The Role of Government Chapter 10

Fiscal Policy Chapter 11

Tax Policy In 2003, Budget Speech the financial secretary announced the salaries and corporate profits taxes would be raised by up to 1% and 2% respectively. What are the reasons for such a rise and what are the implications? The government believes that it must raise taxes to eliminate the operational budget deficit.

Objectives Analyze distortions in the economy generated by taxes. Calculate the sustainable deficit for any level of debt. