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Number 93-31, September 17, 1993

The Federal Budget Deficit, Saving
and Investment, and Growth
In the last decade and a half the federal budget
deficit has mushroomed. Some analysts would
argue that this sets the stage for lower rates of
U.S. consumption in the future. The rationale is
that government borrowing absorbs private sector saving and thereby reduces the rate of capital
formation. This view underlies the current deficit
reduction program of the Clinton Administration.
Other analysts, however, question whether the
linkage between the deficit and investment is as
close as this.
This Weekly Letter first discusses the sources of
the growing federal budget deficit. It then summarizes the evidence in support of the view that
there is a strong linkage between high federal
budget deficits and low national investment, as
well as the possible criticisms of that view.

Sources of the budget deficit
From World War II to about 1970, federal expenditures grew faster than the net national product (NNP), but on average, the expenditures were
balanced by growing receipts. Between 1970 and
1992, however, federal expenditures rose from
22 percent to 27112 percent of NNP, while receipts remained at around 22 percent.
On the expenditure side, entitlement payments
(primarily Social Security, Medicare, and Medicaid), which rose from 6 to 11 Y2 percent of NNp,
accounted for all of that increase. Defense spending fell from 8 to 6 percent of NNp, despite temporary increases during the Reagan years, while
net interest on the federal debt rose by an equal
amount. All other federal spending has been
quite constant as a share of NNP since 1970,
running at about 6 percent.
On the revenue side, contributions to social insurance rose from 5 percent of NNP in the late
1960s to 9 percent in 1992, covering about three
quarters of the increase in entitlement expenditures. But other taxes were reduced by an equal
amount, leaving total receipts as a percent of

NNPunchanged throughout the past two decades. The biggest offsetting changes in other
receipts were in corporate and personal income
taxes, which fell by 2 and 1Yz percentage points
of NNp, respectively. In addition, federal excise
taxes on such things as alcohol, tobacco, and
gasoline dropped by 112 percentage point of NNP.
In summary, the entire increase in the federal
budget deficit was accounted for by higher entitlement payments, while taxes remained constant as a fraction of national income. But the
composition of taxes changed: Taxes for social
insurance rose, while taxes on personal income,
corporate profits, and some commodities fell.

Effect on national investment
Concerns that the large federal budget deficit
will hamper long-term growth revolve around the
deficit's effect on national saving and hence investment. The amount of investment in capital
goods per worker plus improvements in technology and workers' skills ultimately determines
long-term growth in real per capita incomes.
In the national income accounts, net private investment (both domestic and foreign) equals net
private saving less the government's dissaving
(represented by its budget deficit). Net private
saving has trended downward in the last two decades from about 8112 percent of the net national
product (NNP) to about 61;2 percent in 1992. (Net
private saving here includes a fairly steady and
small amount of surpluses of state and local governments, which are mainly due to employee
pension funds and are therefore analogous to private saving.) Net private investment, however,
has fallen from about 8Yz percent of NNP to
a record low of only about 1112 percent; most
of this decline took place in the 1980s when
the increase in the federal budget deficit was
the greatest.
The view that a budget deficit diminishes investment assumes that the higher government

expenditures or increased private incomes from
tax reductions associated with the deficit are at
least partly spent on current consumption. The
borrowing to finance a government budget deficit tends to absorb private saving that would
otherwise go into private investment. If the proceeds of the borrowing are at least partly spent
on consumption goods, then the overall level of
investment in the economy is reduced. If private
domestic investment gets crowded out by the
budget deficit and the government's borrowing is
not spent on investment goods, then future productivityand hence future consumption in the
economy suffers. Alternatively, if private foreign
investment gets crowded out, then future inresidents would receive from
comes that
their investments abroad, and therefore also their
future consumption, are lowered. Either way, the
benefits of higher consumption today are counterbalanced by lower consumption in the future.


Conversely, reducing the budget deficit would result in a reduction of consumption today, and an
increase in consumption in the future. Determining whether this delayed benefit is worthwhile
requires an estimate of the actual trade-off in the
economy between present and future consumption, as well as some measurement of the public's
time preference, or the rate of interest that equates
the utility of current and future consumption. A
reasonable measure of the public's time preference would lie somewhere between the current
real after-tax yield on long-term bonds of about
1112 percent and that on common stocks of around
3 to 4 percent. Standard growth models can be
used to estimate the actual trade-off between
present and future consumption; and they show
that the future gains in consumption from a policy of higher saving and investment would outweigh the current losses in consumption at any
real interest rate below 10 percent. (See, for example, Harris and Steindel (1991).)

the rate of public investment, with no necessary
effect on the true rate of national investment.
Unfortunately, the empirical evidence does not
suggest that this happened. As discussed earlier,
the overall increase in federal spending can be
traced to higher entitlement payments, which
tend to be spent on consumption. Nor has the
composition of federal expenditures on goods
and services shifted toward investment. Net federal investment in nonmilitary physical capital is
relatively small, currently running at only about
$7 billion a year. Moreover, according to the
Congressional Budget Office (1990), net federal
investment in nonmilitary physical capital has
not increased relative to the size of the economy
in the last two decades; and a broader measure
of net federal investment that includes research
and development and investment in human capital has actually declined.
Military assets yield returns over an extended
period also, and net federal investment in such
assets increased by about 0.5 percent of NNP in
the 1980s. But there is an offsetting trend in net
investment by state and local governments, which
has declined rather significantly since the 1970s.
All in all, a proper accounting for the trend in gov~
ernment investment probably would accentuate
the decline in net national investment seen in the
national income' accounts, rather than reduce it.
A second criticism argues that the size of the
budget deficit's contribution to reducing national
saving and investment, is overstated because of
inflation. Payments of interest on government
debt contain an inflation premium to compensate wealth holders for losses in the real value of
their holdings of government debt. But since
wealthholders should tend to reinvest the inflation oremiums in financial markets in order to
mairitain their real wealth, any government borrowing undertaken to pay for these premiums
would tend to be matched by a heightened flow
of private saving and therefore would not tend to
crowd out private investment. It is therefore argued that the measured federal budget deficit
overstates the claim of the government on private
saving by the amount of the inflation premiums.

