself to know whether spending, revenue, and borrowing policies are financially sound.

Why Report Capital Budgets?

State and local governments separate operating from capital expenditures, and report a separate capital budget. For example, spending on public capital infrastructure (government buildings, highways and bridges, etc.) is included in state capital budgets, whereas spending on teacher and administrative salaries is included in operating budgets. Many foreign national governments publish capital, as well as operating, budgets. Capital budgeting requires time and resources.

Do capital budgets have economic benefits that offset these costs? Public capital goods generate returns and impose risks, just as private capital does. Governments issue bonds, so there is risk of government bond default. Governments also maintain portfolios in trust for the public (largely in the form of pensions). There is a risk to taxpayers that pension assets will lose value. Government capital budgets allow taxpayers and investors to more easily evaluate the risk and returns of funds held in trust by the government.

State and local governments are required to balance their budgets. If there were no separation of capital expenditures from current expenditures, the balanced budget requirements would prevent state and local governments from borrowing to finance capital assets. In this case, states would need to finance capital expenditures by collecting taxes in the period the purchases were made: In no period could capital purchases exceed tax revenue collected in that period. This would be inefficient and inequitable.

To see why it would be inefficient, note that financing capital purchases from current tax collections would require outsized tax increases in periods when purchases are made, because capital, by nature, is very costly relative to a single period’s income. Tax finance of capital would lead to large variations in tax revenue requirements because purchases of capital tend to be “lumpy.” For example, once a new school or courthouse is built, government does not need to build another for a while. As explained next, tax variability is economically inefficient (Barro, 1979). As well, the expenditure could require a single-period increase in tax revenue too large to be politically tenable, which could lead to a less than efficient level of investment in public capital.

Financing capital purchases from current tax collections would also be inequitable. First, it would violate the benefit principle because future generations could consume government capital services they have not paid for. Borrowing today and repaying part of the debt with future tax dollars allows the cost to be shared with the future beneficiaries of capital services. Second, it would violate horizontal equity because households with equal abilities to pay, and who receive equal government services but are born to different generations, would face different tax burdens.

Should the U.S. Government Report a Capital Budget?

The U.S. federal government does not publish a capital budget. Some economists argue that publication of a federal capital budget would be beneficial. Others argue that a federal capital budget would be difficult to implement.

A federal capital budget would make it easier for taxpayers and investors to evaluate the risk and returns of federal government investments. Marco Bassetto and Thomas Sargent (2006) argue that the absence of a federal capital budget may tempt some policy makers to make choices inconsistent with Generally Accepted Accounting Principles. For example, it is sometimes argued that the government should sell some of its physical assets to reduce the federal government’s debt. In general, this is not an economically meaningful way of satisfying the government’s budget constraint; instead, it merely replaces a physical asset for cash, and has no effect on social net wealth. The exchange would be economically meaningful only if the private sector pays more for the asset than its true social value. This seems unlikely in most cases. If the federal government published a capital budget, the economic futility of such an exchange would be easier to understand and avoid.

It has been argued that it would be hard to implement a federal capital budget because it is difficult to categorize some public expenditures. Examples are highway spending, public education, and spending on public safety. State governments address this issue by including the cost of school building in capital budgets and teacher salaries in operating budgets. It is unclear why the federal government could not or should not take the same approach.

Weaknesses in Government Budgeting

Budgets should be designed to aid policymaking and provide the public with information about fiscal policy. In this way, budgets provide rough guides to the social costs and benefits of government. However, these goals can be subverted in a number of ways.

First, the government can impose costs and provide benefits in ways that are not captured in budgets. For example, the U.S. federal government has imposed unfunded mandates on subnational governments (e.g., requirements for school achievement), but the costs of such programs do not appear in the federal budget.

Second, many government-imposed costs and benefits are intangible and hard to measure. For example, it may be impossible to measure the social benefits of public education. Even if possible, the cost of conducting the measurements could be prohibitive. In the case of government guarantees of private loans, an implicit social cost is created because taxes may have to be increased if the loans go into default; however, the social cost is not reported in budgets. As well, governments can rule some expenditures “off budget.” In this case, although measurements are available, the government does not report them in its operating budget. At the federal level, Social Security is an example of an off-budget program.

Third, government budgets may be constructed using substandard accounting. For example, most governments use cash flow accounting. Under cash flow accounting, revenues are included in the budget in the period when received: Expenditures are included in the period when they are paid. In contrast, Generally Accepted Accounting Principles, which are established by the Financial Accounting Standards Board and must be followed by all publicly traded corporations, require private firms to use accrual accounting. In accrual accounting, revenues are included in the budget in the period earned, and costs are included when incurred. Cash accounting is easier (than accrual accounting) to manipulate in ways that produce a misleading representation of the government’s true fiscal position. For example, if a state’s operating budget is out of balance, the state may postpone payment for goods and services until the following fiscal year, or may order tax liabilities due in the following year be prepaid, making the budget to appear to be in balance. Cash flow accounting manipulation may delay the appearance of budget problems but does not solve them. In the interim the government’s fiscal position can worsen.

In the United States, delay and erosion in the federal government’s fiscal position appear to be most severe in the Social Security and Medicare programs. Social Security uses “pay-as-you-go” finance—that is, currently employed workers pay Social Security (payroll) taxes, and the government uses the tax collections to make benefit payments to current beneficiaries (mostly retirees). However, pay-as-you-go Social Security satisfies the government’s intertemporal budget constraint only if there are sufficient young taxpaying workers to finance benefits. Assuming the system initially is in balance, if the number of young workers subsequently declines relative to the number of beneficiaries, the system will no longer be sustainable: To satisfy the constraint, benefits must be reduced, taxes must be increased, or both. In the past 35 years, the average U.S. fertility rate has declined, diminishing the number of young workers per retiree, and the mortality rate of retirees has decreased, increasing the number of retirees per young worker. As currently structured, the U.S. Social Security system appears unsustainable, but this is not reflected in the budget.

In any year, the lion’s share of U.S. federal and state budgets consist of previously established programs. The majority of budgeted programs are not subjected to systematic review of their costs and benefits. Programs that outlive their original motivation and usefulness can become a net burden on society, subverting a basic reason for budgeting. Some observers advocate zero-based budgeting. In this case, the government would reevaluate each program at the beginning of each budget year. Such close monitoring of government programs has a potential to reduce unproductive government spending. However, close monitoring imposes administrative costs. Zero-based budgeting would be an improvement if the cost of unproductive programs exceeds the administrative costs of monitoring programs.

State and Local Government Budget Shortfalls: Rainy Day Funds

From time to time, actual expenditures expand faster than tax and fee revenue, or revenue may actually decline, causing a budget shortfall. Budget shortfalls often occur during economic contractions. Shortfalls are created as the decline of household and business income reduces income tax revenue, consumer spending, and sales tax revenue. Occasionally, property values also decline, reducing property tax revenue. Making matters worse, during contractions, demand for government expenditures on social programs tend to increase (e.g., unemployment insurance and social welfare spending increase in recessions).

Can budget shortfalls be avoided by eliminating the instigating factor, economic contraction? The National Bureau of Economic Research defines the business cycle as the recurring and persistent contractions and expansions in economic activity. The term recurring is emphasized because past experience offers convincing evidence that economic contractions are indicative of developed economies and will recur from time to time. The correlated budget shortfalls create enormous fiscal stress, because states must balance their operating budgets. The question here is, how can state and local governments respond to periodically recurring budget shortfalls?

One response is to increase taxes and reduce expenditures. This approach can be counterproductive and tends to be politically difficult. It can be counterproductive because reducing demand for goods and services can worsen the shortfall. It is difficult to increase taxes in contractions because income declines as workers lose jobs and firms go out of business. However, there is a sound alternative to tax increases and expenditure cuts during contractions. Because recurring contractions are almost a certainty, sound fiscal planning would have state and local governments act before economic disaster strikes by establishing budget stabilization funds, also known as rainy day funds (RDFs). In the ideal case, during economic expansions, RDFs would accumulate tax revenue in trust funds. During subsequent contractions, the trust funds would be used to support expenditures, reducing the need to raise taxes and cut expenditures.

The Advisory Council on Intergovernmental Relations, a group of tax administrators and state government officials, recommends that RDFs be established at a target level of 5% of a state’s annual expenditures. However, the 5% target has proven to be very inadequate. For example, in recessions in 1981 and 1982, 1990 and 1991, and 2001, North Carolina budget shortfalls averaged 19% of a typical year’s expenditure. There is evidence that absent or insufficient RDFs contribute to fiscal stress, imposing substantial yet avoidable costs on society. How?

First, without a sufficient RDF, policy makers and administrators spend substantial time and energy reworking policies in response to budget shortfalls, rather than on the formulation of social policy and the ordinary business of running the government. Ignoring the ordinary business of government causes government services to deteriorate.

