EconSouth (Fourth Quarter 2002)


Fiscal Policy: What a Difference a Recession Makes

Fiscal 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.

Photo of Ellis Tallman

What happened to the surplus?
By 1999 the huge federal budget deficits of the 1980s and early 1990s were becoming a distant memory. The apparent disappearance of fiscal deficits at that time was perceived as good news in its own right. But what a difference a recession makes! The fiscal surplus in 2000 was $236 billion; for 2002 the unified deficit hovers around $159 billion. (Both of these figures include the Social Security 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
Medicare and Social Security combine to imply large structural imbalances in their funding relative to the benefits promised. These programs represent large, long-term financial obligations for the government and ultimately the taxpayer, with fairly predictable expense forecasts. In the future, the funding of these obligations becomes the core concern because the impending liabilities associated with Medicare and Social Security dwarf the uncertainty associated with economic growth forecasts.

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
of the Federal Reserve Bank of Atlanta

Return to Index  |  Next