Government and Fiscal Policy

Read this chapter to learn about how the government's fiscal actions influence aggregate demand. The chapter first introduces the components of the government's budget and then discusses discretionary fiscal policy and automatic stabilizers used to influence the economy. Some lags in the implementation of fiscal policy are identified and the concept of crowding out is introduced. Attempt the "Try It" exercises at the end of the section.

1. Government and the Economy

Case in Point: Generational Accounting

One method of assessing the degree to which current fiscal policies affect future generations is through a device introduced in the early 1990s called generational accounting. It measures the impact of current fiscal policies on different generations in the economy, including future generations. Generational accounting is now practiced by governments in many countries, including the United States and the European Union.

As populations age, the burden of current fiscal policy is increasingly borne by younger people in the population. In most countries, economists computing generational accounts have found that people age 40 or below will pay more in taxes than they receive in transfer payments, while those age 60 or above will receive more in transfers than they pay in taxes. The differences are huge. According to a recent study by Jagadeesh Gokhale, summarized in the table below, in 2004 in the United States, a male age 30 could expect to pay $201,300 more than he receives in government transfers during his lifetime, while another male age 75 could expect to receive $171,100 more in transfers than he paid in taxes during his lifetime. That is a difference of $372,400! For future generations, those born after the year 2004, the difference is even more staggering. A male born after the year 2005 can expect to pay $332,200 more in taxes than he will receive in transfer payments. For a woman, the differences are also large but not as great. A woman age 30 in 2004 could expect to pay $30,200 more in taxes than she will receive in transfers during her lifetime, while a woman age 75 could expect to receive transfers of $184,100 in excess of her lifetime tax burden.

The table below gives generational accounting estimates for the United States for the year 2004 for males and females. Figures shown are in thousands of 2004 dollars. Notice that the net burden on females is much lower than for males. That is because women live longer than men and thus receive Social Security and Medicare benefits over a longer period of time. Women also have lower labor force participation rates and earn less than men, and pay lower taxes as a result.

Year of birth Age in 2004 Male Female
2005 (future born) −1   333.2     26.0
2004 (newborn)   0   104.3       8.1
1989 15   185.7     42.0
1974 30   201.3     30.2
1959 45     67.8   −54.1
1944 60 −162.6 −189.4
1929 75 −171.1 −184.1
1914 90   −65.0   −69.2

Generational accounting has its critics – for example, the table above only measures direct taxes and transfers but omits benefits from government spending on public goods and services. In addition, government spending programs can be modified, which would alter the impact on future generations. Nonetheless, it does help to focus attention on the sustainability of current fiscal policies. Can future generations pay for Social Security, Medicare, and other retirement and health care spending as currently configured? Should they be asked to do so?