Second, without a sufficient RDF, state and local governments risk lower credit ratings from bond rating agencies. Lower credit ratings cause interest rates on state and local borrowing to increase, which leads to avoidable increases in future tax liabilities.

Third, without a sufficient RDF, there is a risk to private investment and planning because taxes would otherwise need to be increased, or expenditures cut, or both, during economic contractions. Stop-and-go fiscal policy increases uncertainty, which discourages private investment and tends to retard economic growth.

Fourth, without a sufficient RDF, taxes tend to be more variable than otherwise. More tax variability implies a larger excess burden of taxation. The excess burden of a tax is the social burden of the tax in excess of the amount of tax revenue collected. Excess burden occurs because people substitute lower valued untaxed commodities for higher valued taxed commodities, reducing economic welfare by more than the tax payment remitted to the government. Without RDFs, policy makers tend to respond to budget shortfalls by increasing tax rates. An appropriately sized RDF can reduce excess burden by reducing the need to increase tax revenue during budget shortfalls.

National Debt and Deficits

What is the “national debt”.

National government financial debt is created when the expenditures in a fiscal year exceed tax and fee revenue. The national government finances the excess of expenditure over revenue by borrowing. For example, the U.S. government auctions off U.S. Treasury bills, notes, and bonds (U.S. bonds, hereafter). The U.S. Treasury defines the Gross Debt to be the value of all national government bonds outstanding. However, the media and the public often refer to this same concept as the National Debt. Gross Debt and National Debt are synonyms. The remainder of this research paper uses the former term.

A government’s ability to sell bonds depends on creditors’ faith that the bonds will be repaid and on the creditors’ financial capacity to buy the bonds. Creditors’ faith depends on the economy’s ability to generate future tax revenue, which depends on the economic growth rate. Creditors’ financial capacity depends on their incomes and saving. Because saving cannot grow faster than the economy in the long run, creditors’ financial capacity to buy bonds is limited by the economy’s long-run growth rate. Therefore, if Gross Debt grows faster than the economy in the long run, the economy’s ability to generate tax revenue to service debt, and creditor’s capacity to buy new debt, falls short of the government’s liabilities. If the public understands that the Gross Debt continually grows faster than the economy, creditors will demand abnormally high interest rates to compensate for the risk of not being repaid. Or creditors may simply refuse to purchase additional government debt. In this case, the government faces a “debt crisis,” and the government’s choices become severely constrained: (a) taxes must increase or expenditure must be cut, or both, or (b) government must default on its liabilities and convince creditors to reschedule debt payments. If these options are not available, the only recourse is for the government to repudiate the debt. In this case, government simply declares its intention to not repay the debt.

Interest rates tend to increase greatly in debt crises, and living standards tend to decline. If the government responds to a debt crisis by raising taxes and reducing spending, this exacerbates the decline. Fortunately for the United States, its national government has never experienced a debt crisis. Nevertheless, some public finance economists (Blocker, Kotlikoff, & Ross, 2008; Gokhale, Page, Potter, & Sturrock, 2000; Kotlikoff, 1992) worry that in the decades ahead U.S. Medicare and Social Security obligations could generate fiscal imbalances that could approximate a debt crisis. They argue that U.S. tax rates must increase substantially or benefits must be cut by painful amounts.

Countries that default on debt often have attempted to maintain financial viability by rescheduling debt payments. In this case, the government usually ends up paying much higher interest rates to compensate for the increase in risk perceived by creditors. Even though interest rates increase, the exchange value of the country’s currency tends to decline greatly, as creditors shift funds to safer environments. A large decline in the currency reduces the standard of living because imports become more expensive.

Debt Repudiation

Debt repudiation is the most drastic response to a fiscal crisis. One form of debt repudiation occurs when a government renounces its debt obligations. In 1917, Russia announced that it would not repay debt incurred by the Czars. In the 1930s, the Peronists renounced Argentina’s government debt. A second form of debt repudiation occurs when a government prints money to repay outstanding debt. This form of repudiation often leads to inflation that reduces the real value of debt. After World War I, the Allies imposed war reparation payments on Germany. The German government created a hyperinflation that effectively made the reparation payments worthless.

An advantage of debt repudiation is that it eliminates the burden on taxpayers of repaying previously issued debt. A disadvantage is that repudiation usually decimates the value of a country’s currency, its ability to trade, and the standard of living. For a long time after repudiation, a country may not be able to borrow at all, making it difficult to maintain government services.

How Large Is the U.S. Gross Debt?

The U.S. Gross Debt was about $10 trillion at the end of the federal government’s 2008 fiscal year. As of early 2009, the U.S. Congressional Budget Office estimated that fiscal 2009 borrowing would increase the Gross Debt by about $1.2 trillion.

However, this figure could provide a misleading measure of the effects the debt has on the U.S. standard of living. There are a number of reasons for this.

First, the government’s ability to service its debt, as well as the extent of the debt’s effect on interest rates and the standard of living, depend on the size of the economy. For example, a debt of $10 trillion would overwhelm a small country such as Costa Rica, whose 2007 gross domestic product (GDP) is estimated to be about $48 billion (CIA World Factbook, 2008). If Costa Rica’s debt were this large, interest rates would rise to extreme levels, and the value of its currency probably would decline precipitously along with its standard of living. The $10 trillion U.S. Gross Debt does not cause these dire results because U.S. GDP, at a little less than $14 trillion in 2008, is 287 times larger than Costa Rica’s. Thus, the U.S. debt is a much smaller fraction of its credit markets, so the debt is much easier to service and sustain. As a result, the absolute amount of debt in countries cannot usefully be compared unless each country’s debt is adjusted for the scale of the economy. In fact, a single country’s debt in different periods cannot be usefully compared because the scale of the economy increases over time.

Because economic scale differs across countries and over time, a more accurate assessment of the economic impact of debt is made by adjusting the absolute amount of debt for scale. A common way to do this is to divide the absolute amount of a country’s national debt by its GDP. When the U.S. Gross Debt was $10 trillion, the debt/GDP ratio was about 71% ($10 trillion/$14 trillion). In historical comparison, the U.S. debt/GDP ratio was 120% at the end of World War II (WWII) and did not decline to 73% until the mid 1950s. During the Clinton administration, the ratio declined to about 60% (see Figure 1). The 2007, debt/GDP ratios in seven large capitalist-oriented economies were 64.2% in Canada, 104% in Italy, 170% in Japan, 63.9% in France, 64.9% in Germany, and 43.6 % in the United Kingdom. The arithmetic average is 85.1%.

Second, the U.S. Federal Reserve holds a substantial fraction of the Gross Debt. Federal Reserve holdings of the debt do not impose the same tax burden as other pub-lically held debt because the Fed remits interest income it earns on U.S. bonds back to the Treasury. Prior to the 2008 financial crisis, the Federal Reserve held about $800 billion of the Gross Debt. Subtracting this amount from the Gross Debt reduces the debt/GDP ratio to about 65.7% ($9.2 trillion/$14 trillion).

Third, federal agencies, such as the Social Security Administration, have large holdings of federal government bonds. At the end of fiscal 2008, intra-agency debt was more than $4 trillion. Some public finance economists argue that this debt is not a true burden on taxpayers: Although it is a liability of one government agency, it is an asset to another agency. However, this point is controversial, because Social Security and Medicare suffer from large fiscal imbalances that imply large future tax liabilities (more on this point subsequently).

Figure 1   Ratio of U.S. Federal Gross Debt to U.S. GDP, 1861-2003

Fourth, state and local governments include bond finance of capital infrastructure expenditures in capital budgets. In contrast, the U.S. government does not report a capital budget. Instead, it includes debt finance of capital expenditure in the Gross Debt. However, to the extent that public capital is productive, it provides taxpayer benefits that tend to offset the liabilities. Productive public capital can increase national income, generating tax revenue that reduces future borrowing needs. The 2008 Economic Report of the President reports that federal government net investment was $38 billion in 2007.

Fifth, most outstanding U.S. debt held by the public has a fixed dollar value. However, inflation reduces the real value of this debt. This means that inflation reduces the real value of tax revenue that will be needed in the future to finance debt service. Thus, the current dollar value of the debt overstates its real economic effect. This should not be taken to imply that the national government has license to reduce its real debt by expansionary money policy that would create inflation. For, taxpayers learn to expect persistent inflation. Expected inflation causes nominal interest rates to increase, which causes the dollar value of the debt to rise. Everything else constant, over time, inflation loses its ability to decrease the real value of debt.

Sixth, Laurence Kotlikoff (1992) argues that proper accounting reveals that the true value of the U.S. government’s liabilities far exceeds the Gross Debt. In addition to the government’s explicit liabilities counted in the Gross Debt, there are large implicit liabilities created by the Medicare system and Social Security. Future revenues expected to be generated by these programs fall far short of the implicit liabilities. Estimates of the shortfalls vary between $25 trillion (Rosen & Gayer, 2008) and $40 trillion (Kotlikoff & Burns, 2004). However, in the future, the U.S. government could legislate lower benefits, whereas it almost certainly will not default on its bonds. Thus, the true size of the U.S. Gross Debt remains a matter of debate.

