The debate what is better for the economy federal deficits or surpluses is over discussed but has not been solved. One side proposes that surpluses are better for they take away the burden from future generations to pay the huge debt that the government is accumulating. Less debt will lead to lower interest rates in the future and for this it is desirable. On the surface it really does seem as though to have a surplus is a positive phenomenon. Who does not want to have more revenues than expenditures? However, what can one do with a surplus? One can either spend it or reduce the debt. If the surplus is spent there is no more surplus - it turns into a balanced budget or deficit. If it is used to pay back the debt than no one benefits. The government has less money to spend. The people have less money in their hands, and not only less money but also less government securities and bonds, which earlier acted as a stimulant for spending (knowing they have future income had stimulated consumption). Thus, surpluses not only do not benefit the government, but they hurt the consumers and investors by taking away from their disposable income through tax increases and reduction in government spending.

The negative effect of budget surpluses on the economy is proven by examples in US history. There have been few years at which the economy has generated surpluses, and almost every time the surpluses have been followed by a recession (1819, 1837, 1857, 1873, 1893 and 1929). Recessions in turn lead to further deficits. Why is this so?

Whenever there is a budget surplus it means that tax revenues exceed government spending (T > G). That means that money is taken away from the people and they have less money to spend and invest. That results in a shift of the demand curve to the left at a lower level of income and consequently at a lower level of employment (see graph). Since income is at a lower level the government generates less tax revenue and since employment is at a lower level the government has to pay more transfer payments for the unemployed. This reduces T in relation to G significantly (G > T), which means there occurs a budget deficit. Expressed in equations in a closed economy the relationship is the following:

As Robert Eisner states: "The greater the deficit, the greater the next year’s increase in GNP. The less the deficit, the less the increase or the greater the decline in the next year’s GNP." The greater the federal debt, the greater the wealth and income enjoyed by the nation’s citizens. According to Michael Mandel, the new data disprove the argument that the large government deficits of the 1980's and early 1990's depressed investment and doomed the US to slow growth for the following years. In the aftermath, productivity growth throughout Reagan's office was 1.6%, which is larger than the one during Carter's administration; the average growth rate during the presidency of Bush was 1.7%. No matter the large federal deficits that Reagan and Bush ran the productivity growth appears to be comparatively high.

Nevertheless US presidents have often been concerned with reducing the deficit. The Reagan, Bush and Clinton administrations concentrated particularly on it. In their actions they were lead by the general belief that surpluses are beneficial for the economy and they unburden the citizens from the heavy debt that each of them is carrying, estimated at above $3000 per person.

In the early 1980’s the Reagan administration introduced tax cuts simultaneously with increases in government spending for military purposes (as Reagan wanted) and for domestic spending (as the Congress insisted). At the same time government spending increased even more because of the recession and the need to support the ones hurt by it. Tax revenues fell because of lower income during the recession. This led to huge deficits generated in the early 1980’s. In 1985 both Reagan and the Congress agreed on undertaking measures to reduce the growing deficit. They put into power the Balanced Budget and Emergency Deficit Control Act, which consisted of a series of annual targets, whose final goal was to balance the budget by 1991. Realizing that this was not going to happen they postponed the projected balanced budget for 1993. They did not reach their goal.

In 1990 the Bush administration continued what Reagan started by reducing government spending and increasing taxes with the target to cut the deficit by $500 billion over five years. As a substitute for the Balanced Budget and Emergency Deficit Control Act, the Budget Enforcement Act (BEA) was created. It did not set annual targets but instead limited discretionary spending and ensured that no increase in entitlements and no tax cuts would worsen the deficit. It also created ‘pay-as-you-go’ rules: if there was to be an increase in entitlements or cut in taxes, they had to be financed by decreasing other entitlements or increasing other taxes. The act did work to reduce discretionary spending but did not have the desired effect on the deficit. The deficit rose as a consequence of the 1990 recession – tax revenue decreased because of lower income, and government spending to aid the ones hurt by the recession increased.

In 1993 the Clinton Administration continued the attempts to cut the deficit. The method used was a five-year deficit reduction package of spending cuts and higher revenues, the target being to cut the deficit from 1994 to 1998 by $500 billion. In addition to that, in 1997 the Balanced Budget Act (BBA) was passed. Finally the president and the Congress achieved their goal and the deficit fell from $290 billion in 1992 to a surplus of $69 billion in 1998.

How is the budget deficit/surplus calculated? Whenever government spending exceeds tax revenues there is a deficit, and whenever tax revenues exceed government spending there is a surplus. In general deficits tend to be expansionary/inflationary in their effect, while surpluses are deflationary (this can be seen on the graph on page 1 where prices fall during surplus). It is important to know whether the deficit is active or passive, which is determined by calculating the full- (high) employment budget. The full-employment budget measures what the deficit would have been if the economy was operating at full employment. If in this hypothetical situation the economy is still in deficit it means that the deficit is active: it will have expansionary or inflationary effects on the economy. If, on the other hand an economy which actually has a deficit but at full-employment is balanced or has a surplus, then the deficit is passive and has no implications on policy.

Another very important part of measuring the deficit, which is emphasized by Eisner, is that it should be adjusted for inflation. He calls this the real debt as opposed to the non-adjusted for inflation debt. "The trick, simply enough, is that as inflation wipes out the value of money, it also wipes out the value of the debt." As we know inflation hurts the lenders and benefits the borrowers. In this case lenders are the citizens while the borrower is the government. As in the case when people borrow from a bank inflation is taken into account in the interest rate, it should also be considered when the government does the borrowing from the public. According to Eisner after doing the adjustment in real terms the federal budget for some of the years was not in deficit but in surplus, and for others it was just moderate.

