1

MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT

Fiscal Policy and the Role of Government

2nd edition

10-2

Key Concepts

Debt and deficits Fiscal Finance

Debt versus taxes Intergenerational equity

Debt sustainability and the primary surplus

10-3

Government Spending

Types Consumption of goods and services Investment Transfer payments

Considerable variation in spending

10-4

Fiscal Policy Components

Financing Taxes Borrowing Others?

Composition of Spending (G) Current goods and services Public investment

Government Expenditures Spending + transfer payments + payment on debt

10-5Government Spending% of GDP, 2002

0

10

20

30

40

50

60

70A

ustr

alia

Austr

ia

Belg

ium

Canada

Czech R

epublic

Denm

ark

Fin

land

Fra

nce

Germ

any

Gre

ece

Hungary

Icela

nd

Irela

nd

Italy

Japan

Kore

a

Luxem

bourg

Neth

erlands

New

Zeala

nd

Norw

ay

Pola

nd

Port

ugal

Slo

vak R

epublic

Spain

Sw

eden

United K

ingdom

United S

tate

s

Euro

are

a

Tota

l O

EC

D

Source: OECD online database

10-6

Looming Issues

10-7

Value of government spending

Rationale for Government Role Market Failure & Public Goods

Markets are not allocating all goods efficiently Pareto Efficiency: unable to make anyone better off by

reallocating resources without making someone worse off Public goods will not be provided by private sector…lack of

incentive Redistribution

Paternalistic view People will not always act in own best interest

Subsidize education, force savings (retirement) Social Welfare

Stabilization Policy (later)

10-8

Public Goods

Goods produced in the market have two characteristics: rivalry & excludability rivalry: one’s use of good makes it unavailable for

others (e.g. if I eat the snickers candy bar, you can’t) excludability: those unwilling to pay do not have access

to benefits of product (e.g. if you don’t pay for the snickers candy bar, you can’t have it)

Public goods have characteristic of nonrivalry and nonexcludability

Examples: national defense, lighthouse, highways Degrees of nonrivalry & nonexludability (“quasi-public

goods” like police and fire protection) Nonexludability characteristic creates a free-rider

problem: no incentive to contribute to cost makes private production unprofitable

10-9

Level of Spending

What proportion of GDP should be allocated to public spending? Merit of spending Sources of spending

Taxation creates distortions Creates a wedge between value of labor and availability of

labor May alter a firm’s decision to invest

Deficit financing can have adverse economic effects

Crowd out private investment Intergenerational transfers Unsustainable debt levels => financial crisis

Do benefits exceed costs (distortions)?

10-10

Laffer Curve

Taxes collected = Tax rate x Wage x N Two competing effects

Tax rate x Wage is rising N is falling

Eventually, tax collections will fall

Tax

Rev

enue

Tax Rate0% 100%

10-11

Government Borrowing

Deficit: debt issued in a particular fiscal year Debt: accumulation of past deficits and surpluses Developed country trend: increasing budget deficits

during post-WWII era with increased government spending Historically, deficits during wartime only Revenues have not kept up with expenditures

Figure 10.13, 10.15, page 240 Debt payments increasing portion of budget

Table 10.3, page 242 Primary balance: difference between revenue

and spending not including interest on debt

10-12

De

ficit

DebtDebt

10-13

Su

rplu

s

DebtDebt

10-14

Source: OECD Economic Outlook

0

20

40

60

80

100

120

140

160A

ust

ralia

A

ust

ria

Be

lgiu

m

Ca

na

da

De

nm

ark

F

inla

nd

Fra

nce

Ge

rma

ny

Gre

ece

Ice

lan

dIr

ela

nd

Italy

Jap

an

bK

ore

aL

uxe

mb

ou

rgN

eth

erl

an

ds

Ne

w Z

ea

lan

dN

orw

ay

Po

lan

dP

ort

ug

al

Slo

vak

Re

pu

blic

Sp

ain

S

we

de

nU

nite

d K

ing

do

mU

nite

d S

tate

s E

uro

are

aT

ota

l OE

CD

Debt as a percentage of GDP, 2002

10-15

Cost of Government Borrowing

Intergenerational Redistribution Government effectively reallocates resources between

age groups Running a deficit Unfunded pension programs with rising old-age

dependency Developed countries: younger generation will receive

fewer benefits for taxes paid Figure 10.18, page 246

Deficit financing uses up national saving Less saving for private investment

Poorly managed public debt can create financial crisis Unsustainable debt accumulation

10-16

Present value of net tax payments (until death) by different generations indexed by age in 1995 (Thousands $).

Generational Accounts

10-17

Recall Saving-Investment ModelIn

tere

st R

ate

OutputI0

5%

Private Savings

Investment

10-18

Deficit = Negative Savings

OutputI0

5%

6%

I1

Private Savings

Investment

Private Savings + Government Savings

S1

Inte

rest

Rat

e

Deficit

10-19

Dynamic ResponseSuppose savings increases with the deficit

OutputI0 = S1

5%

6%

I1

Private Savings

Investment

Private Savings + Government Savings

Inte

rest

Rat

e

I0 = I1 S1

10-20

Sustainability of Debt

Debt sustainability: debt does not rise relative to GDP Stable debt/GDP ratio

Can continue to run budget deficits if… GDP grows faster than or equal to growth in debt

Increase in debt/GDP ratio arises from (1) ↑interest on debt changes (2) ↓GDP growth (3) ↑primary deficit

Budget balance = primary balance + interest payments

10-21

Sustainability of Debt

r = real interest rate

g = real growth rate of GDP

GDP

Deficitimary

GDP

Debtgr

GDP

Debt Pr)(

GDP

Surplusimary

GDP

Debtgr

Pr)(

If r > g, must have primary surplus If r < g, can run deficit indefinitely

10-22

Intertemporal Budget Constraint

Year 2005: D(2005) = G(2005) - T(2005)

Suppose debt is paid off in Year 2006Suppose debt is paid off in Year 2006

Year 2006: T(2006) = G(2006) + D(2005)x(1+R)

Hence, taxes are higher in 2006Hence, taxes are higher in 2006

T(2006) - G(2006) = D(2005)x(1+R)

Year 2005: G(2005) = T(2005) +[T(2006)-G(2006)]/(1+R)

10-23

Spending in year 2005 must be supported by current and future taxes.

=

10-24

Implications

Countries with high debt must Default Run tighter fiscal policy in future

Debt levels should vary across countries Purpose of spending (consumption versus

public investment) Role of expected future liabilities (pensions) Intergenerational equity

10-25

Optimal Budget Deficits

For what purpose is spending being used? Consumption Investment

Cyclical considerations Recessions mean low tax collections, high

payouts Should taxes increase during recessions?

Distortionary effects of taxation Tax smoothing

10-26

Summary

Government spending is a significant fraction of economic activity

Role of government spending Financing

Taxes, and their distortionary effects Deficits

Effect of deficit spending Debt sustainability