What Is a Budget “Deficit” and What Is Its Relation to the Debt?

A national government budget deficit occurs when expenditure exceeds tax and fee revenue in a single fiscal year. In this case, the government must borrow to make up the difference. Therefore, a deficit causes the Gross Debt to increase. For example, U.S. federal government expenditures exceeded its revenues by $363 billion in 2007. Thus, the Gross Debt increased from about $8.5 trillion at the end of 2006 to about $8.9 trillion at the end of 2007.

The official deficit reported by the U.S. Treasury in 2007 was $162 billion. Note that this is less than the $363 billion figure just cited. The smaller figure results from the fact that the official deficit includes the “surplus” in the Social Security program. The government spends Social Security surpluses each year. Because the surpluses are spent, when Social Security receipts eventually fall short of benefits paid (around 2017), the difference must be made up by public bond sales, or by increased taxes, or by decreased spending. Public finance economists argue, therefore, that a more accurate accounting of growth in the debt would exclude Social Security surpluses from the deficit. In this case, the $363 billion figure is a more precise measure of the increase in the debt than the official deficit reported by the Treasury.

Recall that the absolute dollar amount of the national debt does not convey its impact on the economy because the size of the economy grows over time. Economic scale also affects the economic impact of a country’s deficit. The preceding figure indicates that the Gross Debt/GDP ratio reached its highest recorded value at the end of WWII. At that time, the deficit/GDP ratio also reached its highest value, about 13%. In 1983, the ratio reached a postwar record of 4.9% (see Figure 1). In 2008 the deficit/GDP had fallen to about 2.8%. However, at this writing, the Congressional Budget Office has predicted that the recession that began at the end of 2007 could drive the ratio above 8% in fiscal 2009.

Do Budget Deficits Improve Economic Welfare?

Almost without exception, U.S. federal government deficits have been a fact of life since the early 1960s. Partly as a result of this record, a vigorous debate over the costs and benefits of deficits has arisen. Deficits have potential to both improve equity and diminish it. They can create efficiencies as well as inefficiencies. This section reviews the arguments pro and con.

It is useful to begin with what the debate is not about. Deficit expenditures on productive public capital investment can be efficient in cases where private markets underproduce such investment. For the most part, the deficit debate is not about debt finance of public capital infrastructure. Instead, the discussion in this section focuses on deficit finance of the national government’s operating expenditures.

The economics of budget deficits are somewhat different in wartime and peacetime. Consider wartime. Wars tend to absorb outsized amounts of an economy’s resources. Rather than relying solely on taxes to acquire resources, national governments often resort to borrowing (see Figure 1). The alternative is to increase taxes. Because the wartime generation sacrifices the use of resources, while future generations presumably benefit from the wartime effort, it has been argued that borrowing to finance wars is equitable. By the same token, it has been argued that debt finance of a war is an efficient investment if it makes citizens in current and future generations better off than they otherwise would be.

The economics of peacetime deficits are more complicated. First, the effects of deficits appear to depend on the specific types of expenditures the deficits support. Second, the effects of deficits appear to depend on the way household saving responds to deficits. Third, the impact deficits have depends on where the economy is located in the business cycle when the deficit is incurred.

Before discussing these issues, it is useful to address a general problem that may arise in the case of debt finance of most types of public expenditures. If current taxpayers believe that others, not they, must repay funds borrowed by the government, debt finance tends to be more politically palatable than taxes. In this case, the ability to finance debt may lead to larger government expenditures than taxpayers would choose if they believed, instead, that they themselves would be required to repay the debt. Therefore, the government’s ability to use deficit finance can lead to inefficiently large amounts of expenditure.

This inefficiency may be offset, to some degree, by the fact that debt finance can be used to reduce the variability of tax liabilities. Reduced tax variability is more efficient (Barro, 1979). To see how, note that variation in tax liabilities from period to period reduces taxpayer welfare, even if the overall tax liability is unchanged. This is true because variability in tax liability causes variability in disposable income, which, in turn, causes variability in household consumption. By the well-known economic law of diminishing returns, an increase in consumption adds less to welfare than a decline in consumption reduces welfare. Consider two ways a household can allocate a given level of income: In the first case, consumption is high at first, followed by low consumption; in the second case, the same level of income is consumed evenly over time. The second case provides more utility. It follows that a given level of tax liabilities reduces utility by less, if tax liabilities are constant over time. In the short run, government revenue requirements vary greatly because of short-run variation in demand for government services. Altering tax liabilities each period to equal the changing revenue requirements reduces welfare more than smooth tax liabilities. Debt finance can be efficient if it is used to smooth tax liabilities: The government can maintain constant tax liabilities by borrowing when revenue requirements are relatively high (e.g., in wartime or in economic crisis) and by repaying loans when requirements are relatively low.

Kotlikoff (1992) argues that the U.S. pay-as-you-go Social Security system incurs large implicit deficits. If the Social Security program is not reformed, current generations are receiving Social Security benefits that must be paid for by future generations, transferring wealth from future generations to current generations. In this case, implicit deficit finance is inefficient: Resources are not allocated where they have the highest social value in the sense that if all citizens, future and current, were fully informed about the system’s costs and benefits, they would chose a different allocation. The Social Security system also is inequitable because citizens who are born into different generations, but have equal abilities to pay, face different levels of taxation.

Further, deficit finance, implicit as well as explicit, has a potential to inefficiently reduce future production and a nation’s standard of living (Altig, Auerbach, Kotlikoff, Smetters, & Walliser, 2001; Auerbach & Kotlikoff, 1987; Feldstein, 1974). This point requires some explanation.

Deficits can reduce the future standard of living if they increase consumption and reduce national saving. To see this, note that national saving is the sum of private, business, and government saving. Also note that the economic effect of borrowing is equivalent to a decline in saving. For example, a household can finance a car by reducing its bank account by $25,000, reducing savings, or by retaining the bank account and borrowing $25,000: The economic effects are the same. Therefore, a deficit is a decline in government saving. If a deficit-induced decline in government saving is not accompanied by an equal increase in private saving, national saving will be lower than otherwise. Lower national saving tends to increase the interest rate: In this case, investment declines because the interest rate is a principal part of the cost of capital. The process by which increased deficits cause investment to decline is called crowding out.

If deficits crowd out private investment, and the government does not use the borrowed funds to purchase productive capital, national capital investment will be lower than it otherwise would be. In this way, crowding out can reduce the amount of capital inherited by future generations, thereby lowering future standards of living. Douglas Elmendorf and N. Gregory Mankiw (1999) estimate that deficits have reduced U.S. incomes by 3% to 6% annually. In this case, unless there is an offsetting economic rationale to run deficits, they are inefficient.

However, deficits may not have such dire effects and, Robert Barro (1974) argues, may not matter at all. Barro argues that deficits (implicit or explicit) do not affect national saving, capital investment, or the future standard of living. This will be true if private savers respond to the deficits by saving more, thereby offsetting the deficit’s negative effect on national saving. Private savers might increase saving if they foresee the negative effect the deficit otherwise could have on future living standards, and if they are determined to prevent deficits from undermining their children’s futures. In opposition to this idea, B. Douglas Bernheim (1987) argues that deficits reduce national saving if the amount that households can borrow is restricted by financial markets. In this case, deficit-financed tax cuts provide these households with funds they would like to borrow from markets, but cannot. These households treat deficit-financed tax cuts as they would borrowed funds, and spend them, reducing private saving and national saving.

Whether debt finance does or does not reduce national saving is an empirical issue and can be decided only on the basis of careful statistical analysis of savers’ behavior (Bernheim, 1987). Currently, there appears to be fairly widespread agreement among economists that deficit finance tends to reduce national saving. In particular, there appears to be a consensus that deficits increase aggregate demand. Economists who take this view argue that if deficit finance is used to increase government expenditures, aggregate demand increases directly. If deficit finance is used to reduce taxes, taxpayers spend at least part of the tax cut, increasing aggregate demand indirectly. The remainder of the discussion studies the effects of deficits in these cases.

Tax collections based on personal income, corporate income, and sales decline during contractions. At the same time, social spending by government tends to rise during contractions. Thus, if the federal government were prohibited from running deficits in contractions, it would be required to increase taxes or cut spending, or both. The federal government’s budget is a very large share of the U.S. economy (about 20% of GDP), so such tax increases or spending decreases would tend to exacerbate contractions, which would inefficiently increase the extent of unemployed resources. Thus, contraction-induced deficits are favored by many macroeconomists and policy makers.

