Thayer Watkins
Thayer Watkins
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The Deficit of the Government

There is a great deal of political concern with balancing the budget. Economists generally maintain that this objective is not as important as politicians think. It may well be that conservative politicians support balancing the budget as a means to limiting government spending. But the budget can be balanced just as well by increasing taxes as by cutting government spending. Milton Friedman stated that the problem with government is not that it doesn't balance its budget but that it spends too much money. His statement could be refined even further. It is not so much that government spends too much money per se, but that it spends too much on things for which the benefits are not greater than the costs. When the government spends for such projects it is decreasing economic welfare, it is wasting resources. Usually the reason that government finances such wasteful projects is shear ignorance but very often government knowingly finances wasteful projects because the benefits to the people who count are greater than the costs to those people even though overall benefits fall short of costs. The people who count are politicians and their benefits in terms of enhanced chances of re-election are more important than the overall costs to the public.

Leaving aside the above problem there is another practical problem of defining the government deficit. There is the matter of on-budget versus off-budget items. Economists, Robert Heilbroner and Peter Bernstein, in their book The Debt and the Deficits: False Alarms/Real Possibilities show the difference between a naive approach to debt and deficits and a more correct, analytical approach.

Heilbroner and Bernstein take the Federal deficit and make adjustments to take into account the limitations of that measure of the deficit.

The Net Debt Held by the Public

First, Heilbroner and Bernstein consider how much of the Federal debt is owned by the Federal Government itself. Deducting the sale of debt to agencies of the Federal Government gives a net concept of the deficit as opposed to the gross deficit concept involved in the official reported deficit.

A Comprehensive Government Sector Balance

Second, there is no reason to limit the concept of government deficit to just the Federal Government. The state and local governments' budgets should be taken into account as well. Usually on balance the state and local governments run a surplus which offsets a major portion of the Federal deficit. This is interesting because a big item of federal expenditure is grants to state and local government. Heilbroner and Bernstein call the combined budget balance of the three levels of government the national deficit.

Correction for Price Level Changes

The above corrections are important but the most important conceptual innovation presented by Heilbroner and Bernstein is the correction of the debt for inflation. The usual way of looking at the deficit is in terms of the following equation:

(Debt at time t+1)
= (Debt at time t) + (deficit for year t)

This equation can be used to compute the deficit; i.e.,

(Deficit in year t)
= (Debt at time t+1) - (Debt at time t)

Thus the annual deficit is the difference between the level of government debt at the end of the year and what it was as the beginning of that year.

Heilbron and Bernstein correctly note that if one wants the real (inflation adjusted) deficit the way to get it is from the above equation in which the value of the debt at time t+1 is adjusted for changes in the price level by dividing by the price index.

(Real Deficit in year t)
= (Debt at time t+1)/(1+f) - (Debt at time t)

where f is the rate of inflation during year t.

This inflation adjustment is especially important during times of high inflation that push up interest rates and require large interest payments on the debt. The real value of the deficit would be far smaller than the nominal value. The quantitative effect of making this inflation adjustment is shown later.

Capital Budget Versus a Current Operating Budget

Heilbroner and Bernstein go on to note that in any business enterprise there is a distinction made between the capital budget and the current operating budget. If a business or household invests in capital equipment this is treated differently than if they threw a party in which there an outlay of funds but no assets acquired in return.

The Application of the Above Budget Concepts

Heilbroner and Bernstein estimate the investment of government in capital and deduct this to get the current or operating budget of the government. Below is shown the results of their computations for Fiscal Year 1988. They show that the deficit reported to the public of $255 billion was more like $3 billion in real terms.

Corrections and Adjustments
of the FY1988 Deficit
Deficit ConceptAmount
Gross Deficit255
Net Deficit162
National Deficit109
Inflation Adjusted
Operating Deficit3

The data is not available to duplicate all of Heilbroner and Bernstein's for later years but the inflation adjustment can be made. Below is shown the information on the Federal debt. The figures on the debt held by the public (as opposed to the Federal Government itself) includes the Federal debt held by the Federal Reserve System, the central bank of the United States. The interest that the Fed earns on its holdings of Federal debt it returns to the U.S. Treasury except for a relative small amount it keeps to cover operating costs. Thus the debt held by the Fed is not a financial burden to the Treasury. Therefore the debt held by the Fed is deducted to get the Federal Debt Held by the Non-Fed Public. The price level index used to adjust for inflation is the GDP implicit price deflator index. The results are much the same if any other general price level index such as the consumer price index is used.

The Real Deficit After the Adjustment for Inflation
In Comparison With Reported Deficit
Fiscal Year Federal Debt
Held by Public
Federal Debt
Held by Fed
Federal Debt
Held by
Non-Fed Public
Implicit Price
Real NonFed
Public Debt
Real           Deficit        
Reported Deficit Inflation-Adjusted
Reported Deficit
 Billions BillionsBillions'2000=100Billions BillionsBillions Billions
2003 3878.4est 660.0est 3218.4est 105.673 3045.6est 220.8est 304.2 287.9
2002 3540.4 604.2 2936.2 103.945 2824.8 103.9 157.8 151.8
2001 3319.6 534.1 2785.5 102.373 2720.9 -177.5 -127.3 -124.3
2000 3409.8 511.4 2898.4 100 2898.4 -305.7 -236.4 -236.4
1999 3632.4 496.6 3135.8 97.868 3204.1 -178.1 125.6 128.3
1998 3721.1 458.2 3262.9 96.472 3382.2 -126.5 -69.2 -71.7
1997 3772.3 424.5 3347.8 95.414 3508.7 -53.5 22 23.1
1996 3734.1 390.9 3343.2 93.852 3562.2 55 107.5 114.5
1995 3604.4 374.1 3230.3 92.106 3507.2 97.1 164 178.1
1994 3433.1 355.2 3077.9 90.259 3410.1   203.3 225.2

The Social Loss of the Government Budget

In addition to the issues considered by Heilbroner and Bernstein there is the matter of social benefits and costs as opposed to the financial benefits and costs. When governments raise revenue through taxes the social costs are generally greated than the amount collected in taxes. Taxes generally distort prices and affect consumers and producers' behavior. When people take a less choice rather than their first choice there is a social cost to them that is not balanced by a tax revenue for the government. See the the impact of a tax on prices. and economic welfare analysis of taxes. Thus even if the government budget is financially balanced there is generally a social welfare deficit for its activity unless the government's acitivities are restricted to pure public goods.

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