Deficits, public debt dynamics, and tax and spending multipliers

Cutting government spending on goods and services increases the budget deficit if the nominal interest rate is close to zero. This is the message of a simple but standard New Keynesian DSGE model calibrated with Bayesian methods. The cut in spending reduces output and thus—holding rates for labor and sales taxes constant—reduces revenues by even more than what is saved by the spending cut. Similarly, increasing sales taxes can increase the budget deficit rather than reduce it. Both results suggest limitations of “austerity measures” in low interest rate economies to cut budget deficits. Running budget deficits can by itself be either expansionary or contractionary for output, depending on how deficits interact with expectations about the long run in the model. If deficits trigger expectations of i) lower long-run government spending, ii) higher long-run sales taxes, or iii) higher future inflation, they are expansionary. If deficits trigger expectations of higher long-run labor taxes or lower long-run productivity, they are contractionary.