Are contraction-induced deficits consistent with the government’s IBC? As explained before, the important economic implication of IBC is that government must reliably pay the market rate of return on its debt; thus, the debt cannot grow faster than the economy in the long run. If the government ran persistent deficits, the debt would outrun the economy’s ability to produce tax revenue required to service the debt, so persistent deficits are not sustainable. Thus, contractionary deficits satisfy IBC only if the government eventually runs surpluses. An efficient deficit policy would have the government repay recessionary deficits with expansionary surpluses. In this case, the government budget would be balanced across the business cycle: Resources absorbed by the government during recessionary deficits would be freed up during subsequent expansions.

Because resources are underutilized during recessions, many macroeconomists argue that the government can and should be more proactive than simply permitting recessionary deficits. They argue that the government should purposely increase deficits during economic contractions, and that doing so would increase aggregate demand, thereby reducing the severity of contractions. In this case, policy makers would resist cyclical contractions by legislating larger expenditures and lower taxes. This is called activist counter-cyclical fiscal policy. Such policy has a potential to be efficient, if it does not short-circuit the economy’s self-correcting mechanisms and if the government balances its budget over the business cycle.

How Are Government Debt and Foreign Debt Related?

The foreign debt is the accumulated amount that foreigners have lent to both private and government borrowers in the United States, minus the accumulated amount foreigners have borrowed from (primarily private) U.S. lenders. A substantial fraction of loans to U.S. governments are provided by foreigners. For example, before the 2008 financial crisis set in, about 32% of U.S. Gross Debt was owned by foreigners.

As explained earlier, budget deficits tend to increase interest rates, particularly if the economy is expanding. The increase in interest rates encourages foreign lending to the United States, which increases the U.S. foreign debt. Thus, U.S. government debt tends to be positively correlated with the U.S. foreign debt.

Does Foreign Ownership of U.S. Debt Affect the Standard of Living?

By themselves, deficits tend to increase interest rates. Foreign lending increases the supply of loanable funds, which tends to offset the positive pressure deficits exert on interest rates. More generally, foreign lending tends to reduce the cost of U.S. borrowing, which can support economic growth. However, foreign lending also tends to increase the foreign exchange value of the U.S. dollar because lenders must buy dollars in order to buy the U.S. debt. An increase in the exchange value of the dollar tends to reduce U.S. exports and increase U.S. imports, which tends to reduce economic growth. Therefore, the net effect that foreign lending has on the U.S. standard of living is an empirical question and cannot be determined by theory alone.

Many economists assume that foreign lending increases growth and the standard of living, at least in the short run. If so, the effect may be temporary: After all, interest on foreign debt must be paid, and foreigner lenders may someday choose not to refinance loans to the U.S. Does government borrowing from foreign investors increase the U.S. standard of living in the long run? There are a number of possibilities.

First, if U.S. governments use the borrowed funds for productive capital investment, the capital stock will be larger and future U.S. production will be larger. If the productivity of the public capital investments exceeds the interest on the loans, future U.S. living standards will tend to be higher than otherwise. However, if interest payments exceed the productivity of public capital, future U.S. living standards would tend to be lower than otherwise, even if U.S. production is larger. In this last case, even though the borrowed funds increase U.S. output, the income generated contributes to foreign living standards, not U.S. living standards.

Second, if U.S. governments use the borrowed funds for consumption, the foreign debt does not contribute to future production, and debt service would reduce future U.S. living standards because part of the unchanged level of production must be delivered to foreign lenders.

Third, a large and rapid shift away from foreign lending to the U.S. could cause the foreign exchange value of the dollar to decline precipitously. In this case, U.S. interest rates would rise, and the U.S. standard of living could decline sharply. Fortunately, events such as these have never occurred in the U.S. However, they are a real risk whose possibility should be taken seriously in fiscal policy makers’ deliberations.

A Balanced Budget Amendment?

The federal government is not required to balance its budget. Because deficits can be used to increase government expenditure above the amount fully informed taxpayers would choose, some public policy analysts advocate a strict Balanced Budget Amendment (BBA) to rule out federal deficits.

A disadvantage of a strict BBA is that it would prohibit deficit spending in recessions. This would require the government to increase taxes or cut spending during economic contractions, which would tend to exacerbate downturns and make taxes more variable, both of which are inefficient. Further, a strict BBA would prohibit countercyclical fiscal policies of the sort that observers of many political persuasions support during recessions.

Are U.S. Deficit (Debt) Policies Sustainable?

The crucial economic implication of the IBC is that government debt cannot persistently grow faster than the economy. If the debt growth persistently exceeds GDP growth, investors would eventually demand prohibitively high interest rates, or simply refuse to purchase additional government debt. The relative growth rates of debt and GDP are reflected in the debt/GDP ratio, which increases if the debt grows faster than the economy. In 1980, 1990, 2000, and 2008, the debt/GDP ratio was, respectively, 32.0%, 55.2%, 57.3%, and 73.0%. For 3 decades now, U.S. debt policy has been on an unsustainable path. The longer the U.S. continues on this trend, the more serious the economic repercussions will be.

Government budgets provide information the public needs to evaluate costs and benefits of government services and indicate whether the government is operating in a financially responsible manner. Capital budgets allow taxpayers and investors to evaluate the risk and returns of government investment more easily. State and local governments report capital budgets. The U.S. federal government does not. A federal capital budget would make it easier for taxpayers and investors to evaluate the risk and net returns of federal government programs.

State and local governments can reduce the adverse budget effects of economic contractions by properly structured and appropriately sized RDFs. RDFs can help reduce the need for ad hoc reductions in expenditures and increases in taxes that often accompany budget shortfalls. Thus, RDFs can reduce the risk of credit downgrades, uncertainty, and the excess burden of state and local taxes.

The National or Gross Debt is the value of all outstanding national government bonds. If government debt persistently grows faster than the economy, creditors will demand abnormally high interest rates or may refuse to purchase government debt. The economy can suffer severe damage. In a debt crisis, the government must raise taxes or cut government expenditure, default on its liabilities, or repudiate the debt.

There is a long list of reasons why the reported value of national debt must be interpreted cautiously, if one is to understand its economic effects. First, the debt/GDP ratio adjusts the raw value of the debt for economic scale and provides a reasonable tool that can be used to compare debt policies in different countries, as well as the debt of a single country in different years. Second, central banks hold substantial fractions of national debt: This tends to diminish some of the adverse effects of government debt and should be taken into account in attempts to evaluate debt’s economic impact. Third, some fraction of debt finances public capital, which can contribute to economic growth and tax revenue needed to service the debt. Thus, government infrastructure investment also should be accounted for when evaluating the effects of debt. For this reason, many economists favor a federal government capital budget separate from the operating budget. Fourth, a substantial part of the debt has a fixed dollar value, which declines in real terms when inflation is positive. Thus, many economists agree that the real value of the debt influences interest rates, investment, and the standard of living. Fifth, the U.S. government has incurred large implicit liabilities that are not counted in the Gross Debt. Thus, the reported national debt understates the government’s true financial liabilities and provides a misleading estimate of future tax revenues necessary to sustain U.S. fiscal policy.

Debt issue can be used to reduce the variability of taxes, increasing efficiency. It can be used to spread out the costs of government to future generations, who benefit from current government expenditures, which most observers judge to be equitable. However, the ability to issue debt can lead to inefficiently large government expenditure if voters believe they will benefit from spending they will not pay for. Implicit government borrowing can also be used to transfer wealth from future to current generations, which can be inefficient and inequitable (Kotlikoff, 1992). Debt finance can reduce future production and a nation’s standard of living, if deficits crowd out private investment and government does not use the borrowed funds to purchase public capital.

Many macroeconomists argue that the government can and should use countercyclical deficit policy to reduce the severity of economic contractions. Countercyclical fiscal policy has a potential to be efficient, if it does not short-circuit the economy’s self-correcting mechanisms, and assuming the government balances the budget over the business cycle.

Deficit-induced increases in interest rates encourage foreign lending to the United States, which increases the foreign debt. Foreign lending tends to reduce borrowing costs and can contribute to economic growth. However, foreign lending also tends to increase the foreign exchange value of the U.S. dollar, which can reduce U.S. net exports, reducing growth somewhat. The net effect cannot be determined by theory. Funds borrowed from foreign investors and used for public investments can increase the standard of living in the long run, if the return on investment exceeds the interest cost. If the funds are used for consumption, foreign lending will tend to reduce future U.S. standards of living. Foreign debt runs a risk that foreigners may suddenly shift investments away from the United States, which can damage the U.S. economy severely.

Finally, government debt cannot grow faster than the economy in the long run. U.S. Gross Debt has grown faster than the economy for decades. U.S. fiscal policy surely is not sustainable.

