Explaining U.S. federal deficits: 1889-1998

Economic Inquiry, July, 2002 by Brian L. Goff, Robert D. Tollison

I. INTRODUCTION

Seater (1993) attempted to provide a common basis for assessing empirical studies of the effects of deficit spending. He concluded that evidence of the existence of appreciable effects of U.S. deficits on macroeconomic variables is questionable. In other words, the data do not allow for a confident rejection of Ricardian equivalence. In a world with no macroeconomic effects from deficit spending, full information, and no distinctions between political and economic markets, fluctuations in deficits merely reflect government financing considerations of secondary importance.

In contrast to this view of the world, deficits and surpluses are treated as an important topic in everyday affairs and discourse. Politicians talk about deficits and surpluses regularly when calling for higher or lower taxes, more or less spending, revisions in Social Security funding, and other changes in public policy. Economists and political analysts continue to debate why deficits became a regular feature of federal fiscal management from the late 1960s into the 1990s.

These debates have spurred divergent theories and conjectures, leading to different empirical hypotheses and variables of interest. Moreover, existing empirical studies of the subject have utilized diverse econometric techniques and specifications. As a result, the competing hypotheses concerning deficit spending have not been tested against one another in a systematic fashion. In this article our principal aim is to analyze the different explanations of U.S. federal deficits, jointly estimating competing hypotheses about deficit fluctuations in a generalized, reduced-form empirical model. To achieve this goal we collected and utilized a time series of data running from 1889 to 1998.

The apparent paradox between the seemingly innocuous effects of deficits and the political preoccupation with them may owe its existence to one or more reasons-limited and noisy information among voters, differences between economic and political markets, inaccuracy in the measured macroeconomic effects of deficits, or other reasons. We do not attempt an explanation of why deficits, which seemingly exhibit no or small real effects (Ricardian equivalence), could lead politicians and voters to treat deficits as if the Ricardian hypothesis were rejected. Instead, we treat explanations of deficits that stem from Ricardian premises as one of several hypotheses to be tested.

II. COMPETING HYPOTHESES

We first describe the leading explanations of deficit spending, organizing them around common theoretical principles. (1)

Tax Smoothing

The explanation of deficits which follows directly from a Ricardian equivalence theory is the tax smoothing theory developed by Barro (1979). (2) If deficits generate no real macroeconomic effects (and the influences of political institutions and politicians are ignored), then optimal public financing considerations govern the use of deficit spending. Simply put, fiscal authorities raise revenue to meet spending needs through income taxation, but both spending and income (the tax base) are subject to uncertain and temporary movements. Minimization of the deadweight costs of raising a given amount of revenue requires keeping tax rates steady in the face of purely temporary changes in income or spending. This is accomplished by running deficits when income is temporarily low or spending is temporarily high and running surpluses in the opposite case.

Imposing a binding no Ponzi game (NPG) constraint leads to similar long-term behavior of deficits as implied by optimal finance models. The NPG condition requires that the present value of taxes must equal the present value of spending plus the initial value of debt. Spending and revenue must share a long-term common trend so that (primary) deficits will be stationary over a long time series-deficits and surpluses will offset each other. The tax smoothing theory uses temporary movements in spending, income, or both to explain the origin of deficits and surpluses, whereas the NPG condition does not offer an explanation of why deficits might arise in the first place. It merely indicates that if they do arise, they will be offset over some long period by surpluses. Hakkio and Rush (1986), Hamilton and Flavin (1986), and Trehan and Walsh (1990a, b) considered deficits from this perspective, investigating the long-run stationarity of US. deficits and the cointegration of revenue and spending streams.

Political Strategy

Over the last decade a number of models have been developed in which strategic behavior on the part of incumbent politicians plays a role in deficit fluctuations. The literature in this vein most directly linked to deficit decisions by fiscal authorities includes models such as Alesina and Tabellini (1990), Persson and Svennson (1989), and several others where the time consistency or inconsistency of policy is of central importance. (3) In these models the presence of binding political constraints, such as term limits, can provide incumbents with an incentive to use deficit financing as a means of constraining the behavior of subsequent politicians. As a result, several of the empirical pieces have focused on the effects of term limits (see note 3).