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October 1985, 
Vol. 67, No. 8
Posted 1985-10-01

Two Views of the Effects of Government Budget Deficits in the 1980s

by John A. Tatom

John A. Tatom explains the predicted effects of deficits based on the conventional analysis and a competing theoretical approach. The conventional analysis, according to Tatom, emphasizes that deficit-increasing fiscal policies initially result in increased demand for goods and services and a reduced supply of national saving. These two effects lead to increases in national output, employment, prices, and interest rates. The down side of such policies is a decline in private saving and investment in business structures, equipment and inventory, and housing. Since the sharp increase in deficits in 1981-82, economic developments have been sharply at odds with these predictions. Tatom explains that the alternative set of hypotheses emphasizes the substitutability between government and private expenditures and the importance of permanent instead of measured income in private spending decisions. These hypotheses indicate that deficit-increasing fiscal actions do not raise demand for goods and services or reduce the supply of national saving. Therefore, they do not affect output, employment, prices, or interest rates. Fiscal deficits arising from government expenditures directly “crowd-out” private spending, especially investment, while those arising from tax reductions have no direct effect on national saving, investment, or interest rates. Comparing the changes in the shares of private saving and investment in GNP in 1980 and 1984, Tatom indicates that both have risen sharply, instead of declining as the conventional view would predict. The author explains that investment incentives provided in the 1981 tax act played a central role in raising the private saving rate and the share of real business investment in real GNP to record levels in 1984. These increases are more broadly consistent with the alternative hypotheses than with the conventional view.