Bibliography:

• Altig, D., Auerbach, A. J., Kotlikoff, L. J., Smetters, K. A., & Walliser, J. (2001). Simulating fundamental tax reform in the United States. American Economic Review, 91(3), 575-595.
• Auerbach, A. J., & Kotlikoff, L. J. (1987). Dynamic fiscal policy. Cambridge, UK: Cambridge University Press.
• Barro, R. J. (1974). Are government bonds net wealth? Journal of Political Economy, 82, 1095-1117.
• Barro, R. J. (1979). On the determination of the public debt. Journal of Political Economy, 87, 940-971.
• Bassetto, M., & Sargent, T. (2006). Politics and efficiency of separating capital and ordinary government budgets. Quarterly Journal of Economics, 121(4), 1167-1210.
• Bernheim, B. D. (1987). Ricardian equivalence: An evaluation of theory and evidence. NBER Macroeconomics Annual, 2, 263-304.
• Blocker, A. W., Kotlikoff, L. J., & Ross, S. A. (2008). The true cost of Social Security. Unpublished working paper, Boston University Economics Department.
• CIA World Factbook. (2008, January). Available from https://www.cia.gov/library/publications/the-world-factbook/index.html
• Economic report of the president. Transmitted to the Congress February 2008, together with the annual report of the Council of Economic Advisers. (2008). Washington, DC: Government Printing Office. Available from https://fraser.stlouisfed.org/files/docs/publications/ERP/2008/ERP_2008.pdf
• Elmendorf, D. W., & Mankiw, N. G. (1999). Government debt. In J. B. Taylor & M. Woodford (Eds.), Handbook of macroeconomics (pp. 1616-1669). Amsterdam: Elsevier North-Holland.
• Feldstein, M. (1974). Social Security, induced retirement, and aggregate capital accumulation. Journal of Political Economy, S2, 905-926.
• Fisher, R. C. (2007). State and local public finance. Mason, OH: Thomson South-Western.
• Fox, W. F. (1998). Can the state sales tax survive a future like its past? In D. Brunori (Ed.), The future of state taxation (pp. 33-48). Washington, DC: Urban Institute Press.
• Gokhale, J., Page, B., Potter, J., & Sturrock, J. (2000). Generational accounts for the U.S.: An update. American Economic Review, 90(2), 293-296.
• Kotlikoff, L. J. (1992). Generational accounting: Knowing who pays, and when, for what we spend. New York: Free Press.
• Kotlikoff, L. J., & Burns, S. (2004). The coming generational storm. Cambridge: MIT Press.
• Lindsey, B. L. (1987). Individual taxpayer response to tax cuts: 1982-84: With implications for the revenue maximizing tax rate. Journal of Public Economics, 33, 173-206.
• Mankiw, N. G. (2007). Government debt. In Macroeconomics (pp. 431-452). New York: Worth.
• Noll, F. (2008, August). The United States public debt, 1861 to 1975. In R. Whaples (Ed.), EH.Net encyclopedia. Available from https://eh.net/encyclopedia/the-united-states-public-debt-1861-to-1975/
• Rosen, H. S., & Gayer, T. (2008). Public finance. New York: McGraw-Hill Irwin.

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National Debt Likely to Grow No Matter Who Wins US Presidential Election

Key Takeaways

• Despite rhetoric to the contrary, the national debt has increased significantly under both Donald Trump and Joe Biden.
• Experts say that trend is likely to continue no matter which presumed nominee is elected in November.
• While the national debt is currently manageable, economists are growing concerned it's on an unsustainable trajectory.

No matter who wins November’s presidential contest between President Joe Biden and former President Donald Trump, forecasters see one likely outcome for the nation’s finances: an ever-growing national debt that’s increasingly burdensome because of high interest rates. 

Trump has repeatedly promised to pay off the $34.6 trillion national debt, most recently at a fundraiser in January, although hasn’t specified how. For his part, Biden’s White House proposed a budget this year that would reduce the budget deficit by $3 trillion over 10 years, though Congress didn’t pass it into law.

Despite promises, however, the government spent far more than it took in under both of them, and economists don’t see any reason for that trend to reverse itself. 

While the upcoming election could be a significant one for financial issues including student loan debt , credit card fees , and taxes , the trajectory of the budget is unlikely to change much no matter which party wins. 

“The election could change the medium-term fiscal outlook, though potentially less than one might imagine,” Alec Phillips and Tim Krupa, analysts for Goldman Sachs, wrote in a commentary earlier this month. “While a Republican sweep would involve an extension of the expiring tax cuts, for the most part, this would simply extend current policy (and the current effect on the deficit). While a Democratic sweep would likely involve tax increases, much of this would likely go toward new spending.”

Federal Budget Trajectory Worries Some Forecasters

The trajectory of the budget is getting worse and is setting off more alarm bells among forecasters. The Federal Reserve’s campaign of interest rate hikes meant to combat inflation has made the debt costlier to service. So much so that for the first time the U.S. will pay more on interest than it spends on defense in 2024 ($870 billion versus $822 billion, according to the Congressional Budget Office.)

By some standards, the national debt is actually fairly manageable despite its immense size because the U.S. economy is so productive and growing at a healthy clip. 

Among the countries of the G7 —a group of nations with advanced economies and democratic governments—the U.S. is about the middle of the pack when it comes to the size of its debt compared to its gross domestic product.

However, it’s not the current debt level that’s alarming experts, but what will happen in the decades ahead. By 2054, the spending deficit will amount to 8.5% of the gross domestic product every year, a spending level only exceeded during and shortly after WWII, the Congressional Budget Office estimated in a March report. “In our view, the problem is not so much the previous debt accumulation in the United States— which is large but manageable—but rather the outlook for sizable budget deficits as far as the eye can see,” Michael Pugliese and Aubrey George, economists at Wells Fargo Securities, wrote in a commentary this week.

Experts Say Deficit Levels Are Unsustainable

The trouble is that unless the government stops spending so much more each year than it takes in, the debt-to-GDP ratio is going to grow much larger, according to an analysis this week by economists at Deutsche Bank. Government deficits would have to run anywhere from 2.4%-4.1% of the GDP for the debt-to-GDP ratio to remain stable, they estimated. The CBO estimates deficits will be much larger than that, at around 5%-6% of GDP over the coming decades. Federal Reserve Chair Jerome Powell and the International Monetary Fund have recently warned the U.S. is on an unsustainable trajectory with its budget. Fixing it would require balancing the books somehow, either by cutting spending or raising taxes, which are usually opposed by Democrats and Republicans, respectively. 

When lawmakers of both parties have negotiated budget deals, they typically have compromised by avoiding both spending cuts and tax increases . Meanwhile, spending on the COVID-19 pandemic and increased spending on defense have combined with higher interest rates to fuel ever-growing deficits. 

The problem is a solvable one, the Wells Fargo economists concluded, given that the U.S. enjoys many financial advantages, including the fact that the dollar is the world’s reserve currency and the U.S. has the world’s largest and most diverse economy. 

“Fiscal consolidation via higher revenues, lower spending or some combination of the two would involve policy trade-offs but help set U.S. fiscal policy on a more sustainable path to help ensure these advantages are maintained,” they wrote.

• Committee for a Responsible Federal Budget. " Can Donald Trump Eliminate the Debt? "

Treasury Fiscal Data. " Debt to the Penny ."

The White House. " FACT SHEET: The President’s Budget Cuts the Deficit by $3 Trillion Over 10 Years ."

Congressional Budget Office. " The Budget and Economic Outlook: 2024 to 2034 "

International Monetary Fund. " General government gross debt ."

Congressional Budget Office. " The Long-Term Budget Outlook: 2024 to 2054 ."

Wells Fargo. " Comparing America's National Debt to Its Peers ."

CBS. " Jerome Powell: Full 2024 60 Minutes interview transcript ."

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Strong peso, stubborn inflation cloud Mexico’s 2024 growth prospects

May 24, 2024

Despite nascent nearshoring trade expectations, the Mexican economy will be challenged by a welter of economic issues during the second half of 2024. The most notable are a still-restrictive interest-rate environment even as Banco de México has begun easing monetary policy, a strong peso and soaring labor costs. Potential economic softening in the U.S. further complicates the outlook.

Long-run challenges also remain, such as reversal of earlier energy sector reforms, poor productivity growth and high crime and violence .

However, Mexican government spending and the possibility of more fulsome nearshoring of manufacturing operations or suppliers could help the country consolidate its position as the main supplier to the U.S. market and aid prospects for 2024.

Real (inflation-adjusted) GDP growth is expected to moderate to 2.0 percent in 2024, down from 2.5 percent in 2023 ( Chart 1 ). Domestic investment and consumption drove performance in 2023, with notable strength in the service sector, construction and auto production.

Downloadable chart

Government outlays support short-run growth

Mexico’s 2024 federal budget projects government spending rising to 26.4 percent of GDP from 25.6 percent of GDP in 2023 and from a 10-year average of 24.7 percent of GDP. Social programs remain a priority, representing about 50 percent of the total budget. The main federal social programs are pensions for the elderly, school rehabilitation and basic education scholarships, and reforestation and development of sustainable rural communities.

