A Note on Government Budgets

By Kyer, Ben L.; Maggs, Gary E. | American Economist, Fall 2005 | Go to article overview
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A Note on Government Budgets


Kyer, Ben L., Maggs, Gary E., American Economist


Introduction

The analysis of government budgets has become quite common in economics classrooms. Indeed, examinations of the Federal government budget in particular are found in textbooks for principles, intermediate macroeconomics, and public finance courses. (1) As part of this discussion the distinction between cyclical and structural budgets and changes thereof is regularly made in order to differentiate between automatic stabilization and fiscal policy.

A re-examination of the standard pedagogical analysis suggests that it may be modestly extended. More specifically, it appears that cyclical changes in the government budget may be separated into a "revenue effect" and an "expenditure effect". While this distinction is implicit in typical textbook approaches and has been used for empirical measurement, (2) to our knowledge it has not been demonstrated graphically or used pedagogically. The purpose of this paper then is to demonstrate, with a graphical analysis appropriate for various undergraduate students, that cyclical changes in the government budget can be decomposed and stated as the sum of the expenditure and revenue effects. We also introduce definitions of these terms and propose the concept of the cyclical effect.

The Analysis

Our analysis is achieved with Figure 1 which shows the two components of the Federal government budget. Given the progressivity of the personal income and corporate profits taxes and the proportionality of the payroll tax, total tax revenue R is shown as a positive function of real income Q. For convenience R emanates from the origin. Total government expenditure S, which is comprised of both government purchases of goods and services and transfer payments, is depicted as a negative function of real income since transfer payments such as unemployment benefits, Medicaid, Temporary Assistance for Needy Families, and grants in aid to state and local governments increase when real gross domestic product decreases. (3) To begin, suppose for simplicity that the economy has achieved the full-employment level of real income [Q.sup.FE] such that both tax revenue and government expenditure are equal to [Q.sup.FE]A, the government budget is balanced and the structural and cyclical deficits are zero. Now assume that real income decreases to [Q.sub.1]

At [Q.sub.1] the cyclical budget deficit (and the actual deficit) has increased and is now equal to the vertical distance BD. This deficit occurs, of course, because of decreased tax revenue and increased government spending and these two distinct effects on the government budget may be graphically identified and measured. First, as real income decreases from [Q.sup.FE] to [Q.sub.1] tax revenue decreases to [Q.sub.1]B. If government spending is theoretically held constant, with the construction of line segment AC, the decrease in tax revenue increases the deficit by the amount BC. We call this impact on the government budget the revenue effect and define it as the change in the government's budget position which is caused by a real income-induced change in tax revenue, ceteris paribus. This definition implies that the revenue effect is limited to movements along a given revenue function for a change in real income. Shifts and rotations of the R line are indicative of fiscal policy changes.

Similarly, as real income decreases from [Q.sup.FE] to [Q.sub.1] government spending increases to [Q.sub.1]D. If tax revenue is now artificially held constant, referring again to line AC, the increase in government spending increases the government deficit by the vertical distance CD, which we refer to as the expenditure effect and define as the change in the government's budget position which results only from a real income-induced change in government spending.

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