Possible criticisms
Several criticisms have been made of the view
that the federal budget deficit has contributed
significantly to the collapse in national saving
and investment and that the surest way to raise
saving and investment is by moving toward budget balance. First, the national income accounts
treat all government spending as consumption. So
theoretically, a rise in the federal budget deficit
could have been accompanied by an increase in

However, while the argument that both the federal budget deficit and private saving are overstated because of inflation is correct, the inflation
adjustment has changed remarkably little over
time relative to NNP because changes in inflation
have tended to be offset by opposite movements
in the debt-to-NNP ratio. Thus, the debt-to-NNP
ratio fell through the 1970s as inflation rose, but
then rose in the 1980s as inflation fell. So the

inflation-adjusted deficit increased in relation to
NNP by about as much as the unadjusted deficit
did (Congressional Budget Office (1990)). As a
result, the measured contribution of the federal
budget deficit to the collapse in national saving
and investment is about the same, whether this
adjustment is made or not.
A final criticism is that households make farsighted adjustments to government deficits. In
this case, any increase in the federal budget deficit would be perceived to imply equally large tax
increases (plus interest payments on the accumulated debt) to be paid in the future either by
themselves or their heirs. Therefore, households
would save an equal amount and use it to pay future taxes. As a result, the increase in government
dissaving due to the emergence of the deficit
would be exactly offset by a rise in private saving, leaving total saving and investment unaffected by the budget deficit.
This point, known as "Ricardian Equivalence;' is
currently disputed among economists. On the

cent, compared with a historical range of 6% to
11 percent during other periods of balanced budgets, which seems unlikely.

The basic source of the growing federal budget
deficit since the late 1960s has been rising entitlement payments relative to income. Taxes to
pay for social insurance have risen by almost as
much, but offsetting this on the revenue side
have been falling corporate, personal income,
and excise taxes relative to income. Although
net private saving has declined somewhat in this
period, the rising federal budget deficit appears
to have been the largest contributor to the collapse in national saving and investment. All else
equal, moving toward a federal budget balance
likely would contribute to bringing the rate of
national saving and investment back to normal.
Absent a correction in the rate of saving and
investment, the economy likely would continue
on a lower long-term path of growth, in which
losses from lower future consumption would outweigh the gains from higher current consumption.

surface, at least, this vievv' appears to be grossly
contradicted by the events of the last two decades: The increase in the federal budget deficit
was accompanied by a decrease, not an increase,
in private saving. Proponents argue, however, that
other factors were working to reduce the saving
rate at the same time that the budget deficit was
acting to increase it. The most likely candidate is
an unanticipated increase in wealth, due first to
price increases in houses and later in equities,
which reduced the incentive to save. However,
by the end of the 1980s the Federal Reserve
Board's comprehensive measure of real national
net worth, at market value, was somewhat below
trend rather than above it.
In practical terms, would balancing the budget
be more likely to return the economy's saving
and investment back toward historical norms or
leave them unchanged? According to the Ricardian Equivalence view, private saving would fall
by about as much as the reduction in the budget
deficit. But that would lower private saving to levels far below the range of historical experience.
Specifically, the 4 percentage point reduction in
the high-employment budget (relative to NNP)
required to move it to a balanced position would
push the private saving rate down from its current
level of about 6Y2 percent of NNP to only 2Y2 per-

Closing the budget deficit requires restoring
some taxes, as well as cutting entitlement and
nonentitlement spending. However, high marginal tax rates that tend to yield little revenue and
discourage private saving and investment and
cuts in government investment that would be
counterproductive should be avoided. In this
connection, the Clinton Program does increase
tax revenues and reduce spending growth; however, it remains to be seen whether its relatively
high marginal tax rates will yield as much revenue as projected, or encourage investment as
much as hoped.

Adrian W. ThrooD
Research Officer

Congressional Budget Office. 1990. "The Federal
Deficit: Does It Measure the Government's Effect
on National Saving?"
Harris, E., and C. Steindel. 1991. "The Decline in U.S.
Saving and Its Implications for Economic Growth:'
Federal Reserve Bank of New York Quarterly
Review (Winter).

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.•.. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.



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Index to Recent Issues of FRBSF Weekly Letter







Saving-Investment Linkages in the Pacific Basin
A Single Market for Europe?
Risks in the Swaps Market
On the Changing Composition of Bank Portfolios
interest Rate Spreads as Indicators for Monetary Policy
The Lonesome Twin
Why Has Employment Grown So Slowly?
Interpreting the Term Structure of Interest Rates
California Banking Problems
Is Banking on the Brink? Another Look
European Exchange Rate Credibility before the Fall
Computers and Productivity
Western Metal Mining
Federal Reserve Independence and the Accord of 1951
China on the Fast Track
Interdependence: U.S. and japanese Real Interest Rates
NAFTA and U.S. jobs
japan's Keiretsu and Korea's Chaebol
Interest Rate Risk at U.s. Commercial Banks
Whither California?
Economic Impacts of Military Base Closings and Realignments
Bank Lending and the Transmission of Monetary Policy
Summer Special Edition: Touring the West



The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.