The government’s revenue estimate is conservative. Notably, oil sales assume a price of $57 per barrel compared with the early 2024 price of Mexican mix near $70 per barrel. If oil remains elevated, the government may seek to spend even more than originally planned. Either way, unusually high and growing government spending could fuel inflationary pressures.

Anticipating the impact of nearshoring

There is expectation that nearshoring could significantly benefit Mexico’s economy and deepen the U.S.–Mexico economic partnership. Nearshoring is the relocation of company operations and supply chains from overseas to North America, principally from China to Mexico .

Higher U.S. tariffs on goods from China and U.S. industrial policy favoring North American production and inputs have helped reshape some global value chains in ways that may benefit Mexico.

Supply-chain dislocation during the pandemic has also lent urgency to the idea of derisking supply chains by bringing them closer to their ultimate destination, generally the U.S.

Mexico surpassed China as the main manufacturing trading partner of the U.S. in 2022 and was the principal trading partner in 2023 ( Chart 2 ). If this trend continues, it will produce positive economic spillovers within Mexican manufacturing, expanding into the services sector and contributing to higher growth levels in 2024 and beyond.

Recent Georgetown University research shows that before 2022, nearshoring had increased Mexico GDP around 1 percent. The rise is in part attributable to higher exports of computer and peripheral equipment, semiconductors and other electronic components. Georgetown researchers estimate a 0.8 percent GDP increase in the succeeding years. When adding up the effects, nearshoring could bring an overall increase of almost 2 percent to Mexico’s GDP.

Mexican manufacturing shows signs of bulking up

There are also initial signs of nearshoring activity at the company level resulting from U.S. tariffs on Chinese goods that began in 2018. Firms that are part of the Mexican government’s Manufacturing, Maquila and Export Services Industry Program (IMMEX) and are part of global value chains have increased exports to the U.S. in skill and technology-intensive industries. They include chemicals, computers, aircraft and automotive. Overall, IMMEX firms are exporting more final goods.

Additionally, research by Mexico ’s central bank found that after June 2020, manufacturing industries prone to relocating operations to Mexico from China, such as electric and electronic components, office equipment, and machinery and equipment, have exhibited higher levels of production and employment than other firms. Researchers pointed to signs the relocation process is slowly occurring in regions that traditionally receive greater flows of foreign direct investment, areas in the north and central parts of Mexico.

However, the expected increase in nearshoring-related foreign direct investment isn’t yet readily apparent. Foreign direct investment fell in 2023 despite slight gains in manufacturing, ending a slide that began in 2016 ( Chart 3 ).

Reinvestment of profits in the same facilities accounted for much of the marginal manufacturing investment increase. Manufacturing companies are first expanding existing capacity, Dallas Fed contacts say, adding production lines, buying new equipment and adding employees. Companies are quick to announce new projects; however, it is unclear how many will be subsequently scaled back, delayed or canceled.

Elevated inflation among short-term challenges

Less restrictive monetary policy should boost Mexico’s economic growth this year, although the impact may be muted, given policymakers’ cautious approach. Banco de México lowered its reference rate 25 basis points (0.25 percentage points) to 11 percent in March and held it in April, marking the end of the tightening cycle. The central bank had kept its policy rate unchanged for seven consecutive meetings, beginning in March 2023. The central bank is expected to favor a restrictive monetary policy stance due to persistent inflation concerns.  

Inflation soared with the pandemic, reaching an annual rate of almost 9 percent, and the central bank’s proactive policy stance has helped reduce inflation. CPI core inflation, which excludes food and energy, has declined since early 2023. However, services inflation persists, keeping overall inflation above the central bank’s 3 percent target rate ( Chart 4 ).

The central bank has indicated the reference rate will remain elevated, as inflation isn’t likely to converge with the target rate until the second quarter of 2025, signaling that the reference rate will remain high for some time. As a result, borrowing costs will stay elevated, damping investment and consumption this year.

High interest-rate differentials relative to the U.S. have also contributed to the peso appreciation. The Mexican peso has gained around 18 percent against the dollar in the past two years. A sustained appreciation of the peso boosts the relative cost of exports and reduces the cost of imports and could slow growth. The strong peso stymies tourism and foreign investment. Relocation of supply chains to include Mexico has offset some of the negative effects.

The strong peso also means dollar remittances are worth less to their recipients in Mexico. Despite record nominal remittances from Mexican citizens working in the U.S., the value of the payments has declined in real terms, which adjust for inflation and peso appreciation. While average dollar-denominated monthly remittances rose from $389 in 2022 to $393 in 2023, in real pesos they fell from 6,391 pesos to 5,398 pesos, a 16 percent drop.  

Rising labor costs outrun productivity

Labor costs are rising faster than labor productivity, posing another challenge. Mexico’s government has increased the federal minimum wage 88 percent in real terms over the past five years. The increases, at the start of each year, have been implemented annually.

Although the majority of workers in the formal sector—which the government can directly influence—earn more than minimum wage, it’s a reference wage that drives other labor costs and can push up prices ( Chart 5 ). As a result, average daily wages in the formal sector increased 14 percent in real terms between 2019 and 2023.

Higher worker compensation is a benefit for workers and not a concern for firms and consumers if labor productivity gains match rising labor costs. But labor costs have increased faster than worker productivity in manufacturing and services since 2019. Unit labor costs increased 1.8 times faster than labor productivity in manufacturing and 1.5 times faster in services on a monthly, annual average basis.

When labor costs rise faster than labor productivity, they can impede hiring and lower the competitiveness of domestic and international firms in Mexico. The situation can also drive up hiring in the informal sector that is less compliant with minimum wage regulations.

Research by Mexico’s central bank finds a negative relationship between formal sector employment growth and federally mandated minimum wage increases. The study highlights the need to adopt measures that can increase labor productivity—the only way to sustainably create better-paying jobs.

Energy sector, fiscal discipline pose challenges to long-run growth

Mexico’s energy sector faces a number of barriers, particularly following the recent reversal of reforms enacted in the previous decade that had upended state-owned oil and electricity monopolies. Energy prices have risen amid lapses in reliability, particularly affecting manufacturing.

A lack of reliable and affordable electricity could damp nearshoring momentum . (Separately, Dallas Fed contacts have also noted the importance of providing access to plentiful and reliable water supplies.)    

While fiscal spending boosts the economy, this year’s outsized expenditures represent a possible deviation from the fiscal prudence that characterized Mexican administrations since the 1990s. Some analysts see signals of structural change in fiscal discipline; others view the spending as temporary, no different than peer nations that didn’t experience any impact on country risk valuations.

The federal budget deficit this year is expected to be 5.4 percent of GDP, the largest since 1988. Much of it has been used to fund social spending programs and infrastructure projects.

There can be long-run benefits from fiscal spending, particularly if it represents investment in human capital and results in higher educational attainment and better health. Well-conceived infrastructure projects can also boost productivity and economic growth.

Conversely, a recent Federal Reserve Bank of Dallas Southwest Economy report documents Mexico’s long history of disappointing productivity growth. The article notes that with labor force growth slowing, the nation must invest more in education and advanced technology in order to sustain future economic growth.

Crime, violence deter economic growth

High levels of violence and, more generally, criminal activity are obstacles to economic activity and foreign and domestic investment and ultimately long-run growth. Homicides have averaged 35,500 per year over the past four years, an increase of 25 percent from the previous four years ( Chart 6 ).

Mexico’s homicide rate of 28 per 100,000 population compares with the global average of 6 per 100,000, the U.S. at 7 per 100,000 and Latin America and the Caribbean at 20 per 100,000.

Homicide is correlated with other activities, such as corruption and extortion and compromised law enforcement, which harm commercial growth and entrepreneurship. Crime disproportionately constrains micro and small firms in Mexico, prompting them to defer growth plans and reduce working schedules or even close. Crime raises operating costs, notably for security personnel and transportation. In addition, research shows that homicides and thefts negatively affect foreign direct investment.

Domestic investment, consumption momentum pace growth

Strong private domestic investment and consumption accounted for the bulk of GDP growth in 2023, offsetting the weak external sector performance ( Chart 7 ).

Private investment has trended higher as the pandemic recedes. The increase in private investment is partly due to investment catching up with suspended pandemic-era projects. Companies have taken advantage of the peso’s buying power to replace outdated machinery and equipment. Finally, some of this domestic private investment is in preparation for nearshoring projects, according to anecdotal evidence.

Private consumption has also grown steadily since the pandemic, fueled by a strong labor market and unprecedented real wage growth as well as record high remittances from the U.S.

Strong labor market conditions in the U.S., wage growth and unprecedented pandemic-era fiscal stimulus explain the flow of real remittances from the U.S. At the micro level, remittances generally go to families in Mexico’s poorest states in the central and the southwest regions. There, the payments smooth consumption and are mainly used for necessities such as food, clothing and health care.

