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Calculating the Structural and Cyclical Parts of the Budget Deficit
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From the course by University of California, Irvine
The Power of Macroeconomics: Economic Principles in the Real World
1297 ratings
University of California, Irvine
1297 ratings
From the lesson
Budget Deficits and the Public Debt
Meet the Instructors
Dr. Peter NavarroProfessor
Paul Merage School of Business
[MUSIC]
To fix our ideas about these two types of deficits,
let's actually calculate them in an example.
Suppose the gross domestic product is $10 trillion.
Budget deficit is $100 billion.
And the unemployment rate is 7%, or 1% above the assumed full employment rate.
Suppose further that the marginal tax rate is 30%,
meaning that for every additional dollar that the GDP grows,
the government will collect 30 additional cents in taxes.
How can we calculate which portion of the hundred billion dollar deficit is
structural and which portion is cyclical?
Let me give you a hint.
We need Okun's Law to help us.
Do you remember what that law is?
Remember that Okun's Law says that a 1% fall in
the unemployment rate will lead to a 2% increase in GDP.
So, for step one of this example, try using Okun's law to
calculate the increase in GDP that would result if the unemployment
rate were to fall from 7% to the full employment rate of 6%.
If the unemployment rate falls by 1%, by Okun's Law,
real GDP must increase by 2% times $10 trillion, for a total of $200 billion.
Now, in step two, we have to calculate the additional tax revenues
the government would collect from this increase in GDP.
How much is that?
At our assumed marginal tax rate of 30%, the additional $200
billion of GDP income would generate an additional $60 billion in tax revenues.
Knowing this, what part of the total $100 billion deficit is structural?
And what part is cyclical?
In this case, the structural deficit clearly is $40 billion,
because, that's how much of the deficit that would remain at full employment.
That of course means that the cyclical deficit must be $60 billion.
You can see now why this distinction is so important.
It helps policy makers distinguish between long term changes in the budget caused
by discretionary policies, versus short run changes caused by the business cycle.
In doing so,
this distinction helps provide a policy guide to tackling the deficit problem.
For example, since we can grow our way out of a cyclical deficit
simply by reaching full employment, expansionary fiscal or
monetary policies may well be appropriate in a sluggish economy.
In fact, such a Keynesian policy prescription
would've been quite appropriate way back in 1958.
At that time, in the middle of a recession, the Eisenhower administration
was running a deficit, totally cyclical in nature, of $10 billion.
Vice President Richard Nixon was deeply concerned that a stagnating economy
would make him vulnerable in the upcoming 1960 presidential election.
Accordingly, Nixon vigorously advocated an expansionary tax cut
to stimulate the economy.
However, President Eisenhower wanted to balance the budget before he left
office and rejected such a tax cut for fear it would balloon the deficit.
Absent anti-stimulus, the economy limped into the presidential election season.
John F Kennedy seized on the slogan, let's get the country moving again, and
Kennedy squeaked by Nixon in one of the tightest presidential races in history.
Now here's the irony.
If Eisenhower had listened to Nixon and cut taxes, the result would
not only have been strong economic growth, Eisenhower would have left office
basking in the glow of a budget surplus of about five billion dollars.
More than enough to have paid for Nixon's tax cut.
This is because the additional economic growth
would've generated billions of dollars of additional tax revenues.
President Bill Clinton's campaign for re-election in 1996 offers
a final example of why understanding the difference between the structural and
cyclical deficits can be useful.
In the 1996 campaign, Clinton proclaimed that
policies such as his deficit reduction act of 1993 had been
successful in reducing the budget deficit by more than half.
However, Clinton's Republican critics argued that
it was mainly the recovery from recession that was responsible for the improvement.
And some of these critics even claimed that it was George Bush
who deserved most of the credit since the economic recovery began
well before Clinton ever took office.
So let's look at the facts.
Between 1992 and 1996, the federal deficit declined by $146 billion.
From $290 billion to $144 billion.
And yes, that is more than a 50% reduction.
But how much of this deficit reduction was structural?
Let's look at some estimates of the changing structural deficit
calculated by the Congressional Budget Office.
According to the CBO, the structural deficit declined
by $70 billion between 1992 and 1996,
from $224 billion to $154 billion.
This means that of the $146 billion in deficit reduction,
about half of that was due to Clinton administration policies, and
the other half was due to improved economic conditions.
This discussion in turn leads to a final important point.
Calculation of the structural deficit is clearly determined by
what economists assume the full employment natural rate of unemployment to be.
In particular, the structural Structural deficit will be lower
if we assume the economy can sustain a 4% rate of unemployment
without increasing inflation as opposed to, say, a 6% rate.
In fact, using Okun's Law, and again assuming a $10 trillion GDP,
we can calculate the difference in the assumed structural deficit
with these two different unemployment rate scenarios, to be $120 billion.
But, of course, you see the fiscal policy problem here.
Suppose we believe that the 4% unemployment rate
is the correct assumption for full employment output and
that the economy is currently at 6% with a budget deficit of $120 billion.
Based on that 4% assumption,
we must conclude that the budget deficit is purely cyclical in nature.
So what change in fiscal policy would a Keynesian economist recommend
facing such a large cyclical deficit?
And, what would happen if the natural rate of unemployment
actually turned out to really be 6%?
A Keynesian would clearly argue for
an expansionary fiscal policy of to close the perceived recessionary gap and
eliminate the perceived purely cyclical deficit.
If, however, it turns out that the natural rate of unemployment was actually 6%,
the Keynesian expansion would not only not eliminate the cyclical deficit,
which, as it turns out, was purely structural, it would also result
in an even bigger deficit and a bad case of demand-pull inflation!
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