The Economics of the Federal Budget Deficit

Publication Date: February 2009

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

The Congressional Budget Office (CBO) estimates that the federal budget deficit for FY2006 was $247.6 billion, a decline from the $318.3 billion deficit recorded in FY2005. The CBO baseline deficit projection for FY2007 is $172 billion.

Over fairly short periods of time, say three or four years, fiscal policy can affect the rate of economic growth by adding to, or subtracting from, aggregate demand. For a time, the effect on the economy may even be larger than the initial change in the budget. These effects, however, tend eventually to diminish because of either higher interest rates or rising prices. Estimates of the multiplier effect on the economy of a change in fiscal policy vary, but most of them suggest that it reaches a peak somewhere between one and one-and-a-half times size of the change in the budget. In most economic models, that peak effect is realized within one or two years of the initial change in policy.

One measure economists use to assess fiscal policy is the structural, or standardized-employment, budget. This measure estimates, at a given time, what outlays, receipts, and the surplus or deficit would be if the economy were at full employment. Although the actual budget was in surplus beginning in 1998, the standardized measure first registered a balanced budget in 1999. Between 1992 and 2000, the actual budget surplus increased from -4.7% (a deficit of 4.7%) to 2.4% of gross domestic product (GDP), a shift of 7.1 percentage points. During the same period, the standardized measure rose from -2.9% to 1.1% of GDP. That suggests that a little more than half of the shift was the result of changes in policy, and a little less than half was attributable to the economic expansion. Between 2000 and 2006, the actual surplus fell from 2.4% to -1.9% of GDP, whereas the standardized measure fell from 1.1% to -2.2% of GDP.

In the long run, economic growth is determined primarily by three factors: growth in the labor force, the rate of technological advance, and the amount of capital available to the workforce. Of the three, the last one may be the most susceptible to the influence of policymakers. The larger the capital stock is, the more productive the labor force tends to be. Although it is possible for fiscal policy to have an effect on the rate of technological progress in the way public money is spent, it probably has a much larger effect on growth through its influence on the size of the domestic stock of capital and the amount of capital available for each worker in the labor force.