Public investment is also growing after years of decline, notably major construction projects such as the Maya train in the Yucatan Peninsula and the Dos Bocas refinery in Tabasco. Still, the government’s contribution to GDP growth is relatively small.

Net exports were a negative contributor to real GDP growth in 2023, as bilateral surpluses with the U.S. and Canada were more than offset by deficits with Asia and Europe. China alone accounted for more than half of the deficit with Asia. The strong peso and falling oil exports also contributed to the negative balance.  

Slowing growth anticipated through year-end 2024

The Mexican economy is expected to continue slowing in 2024, with only moderate expansion in the U.S. dimming prospects. A beneficial slowing of inflation in Mexico may follow. 

It is unclear if domestic investment, particularly construction investment, a major contributor to economic growth last year, can continue this year as major infrastructure projects are close to completion. Presidential elections in the U.S. and Mexico will likely add to uncertainty about future prospects.

Remittances may have topped out, and U.S. economic slowing could diminish manufacturing exports. Indications of nearshoring acceleration are scant. Were it to materialize, such activity would provide growth potential in 2024 and in coming years.

About the authors

Jesus Cañas is a senior business economist in the Research Department of the Federal Reserve Bank of Dallas.

Luis Torres is a senior business economist in the San Antonio Branch of the Federal Reserve Bank of Dallas.

Diego Morales-Burnett is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.

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The Political Economy of Budget Deficits

This paper provides a critical survey of the literature on politico-institutional determinants of the government budget. We organize our discussion around two questions: Why did certain OECD countries, but not others, accumulate large public debts? Why did these fiscal imbalances appear in the last twenty years rather than before? We begin by discussing the 'tax smoothing' model and conclude that this approach alone cannot provide complete answers to these questions. We will then proceed to a discussion of political economy models, which we organize in six groups: i) Models based upon opportunistic policy makers and naive voters with 'fiscal illusion'; ii) Models of intergenerational redistributions; iii) Models of debt as a strategic variable, linking the current government with the next one; iv) Models of coalition governments; v) Models of geographically dispersed interests; vi) Models emphasizing the effects of budgetary institutions.

• Acknowledgements and Disclosures

MARC RIS BibTeΧ

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Published Versions

With Jose Tavares, published as "The Political Economy of Fiscal Adjustments", Brookings Paper, Vol. 28, no. 1 (1998): 197-248.

Alberto Alesina & Roberto Perotti, 1995. " The Political Economy of Budget Deficits, " Staff Papers - International Monetary Fund, vol 42(1).

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Senate Committee on the Budget: Extending Trump Tax Cuts Would Add $4.6 Trillion to the Deficit, CBO Finds

According to the   latest report  by the nonpartisan Congressional Budget Office (CBO), extending the Trump tax cuts for the next 10 years—as Republicans have proposed—would add $4.6 trillion to the deficit.

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Articles on Federal budget 2024

Displaying 1 - 20 of 32 articles.

A rush on critical minerals is coming for our most remote and disadvantaged communities

Deanna Kemp , The University of Queensland and John Burton , The University of Queensland

Labor takes a hit in Resolve polls in Queensland and Victoria

Adrian Beaumont , The University of Melbourne

The budget pledged $12.5 million for free menstrual products in Indigenous communities. Here’s why it’s needed

Nina Lansbury , The University of Queensland and Minnie King , The University of Queensland

Our research shows what the rental market is really like for international students

Hannah Soong , University of South Australia and Guanglun Michael Mu , University of South Australia

Labor and Albanese gain in post-budget Newspoll, but other polls don’t look as rosy

Threatened species have declined 2% a year since 2000. Nature positive? Far from it.

Megan C Evans , UNSW Sydney ; Brendan Wintle , The University of Melbourne , and Hugh Possingham , The University of Queensland

The budget has earmarked $8.6 million for live music. Is it enough to save the flailing industry?

Catherine Strong , RMIT University ; Ben Green , Griffith University , and Sam Whiting , University of South Australia

There’s $110 million for Indigenous education in the budget. But where’s the evidence it will work?

Marnee Shay , The University of Queensland and Grace Sarra , Queensland University of Technology

At the heart of the budget is the sad truth the economy is weak. That’s one reason inflation will fall

Aruna Sathanapally , Grattan Institute

It’s time to give Labor’s first term a scorecard – have we actually seen any transformative vision?

John Quiggin , The University of Queensland

PrEP was earmarked $26m in the budget. What is it? Will it stop me getting HIV?

Bridget Haire , UNSW Sydney

Choice and control: what can the ACCC do to stop NDIS price gouging and reduce costs?

Mona Nikidehaghani , University of Wollongong

The budget couldn’t include every ‘good idea’ but not boosting JobSeeker and the Youth Allowance were obvious misses

Cassandra Goldie , UNSW Sydney

Funding might change, but Job-ready Graduates stays for now. What does the budget fine print say about higher education?

Gwilym Croucher , The University of Melbourne

The budget is full of good news, but good news isn’t the same as good management

Kate Griffiths , Grattan Institute

Why is the government proposing caps on international students and how did we get here?

Christopher Ziguras , The University of Melbourne

For a ‘future made in Australia’, we need more innovation and diverse people in science and tech

Kylie Walker , Australian National University

Cheaper medicines and a new approach for mental health care. Will the budget make us healthier?

Peter Breadon , Grattan Institute and Anika Stobart , Grattan Institute

Green industry yes, conservation no: a budget for people, not for nature

Timothy Neal , UNSW Sydney

At a glance: the 2024 federal budget split four ways

Matt Garrow , The Conversation and Erin Cooper-Douglas , The Conversation

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Child Tax Benefits and Labor Supply: Evidence from California

In the United States today, some of the largest social welfare programs focused on children – including the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC) – require that parents earn income from work. While intended to encourage recipients to work, tax credit work requirements may also harm the lowest-income families. In this paper, the authors study whether eliminating child tax credit work requirements affects parents’ decision to work.

The authors study this question in the context of California’s Young Child Tax Credit (YCTC), a refundable state tax credit for low-income parents with children younger than six. When the YCTC was enacted in 2019 it was available to any taxpayer with income over $1. Then, beginning in 2022, California eliminated the work requirement altogether.   Using federal administrative tax data, the authors compare the labor force participation of mothers with children who just barely qualify for the YCTC to those with children just above the age cutoff, before and after the work requirement was eliminated. They find the following:

• Eliminating the YCTC work requirement did not cause a significant number of California mothers to exit the labor force. The authors estimate that working mothers’ labor force participation fell by no more than 0.4 percentage points with the elimination of the work requirement.

The results of the study suggest that eliminating the work requirement from the federal CTC would cause fewer exits from the labor force than prior studies suggest. The results also provide new evidence for states considering adopting or reforming their own child tax benefits, as a central issue in designing such policies is whether to condition benefits on work.

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Tax Policy and Investment in a Global Economy

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Budget to confirm a surplus this year, but bigger deficits for the next three years

Today's federal budget will deliver a $9.3 billion surplus for the current financial year ending in June.

It's the second consecutive budget surplus – where revenue exceeds spending – in nearly two decades.

But the next three financial years will each have higher deficits than the government had expected as recently as December, owing to what it calls "unavoidable spending".

The size of those deficits is not yet known, but the December estimates were $18.8 billion, $35.1 billion and $19.5 billion, respectively.

The figures for the upcoming financial year, 2024-25, will be watched particularly closely in the context of inflation.

The Reserve Bank of Australia (RBA) last week revised its forecasts to predict higher inflation for the rest of the year, but the government revealed on Sunday that Treasury had shifted its own forecasts in the opposite direction.

That means the RBA is now more pessimistic about inflation than the government, a reversal from earlier in the year. The RBA has indicated it is monitoring inflation carefully and leaving its options open on interest rates.

RBA governor Michele Bullock also said she would watch federal, state and territory budgets carefully to determine whether any significant spending was contributing to inflation, though she added she believed the federal government had "inflation on its mind" in its budgeting.

Treasurer Jim Chalmers said the budget would "ease cost-of-living pressures, not add to them … The forecasted surplus has come on top, not at the expense, of helping those doing it tough".

But the government has flagged a number of areas of new spending, including a multi-billion-dollar commitment to increase aged care and child care wages, over $3 billion in new defence spending, and some form of welfare increase.

At the same time, this year, it redesigned tax cuts due to start on July 1, leaving their magnitude roughly unchanged.

But Finance Minister Katy Gallagher said the government had also found new savings and had either saved or offset $77 billion since coming to office.

"We understand that there are still pressures on the budget, including spending on the NDIS, aged care, hospitals, Medicare and debt interest," she said.

"That's why we've put a premium on responsible economic management that strikes the right balance between strengthening the budget and funding our priorities."

The budget will also be helped by $25 billion in revenue upgrades, though this is a smaller figure than in previous years.

The government has previously touted its record of banking most of its revenue upgrades, a major reason why it has delivered two surpluses.

