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Long-Term Economic Effects of Chronically Large Federal Deficits 1 (October 2005)

handle is hein.congrec/cbo8629 and id is 1 raw text is: A series of issuze summaries from the Congressional Budget Office OCTOBER 13, 2005 Long-Term Economic Effects of Chronically Large Federal Deficits Since fiscal year 1960, the federal government has re- corded budget deficits averaging 2.1 percent of gross do- mestic product (GDP), and those deficits have been espe- cially large in each of the past three years. Depending on the course of policy and the economy, deficits may mod- erate as a share of GDP over the next decade. But looking farther ahead, the demand for federal budgetary resources is expected to rise steadily under current law as the baby boomers retire and become eligible for Social Security and Medicare. Persistently large federal deficits can erode the growth of future living standards by reducing national saving, which slows the accumulation of wealth, and degrading economic performance. Thus, they differ from temporary deficits, which may serve to support economic activity and other policy objectives in the near term. The degree to which chronically large deficits adversely affect future living standards depends in part on the policies that pro- duce them. Policies that increase the deficit but also pro- vide incentives for people to work, acquire more skills and e ducation, undertake research and development, in- vest, innovate, or use resources more efficiently may do less harm to future living standards than policies that in- crease the deficit without providing such incentives. The Links Between National Saving, Wealth, and Future Living Standards The amount of national wealth accumulated by U.S. resi- dents depends on national saving-the part of national income that is not currently consumed. National wealth rises through the acquisition of claims to productive as- sets both here and abroad, and more national saving per- mits more wealth accumulation. Claims to productive as- sets provide financial resources that permit U.S. residents to enjoy higher living standards in the future. Future living standards also depend on factors such as productivity. Growth in total factor productivity (TFP)-the growth of output that is not explained by the growth of capital and labor-accounted for roughly 40 percent of the overall growth in the nonfarm business sec- tor's potential output during the 1950-2004 period. Higher productivity directly raises national income and opportunities for future consumption even without any change in saving. Thus, activities that increase productiv- ity, such as technological innovation, research and devel- opment, training and education, and more-efficient use of resources, also help to raise future living standards. How Deficits Affect National Saving Federal deficits can have a significant impact on how much the nation saves. National saving consists of saving by the private sector (households and businesses) and by governments (federal, state, and local). If all other parts of national saving remain the same, national saving falls when the federal deficit increases, because deficits raise the fraction of income that is consumed.' That switch from saving to consumption occurs regardless of whether federal deficits result from cuts in federal taxes or hikes in current federal spending. Reductions in federal taxes will tend to finance more private consumption, as will in- creases in spending for federal entitlement programs. In- creases in current federal purchases (which do not include public investment) will raise government consumption. 1. In the national income and product accounts (NIPAs), federal deficits reflect government consumption expenditures but not government investment expenditures. Consequently, federal investment expenditures do not reduce gross federal saving (or gross national saving). By contrast, investment spending is treated as part of outlays in the calculation of the federal budget surplus (or deficit) as reported by the Office of Management and Budget (0MB). For a discussion of the differences between the NIPAs and the budget as reported by 0MB, see Congressional Budget Office, The Treatment of Federal Receipts and Expenditures in the National Income and Product Accounts (September 2005). f

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