WHAT IT TAKES TO SOLVE THE U.S. GOVERNMENT DEFICIT PROBLEM

Abstract

1. INTRODUCTION This paper estimates, using a structural multi-country macroeconometric denoted the model, what it takes to stabilize the long-run U.S. federal government debt/gross domestic product (GDP) ratio. The fiscal policy tool is federal transfer payments. This question is complicated in part because of endogeneity issues.A fiscal-policy change designed to decrease the deficit has effects on the macroeconomy, which in turn affect the deficit. Any analysis of fiscal-policy proposals must take these effects into account: one needs a model of the economy. The period considered is 2013-2022. The experiments are performed off of a base run.The base run is one in which there are no major changes in U.S. fiscal policy from 2013 on. Aggregate tax rates are taken to be unchanged from their values in 2012:4 except for the payroll tax rate, which is taken to go back to its 2010:4 value. (The payroll tax cut is not extended beyond 2012:4.) This treatment of tax rates means that the Bush tax cuts are assumed not to expire at the end of 2012. Federal government purchases of goods and services and federal transfer payments to households and to state and local governments are assumed to grow at recent historical rates net of the effects of the various stimulus measures. This means that the currently legislated cuts in future defense spending are assumed not to go into effect. As will be seen, the base run has an ever increasing debt/GDP ratio. This is, of course, consistent with almost all recent analyses. Without major fiscal-policy changes, the U.S. government debt/GDP ratio is expected to rise without limit. See, for example, Penner (2011) and CBO (2011). The experiments consist of decreasing transfer payments from the base run beginning in 2013:1. The size of the decrease is chosen to stabilize the debt/GDP ratio by 2022. The results show that decreasing transfer payments by 2% of GDP from the base run stabilizes the debt/GDP ratio. The decrease in transfer payments over the 10 years is $4.8 trillion in current dollars and $3.2 trillion in 2005 dollars. The sum of the real output loss (2005 dollars) over the 10 years is $1.8 trillion, which is 1.1 % of sum of real output over the 10 years from the base run. The average number of jobs per quarter is 1.55 million lower, and the average number of people unemployed per Quarter is 680,000 higher. Monetary policy is endogenous in the model; it is determined by an estimated interest rate rule. Monetary policy mitigates the fall in output from the fiscal contraction, but it is not powerful enough to eliminate all of the output loss. (1) Section II discusses the MC model; Section III presents the base run; Section IV presents the alternative run; and Section V discusses some robustness checks. II. THE MC MODEL (2) The MC model uses the methodology of structural macroeconometric modeling, sometimes called the Cowles Commission approach, which goes back at least to Tinbergen (1939). I contrast this methodology with that of dynamic stochastic general equilibrium (DSGE) models in Fair (2012). The main arguments against the DSGE methodology are that the models tend to be heavily calibrated, leave out many features of the economy, use theory in a highly restrictive way, and are based on the assumption of rational expectations, which may not be realistic. The MC model is much more empirically based than are the DSGE models, but the model is not just a series of ad hoc regressions. In the theory behind the households maximize expected utility and firms maximize expected profits. The theory is used to choose left-hand-side and right-hand-side variables in the equations to be estimated. The estimated equations are taken to be approximations to the decision equations of agents. The theory leads to many exclusion restrictions in the estimated equations, and lack of identification is not an issue. Expectations are assumed to be adaptive. …