When measuring budget deficits Eisner also emphasizes the importance of distinguishing between capital and current expenditures. He accuses the federal government of not doing so. There is a big difference in personal accounting, he says, whether the deficit comes from gambling losses in Las Vegas or because of expenditures for a new house. It should make a difference whether the government expenditures go for covering the basic needs of the unemployed or for education. One is a repetitive occurrence with no productivity value while the other is an investment, which will pay back in the future (house: save on rents; education: better paid jobs).

What is essentially the deficit? Eisner’s answer is that the federal deficit is someone else’s surplus. As long as the government is borrowing from the citizens, that means that the citizens have a surplus, which they are willing to lend. If the government is perceived as getting poorer by going into debt, then the individuals, businesses, and state and local governments that acquire the debt are getting richer. The economy is healthy as long as the debt is owned by US citizens, businesses, and local governments. Do they own it? Estimations show that foreigners possess less than 11% of the federal debt. The answer to who has the surplus, then, is that it is US citizens and businesses.

By the same token the opposite argument can be carried through. For every surplus there must be a deficit and for every creditor there must be a borrower. If the government runs federal surpluses someone must be running a deficit. If the share of the foreigners is less than 11%, then more than 89% of the deficit will be experienced by US citizens, businesses, and local governments. Then, surplus occurs to be a harmful phenomenon in the economy, a phenomenon that should be avoided.

However, here we have it: a federal surplus for the third quarter of 1999. What should be done with it? There are several options: pay back the debt; use it for Social Security purposes; invest in education; invest in health care; use it to create more jobs through government expenditure; cut taxes. Today's debate between the Clinton Administration and the Congress over what to do with the budget surplus reflects the different positions of supply-siders, conventional economists, and New Economy advocates.

Clinton’s plan is to save the surplus until the Social security is reformed and spend 62% of the projected surplus for 15 years ahead on Social Security stabilization.

Bill Bradley, candidate for president, has a different proposal about how to spend the current federal surplus. His goal is to provide health care to almost all Americans, including mandatory coverage for children. "The objective is to see that at least 95% of the American people have health insurance". The price of this project is $65 billion-a-year. Bradley’s health care initiative is different from Hillary Clinton’s of 1994 because it does not aim at replacing the already existing private health-insurance system. Instead, Bradley would require parents to purchase insurance coverage for their children, with the government subsidizing low-income households. According to his plan insurance premiums would be tax deductible and the elderly would get free prescription drugs under Medicare for chronic illnesses. Bradley proposes to use the majority of the non-Social Security surplus for health care rather than for tax cuts.

On the other hand if the debate is whether the surplus should be used for decreasing the debt or for tax reductions Bradley’s answer is "I’d choose [reducing the federal debt], because that’s a reduction in future interest rates". This argument seems insubstantial since there are better ways of controlling the interest rates than through reducing the debt. The Federal Reserve is usually in charge of controlling the interest rates but the role of foreign investment in determining the interest rates should not be underestimated.

Another way of utilizing the surplus is through a tax cut. A potential tax cut designed by the government is in the amount of $792 billion. Its positive effects are that it would put money in the hands of the consumers, which will increase demand and thus will lead to increases in output. A tax cut has basically the same impact as enlarging the federal deficit.

Robert Kuttner proposes to spend the surplus by investing in education. "What Congress ought to do, instead of cutting taxes or paying down the national debt, is to invest in public education." The surplus derives from three main sources, says Kuttner, higher than projected economic growth, reduced interest costs, and sharp reduction in domestic spending. Once it is there it should be made use of reasonably. Paying off the debt is a 'needless badge of parsimony', according to Kuttner. What is worth it, is the training of tomorrow’s workforce. An increase in skilled workers will only stimulate growth in the economy.

According to an ABC/Washington Post poll 37% of the polltakers preferred that the surplus be spent on education and health care. Social Security was next, favored by 29%. Only 19% wanted to reduce the debt, and just 14% wanted a tax cut. Only in Washington are surplus and further debt reduction equated with virtue.

Middle way in the debate between deficits and surpluses is the balanced budget. A situation in which government spending equals tax revenue seems ideal. In such case the effect on spending and output is not neutral, as it might seem. A change in government spending has a direct influence on output which change is additionally multiplied by the multiplier. A change in taxes on the other hand has only an indirect impact on the income:

In a closed economy Y = C + I + G

C = Co + a(Ynp - T)

Y = Co + aYnp - aT + I + G, where a is the marginal propensity to consume

Thus, a simultaneous change in both government expenditures and taxes with an equal magnitude will increase output because of the multiplier effect associated with the government spending. A shift in the aggregate demand function is governed by the value of the marginal propensity to consume out of disposable income, while the magnitude of the ultimate change in the net national product depends on the value of the marginal propensity to tax. However, when there is a balanced budget the boost on demand and output is not as large as it is when the budget is in deficit. If compared with budget surpluses, though, balanced budget is preferable.

There are three targets that a government can follow: a federal deficit, a federal surplus or a balanced budget. If a government is only superficially interested in its image then it sounds good in front of the rest of the world to say that it is a rich government running surpluses or balancing its budget (as a respectable firm would like to claim it is running surpluses). However, if the government is primarily concerned with the wealth and welfare of its citizens, the only option left is to run deficits: they increase consumption, augment output, stimulate growth, and decrease unemployment. Deficits reflect the surplus of the citizens and businesses; the larger the deficit the wealthier the citizens and business are and will be in the future.

Robert Eisner, "How Real Is the Federal Deficit"

Dimitri B. Papadimtriou, L. Randall Wray, "What to do with the surplus"

Business Week, November 15, 1999

Business Week, October 11, 1999

Wallace Peterson, "Income, Employment, Economic Growth"