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? Financial Management Fiscal Policy ?

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But excluding the trust fund surpluses from the estimated overall surplus is only the small first step toward acknowledging that the surpluses projected beyond the end of this decade are not "real" surpluses, because it still ignores the much larger implicit liabilities that are accumulating in the Social Security and Medicare programs. The president's proposed budget for fiscal year 2004 contains a section titled "The Real Fiscal Danger," which estimates the unfunded liabilities of these two programs. (5) At $21.5 trillion, that estimate swamps the publicly held national debt of $3.6 trillion, yet even this calculation still understates the magnitude of the problem, as I will show below. (6) In the face of this enormous fiscal obstacle, highlighted in his own budget presentation, the president has offered a new round of substantial tax cuts, aimed primarily at the long term, and an increase in Medicare benefits. Clearly, there must be some other motive than a wish to stimulate the economy or to close the long-term fiscal gap. Two that have been mentioned are reform of the tax system and control of discretionary government spending, the latter on the theory that sustained large deficits may force spending to grow more slowly.

One last important aspect of the current fiscal situation is the position of state and local governments, which in the aggregate face budget deficits of unprecedented size. Figure 2 shows two aggregate measures of state and local budgets, both on a national income and product accounts (NIPA) basis, since 1978. The combined current balance of state and local governments, which treats the flows from capital goods (as measured by depreciation) rather than investment expenditure itself as an expenditure component, hovered in the range of-0.5 percent of potential GDP throughout calendar year 2002--roughly twice the size, relative to potential GDP, of the deficits recorded during the recessions of the early 1980s and the early 1990s. (7) A simpler cash-flow measure of net lending tracks the current balance closely but has been consistently lower over the period shown, because investment spending has exceeded depreciation. In 2002 net lending reached a deficit of about 1.2 percent of potential GDP.

Figure 4 shows separately the revenue and the expenditure of state and local governments since 1978, demonstrating that the recent deficits are associated with sharp expenditure growth since the late 1990s together with a leveling off of revenues. Some have seen this pattern as implicating uncontrolled spending as the root cause of the crisis. But trends in some important components of revenue and spending suggest a more complicated story. Figure 4 also shows personal tax and nontax receipts of state and local governments, as well as their transfer payments to persons. The series for personal tax and nontax receipts shows more clearly than does the aggregate revenue series that a decline in personal income tax revenue (which dominates personal receipts) is an important factor that the state and local fiscal picture shares in common with the recent federal experience. As a fraction of potential GDP, this component of revenue had been rising steadily for decades, and that growth accelerated in the late 1990s. Then, around the end of 2000, the growth ended, and the ratio of this component to GDP began falling more sharply than simple cyclical adjustment can explain. As at the federal level, the drop in tax payments on options and capital gains was considerable. In some states the drop was particularly severe. California, for example, estimates that, at their peak in fiscal year 2000-01, taxes on capital gains and options amounted to $17.6 billion, or just under 25 percent of all general fund revenue in the state, and that declines in this revenue source alone reduced state revenue by $12.0 billion between that fiscal year and the current one. An increase in spending has indeed accompanied this decline in revenue, but an important part of this spending increase has been in transfer payments, fueled by autonomous growth in health care costs, rather than discretionary spending. Figure 4 also shows the rapid recent growth in these transfer payments, most of which are for a single program, Medicaid. In 2001 Medicaid payments (which are partly offset by federal grants) accounted for 18 percent of all current spending by state and local governments.

Whatever the cause of the reemergence of state and local deficits, these governments have much less capacity than the federal government to engage in budget smoothing. Most states have balanced-budget requirements, forcing a broad consideration of major tax increases as well as spending cuts, and these policy changes influence the desirability of fiscal action at the federal level.

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consider the standard Hall-Jorgenson user cost of capital, which provides a measure of the required gross, before-tax return to capital, and hence a measure of the incentive to use capital in production, under the assumption of instantaneous adjustment. For a constant-tax system, the user cost is

(1) c = q / p([rho] + [delta]- [DELTA]q / q)1- k- [tau]z / 1-[tau],

where p is the price of output, q is the price of new capital goods, [rho] is the nominal discount rate, [delta] is the exponential rate at which capital actually depreciates, k is the investment tax credit, [tau] is the corporate tax rate, and z is the present value of depreciation allowances per dollar of capital purchased. If one modifies the assumptions to incorporate changes in tax policy, the user cost of capital becomes

(2) c = q / p([rho] + [delta]- [DELTA]q / q)1- [GAMMA] / 1- [tau] + q / p [DELTA][GAMMA] / 1- [tau],

where [GAMMA] equals the sum of the investment tax credit and the present value of tax savings from depreciation deductions. (25) The presence of the additional term on the right-hand side of equation 2 means that there is now a second way in which tax policy may affect investment, namely, through expected changes in policy, as well as through current policy. For example, the expected elimination of an investment tax credit has a powerful effect on the user cost of capital as computed from equation 2, because it induces a huge capital gain at the time of the credit's elimination. Thus the introduction of an investment tax credit that is expected to be temporary has two effects that encourage investment--through the tax credit itself as well as through its expected elimination--which together can be thought of as corresponding to changes in the desired level of capital as well as changes in the desired timing of capital purchases.

As noted, equation 2 applies only under the assumption of instantaneous capital stock adjustment. Optimal investment behavior in the presence of convex adjustment costs may be characterized by a partial-adjustment investment process in which the desired capital stock at date t varies inversely with the weighted average of the current and expected future user costs of capital based on equation 2: (26)

(3) [C.sup.*.sub.1] = [E.sub.t] [summation over (s[greater than or equal to]t [W.sub.s-t][C.sub.s]

where the weights [W.sub.i] sum to unity and decline exponentially, at a rate that is inversely related to the size of adjustment costs; the more sluggish the investment response, the more the future matters. Estimates by Auerbach and Kevin Hassett indicate that it is reasonable to assume an annual decay rate of 0.5 in calculating the weights. (27)

The estimated coefficients are all significant and quite consistent with those reported by Poterba, despite differences in the other explanatory variables, in the sample period, and in the method of estimation (panel data versus aggregate time series). (37) But the impact of this additional variable is offset by weaker estimated effects of the others, so that the overall picture does not change appreciably. (38)

In summary, state governments appear even more responsive to their own budget conditions than the federal government does to its. This is consistent with the tighter restrictions on the typical state's budget process. The estimates in table 6 imply that enormous fiscal changes are to be expected at the state level in the current fiscal year: the results in the middle three columns of the table imply tax increases of $4 billion this year and $22 billion next year, and current-year spending cuts of $24 billion. The full-year response of spending cuts and tax increases is actually larger than the federal tax cuts and spending increases implied by the model presented above, indicating that the state fiscal situation, indeed, is more than a sideshow for macroeconomic policy in the current fiscal environment.

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