For example, it confirmed on Monday that 96 per cent of the more than $100 billion in revenue upgrades in 2023-24 have been banked.

It has not revealed what that figure will be for the 2024-25 year, but Mr Chalmers suggested last month it would not be as high as in previous years.

This suggests that overall, the government's third budget is expected to follow the pattern of its first two, with its own policy decisions detracting from the budget balance and adding to economic activity.

On Sunday, Shadow Treasurer Angus Taylor said the government should be "restrained in spending … We've seen a government that loves to spend, it's their natural instinct".

He criticised the government for discarding fiscal "rules" established by former Liberal treasurer Peter Costello during the Howard government and retained in principle by successive governments.

Those rules include a requirement that any new spending be offset by an equivalent spending reduction in the same portfolio area.

While those rules have often been aspirational rather than literal, Mr Taylor said they could "ensure that governments, when they're putting together their budgets, have a process where they do exercise restraint … We're proposing to put those back in".

But the government has argued its own budgets have improved by $200 billion over six years compared to the Coalition's own plans, in large part because of the enormous revenue upgrades that have been banked since that time

"We're not taking lectures from the same Liberal and National clown show which left us … more debt and much bigger deficits," Mr Chalmers said.

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Federal Spending Rescued Mass Transit During Covid. What Happens Now?

The government provided $69.5 billion in relief funds to help keep transit on track during Covid-19. But many rail and bus systems are now facing layoffs and cutbacks.

By Colbi Edmonds

As commuter buses and trains ran nearly empty at the height of the Covid-19 pandemic, the federal government stepped in with $69.5 billion in relief funds.

It was about five times the federal support for transit approved for 2019, and it is credited with rescuing public transit and saving more than 50,000 jobs in the United States.

“It was really a lifeline for the industry for Congress to step up and provide those resources,” said Paul Skoutelas, president and chief executive of the American Public Transportation Association. But, he added, “Those dollars have essentially run out.”

With ridership still lagging and the prospects for mass transit again uncertain, the health of large transportation agencies around the country could hinge, in large part, on how much aid and in what form the federal government can supply.

“The stakes are high,” said Lindiwe Rennert, a senior research associate at the Urban Institute. “We’re really talking service or no service. For some agencies, it is at that point.”

Already Feeling Squeezed

Transportation agencies around the country are already feeling the pressure.

The three transit operators serving the Chicago region are anticipating a deficit of more than $700 million by 2026, and riders could face service reductions of 40 percent or more without additional funding, according to the Chicago Metropolitan Agency for Planning.

New Jersey Transit, the nation’s third largest transit system, announced in January that it planned to raise fares by 15 percent on July 1 and, after that, by an additional 3 percent annually. The agency received $4.4 billion in federal aid during the pandemic, but more than 80 percent of that money has been spent.

Some agencies like the Maryland Department of Transportation, have received a one-time allocation of money from the state to restore funding for key transit services. But the department projects revenue is expected to grow by 1 percent annually while operating costs grow by 7 percent.

The Washington Metropolitan Area Transit Authority, which serves Maryland, Virginia and the District of Columbia, in December released a budget that predicted “an unrecognizable Metro” because of service cuts. The agency said 41 Metro lines would have reduced service, 67 of 135 bus lines would be cut and more than 2,200 people out of about 13,000 staff members would be laid off.

In late April, Metro approved a $4.8 billion capital and operating budget after receiving additional funding from its jurisdictions, avoiding major service cuts. But riders will face a fare increase of 12.5 percent, and since the agency does not have a sustainable funding source officials will face similar challenges the next fiscal year.

“This budget crisis, fiscal cliff, has happened multiple times,” Randy Clarke, general manager and chief executive of Metro, said after a board meeting in March, “but the magnitude this time is just not comparable.”

From Reagan to Biden

It’s not as if federal transit aid has completely dried up.

The Biden administration provided landmark support for transit through the 2021 infrastructure bill. It put $1.2 trillion toward infrastructure projects, with $108 billion specifically for transit.

But even such a large amount of money was not enough to address decades of funding restrictions, including a key development in the 1980s. When former President Ronald Reagan was in office, he pushed for reductions in federal spending, arguing that state and local governments or private businesses would be better suited to take on some of those responsibilities.

And in the late ’90s, Congress eliminated federal operating assistance, which covers salaries, for agencies in areas with populations larger than 200,000 people, but kept it available in smaller communities, which often have economies that cannot afford those extra costs. Larger areas can get money only for capital projects, which made the Covid-19 relief funds — which did cover operating expenses — unique.

“I’ve always felt like that is the wrong dividing line, and it results in some really weird outcomes,” said Beth Osborne, director of Transportation for America, an advocacy organization for safe and convenient transit. “There are areas that will be building things where they can’t afford to operate what they already have.”

The Biden administration has continued to push for more operating funds for transit. And, important, its proposed budget for the 2025 fiscal year calls for larger transit agencies to be allowed to use federal funding for operations for a year. (The administration’s budget request for the current fiscal year also included language asking for that change, but it was not approved, and Congress has yet to decide on the new request.)

“Looking just at these last couple of years where, even though you have very deep ridership losses initially and very slow recovery, transit agencies have basically been able to maintain their service overall,” said Nicholas Dagen Bloom, an urban policy and planning professor at Hunter College in New York City. “So that gives you a sense of the power of what federal operating support could be.”

Lawmakers have until the end of September to agree on a new spending plan to fund transportation in the 2025 fiscal year, but they are unlikely to be able to strike a deal in an election year, transit experts say. Most likely, the current spending levels will stay in place until the next Congress, which begins in January. Congress may also start considering the country’s next five-year infrastructure bill in 2025.

“Transit agencies are seeing unprecedented shortfalls on the operating side,” Veronica Vanterpool, acting administrator for the Federal Transit Administration, said in an interview. “Congress does need to act on what the president’s proposals have been.”

Polly Trottenberg, deputy secretary at the Department of Transportation, said the Covid-19 relief funds and the bipartisan infrastructure bill were the largest support for transit the country had seen.

But despite major bipartisan efforts to approve the 2021 bill and the funds, experts are skeptical about the prospects for Mr. Biden’s transit agenda — in part because of the present and in part because of the past.

“If you back up and look at what the appetite was to support transit in the past, frankly, it’s always been somewhat shaky,” said Ms. Osborne, a former official at the Department of Transportation. “I just don’t think we’ve done a good enough job at the national level of making sure people in Congress recognize how essential transit is to a 21st century economy.”

Representative Steve Womack of Arkansas, a Republican who is the chairman of the House subcommittee that oversees transportation funding,said in a statement that the federal government’s operational assistance for urban transit agencies during the Covid-19 economic crisis was not meant to continue permanently.

“To claim there is a transit funding cliff is disingenuous,” said Mr. Womack. “We must take a hard look at how taxpayer dollars are spent and ensure the federal government is not used as a crutch for systems that can’t stand on their own.”

Some Brights Spots Amid ‘Demonstrated Need’

Some leaders at the state level — for example, in New York and Minnesota — have begun to increase their investments in public transportation, providing much-needed support not dependent on action in Washington.

In New York City — which has the largest transit network in North America — a combination of federal pandemic aid and an increase in funding from the state has helped the Metropolitan Transportation Authority achieve long-term fiscal solvency for the first time in decades. As a result, the authority balanced its operating budget through the next five years.

And some smaller transit systems, eligible for operating funds from the federal government, are doing better than many larger ones.

In Richmond, Va., the Greater Richmond Transit Company operates a thriving bus agency that has exceeded prepandemic ridership, introduced on-demand ride services and rehired and expanded its work force of bus drivers after facing large losses in its staff.

Richmond started providing free fare during the pandemic, an initiative that has continued with support from a state grant program. Henry Bendon, a spokesman for Richmond’s transit agency, said there was not an equitable way to charge fares in a city where 71 percent of bus riders come from households that make less than $40,000 a year.

“We carry Richmond’s essential workers,” he said from the city’s new downtown transfer center, where bus stops are outfitted with charging ports, Wi-Fi and real-time information screens to track buses. This transfer station, which opened in September, is temporary, but the agency is looking to build a permanent location that would also include shopping and affordable housing.

A number of other transit agencies have also shown clear signs of progress. Seven large transit systems — including the transit authority in Worcester, Mass.; CT Transit in Stamford and New Haven, Conn.; and Sun Tran in Tucson, Ariz. — have exceeded ridership levels from 2019 , and places like Richmond embody the possibilities of well-funded models.

Ms. Rennert, the senior research associate at the Urban Institute, said advocates for better transit are continuing to put pressure on Congress to “meet what is very obviously the demonstrated need.”

She added, “This issue is not something that transit agencies can solve by themselves.”

Ana Ley and Patrick McGeehan contributed reporting for this story.

Colbi Edmonds writes about the environment, education and infrastructure. More about Colbi Edmonds