Public Finance, Foldvary

Anderson, chapter 18

Budgets, borrowing, deficits

Government budgeting does not reflect economic reality, deliberately so.

Outlays: spending

Net outlays: spending minus transfers to other domestic governments.

Revenues: funds that are received..

Trust funds: money in the accounts of a program.

On budget and off budget

The USPS is governmental but off-budget, having its own accounting.

Consolidated budget: on and off budget.

The unified federal budget, p. 515.

Governmental accounting uses a cash basis rather than accural.

Accrual accounting records income and expenses when incurred, more realistic.

Cash accounting facilitates manipulation, such as postponing payments,

and collecting taxes earlier.

Private enterprise uses GAAP, Generally Accepted Accounting Practics.

Not so government.

However, the federal government does publish the

Financial Report of the United States Government,

showing its financial position using accrual accounting.

The General Accounting Office GAO audits federal agencies and reports to Congress.

It is sound economics to have a current and capital account,

or operating and capital budgets.

Current expenses should come from current income,

while it can be good economics to borrow for the capital budget,

for investment in productive capital goods.

A capital account would also enable a government to account for depreciation expenses.

The surplus from Social Security is used to reduce the overall deficit.

The SS liabilities are not accounted for.

Fannie Mae was not included, so the implicit government liability was not in the budget.

Federal fiscal year starts Oct. 1.

Congress is supposed to finish its budgeting in the summer.

California’s fiscal year starts on July 1.

1921 Budget and Accounting Act, made the president the chief budget officer.

Submits a budget to Congress. Provides legislative power.

Office of Management and Budget OMB develops the budget.

President submits the budget to Congress in January.

Congressional Budget Office provides research, analysis.

Congressional budget committees evaluate and modify the budget.

House Ways and Means Committee, Senate Finance Committee, hold hearings.

Senate and House bills get reconciled.

Budget Enforcement Act of 1990 (BEA)

distinguishes discretionary and direct spending for entitlements.

Pay-as-you-go: new spending has to have revenue sources: taxes or reductions in other areas.

Congress can enact supplemental appropriations to add to spending.

For example, the cost of the Iraq war is difficult to calculate.

Stiglitz, Joseph E. and Linda J. Bilmes. 2008. The Three Trillion Dollar War: The True Cost of the Iraq Conflict. NY: W. W. Norton.

During past conflicts, the Pentagon usually established a separate account to keep track of operation funds. However, no such distinct account exists for the war in Iraq. As the authors state, “War and baseline funds are mixed in the same accounts.”

The government’s accounting is so shoddy, say Stiglitz and Bilmes, that the Securities and Exchange Commission would prosecute any private firm with such a mess.

Even worse, the government has not made it easy to obtain figures; the uncovering of some of the data required the use of the Freedom of Information Act by veterans’ organizations.

Another factor distracting the public away from understanding the direct cost of the war is that the military operations have been almost entirely funded via a series of “emergency” supplemental spending bills totaling in the hundreds of billions.

This budget gimmick makes it possible to avoid painful budget choices since “emergency spending” is exempt from the budget caps designed to set an upper limit on government spending.

The professional budget staff in Congress is therefore unable to do its usual thorough review of the numbers, and there has been little Congressional oversight,

since emergency spending takes place mainly outside of the regular budget process.

Congress is not blameless in this process, as it has used the war to attach special and local interest spending to war bills with minimal scrutiny, despite the legal requirement to separate war spending from regular defense appropriations.

Concept of Incrementalism

Budget next year = this year plus modest increment.

Increase promoted by special interests and the bureau.


Programs that provide benefits to those who meet eligibility requirements.

Such as unemployment money.

Congress then does not control the budget.

Off-budget expenses

Government owned corporations, such as USPS,

Student Loan Marketing Association

No good economic reason for off-budget.

Budgets can be organized by program rather than by line item of expenses.

The bond market.

A bond is an IOU issued by a firm or a government.

It is a certificate of indebtedness. Nowadays electronic.

The amount borrowed is the principal.

Bonds are usually issued for a limited time interval, called the “term”.

The bond specifies the date of maturity, when the principal is paid back.

The bond also specifies an accounting rate of interest based on the face value at the time of purchase.

In Great Britain, there are perpetual bonds, called consols or perpetuities, which never mature.

The bond specifies how often interest is paid.

The market price of a bond is usually different from the face and maturity value.

If we ignore taxes, the market price (p) of a bond equals the annual return (r) divided by the real interest rate (i): p = r/i

With a tax rate t on the price p: p=r/(i+t)

The price of a bond with taxes compared to without taxes is:

[r/(i+t)] / [r/i] = i/(i+t).

So for bonds of the same price, the return on a taxed bond must be multiplied by (i+t)/i, e.g.:

p = [r(i+t)/i]/[i+t]

For example, if the interest rate is 4% and the tax rate is 1% of the price, then the taxed bond must pay r*.05/.04 = 1.25r to make the market price equal to that of a non-taxed bond.

If a municipal bond pays 4%, the taxed bond must pay 5%.

After paying 1% of the 5% as a tax, the returns are equalized.

For example, suppose the tax-free bond pays $100 per year at 4%.

The price of the bond is 100/.04 = $2500.

The taxed bond pays $125, and a 1% tax on $2500 is $25, so the after-tax return is $100.

Tax anticipation notes TAN, short term debt by a school district, like commercial paper.

Cities use bond anticipation notes, or grant anticipation notes.

The money or accounting interest paid by the borrower, bond issuer, consists of several elements:

1) pure interest. This is the real interest rate, excluding risk and taxation.

2) inflation premium. This makes up for the change or expected change in the price level.

            The US government issues inflation-protected bonds.

            The principal rises with inflation, although that increase is taxed.

            So this bond has no inflation premium.

3) risk premium. Risk is the possibility of a loss of the accounting interest or the principal.

            It is also called credit risk or default risk.

            A borrower can declare bankruptcy and have some debts cancelled.

            Credit card accounting interest is high because of the default risk.

            Corporate bonds that are very risky are called “junk bonds”.

            There are companies that rate the risk of bonds, such as Standard and Poor’s.

            Some state and local government bonds are risky;

            California has recently gotten a low credit rating.

            U.S. treasury bonds have no risk premiums.

4) fluctuation risk. The real interest, inflation, and thus the price of a bond can fluctuate.

            The fluctuation premium is higher for long-term than short-term bonds.

            There is also fluctuations risk from changes in the supply or demand for bonds.

5) The tax premium for having to pay taxes on the nominal return.

            Municipal (city) bonds are not subject to federal income taxes.

            California municipal bonds are also tax-free to California taxpayers.

            But municipal bonds may be taxed under the Alternative Minimum Tax.

            Federal treasury bonds are not subject to state income tax, but they are taxed by the federal income tax.

A government budget deficit causes distortions.

Government bonds compete with corporate bonds, and reduces the supply of loanable funds for private investment, raising interest rates.

This is called “crowding out” private investment, and it reduces future economic growth.

There is less domestic crowding out if the funds are borrowed from abroad.

But the spending crowds out private spending.

A major cause of government budget deficits is military spending for war.

A second major cause is recessions and depressions.

This year’s federal budget deficit will be over $1 trillion.

California’s, $28 billion.