CURRENT ISSUE Fiscal Policy: What a Difference a Recession Makes
What happened to the surplus? The recession surely contributed to the reversal in fiscal balances, but fiscal policy actions also played a role. The currently projected federal budget deficit reflects the implementation of new fiscal initiatives (the tax cut in President Bush’s 2001 legislative agenda and the Economic Recovery Act of 2002, which passed in March) along with the systematic responses from the so-called automatic stabilizers. These stabilizers, including unemployment insurance and lower tax revenues, took hold as the economy weakened. Unfortunately, it’s hard to know with much certainty how big these cyclical effects are and how long they’ll last. In general, unpredictable fluctuations in the business cycle and in economic growth can generate large errors for federal deficit forecasts. The Congressional Budget Office performs rigorous analyses of budget projections, but those projections are sensitive to any unseen economic developments. Although unpredictable fluctuations in the business cycle and in economic growth can generate large errors in these forecasts, monitoring them may uncover the spending/tax imbalances that produce the deficit. Thinking ahead New spending initiatives and tax policies, along with the growth rate of the economy, will in large part determine the budget position over the short term. But the likely state of the budget over the next few years remains unclear because of the recession’s lingering effects and related uncertainty about the average rate of real economic growth. Budget forecasts, in themselves, will not reveal much about fiscal policy’s economic impact. Instead of focusing on fiscal deficits, policymakers and voters should focus on active fiscal policies — namely, spending and tax policies — and on the economic incentives those policies put in place for firms and consumers. Such incentives can materially affect the economy’s long-run behavior, and the long run is a concern we all should have. As future Social Security and Medicare funding comes onto the radar screen, fiscal policy will be forced to take careful aim at these long-run objectives. By Ellis Tallman, assistant vice president of macroeconomic research |
iscal policy is in the news again, and projections of a resurgence in federal fiscal deficits are making headlines. In contrast, detailed analyses of federal tax and spending policies — the key, active components of fiscal policy — are relegated to editorials and business sections’ back pages. So what does a reprise of federal budget deficits imply about the state of fiscal policy? Budget deficits are not the problem; they are really only a symptom (that is, the excess of spending over revenues). Instead, we should think carefully about spending and tax policies that can produce deficits. More importantly, we should consider the economic incentives that tax and spending policies present taxpayers, both firms and consumers.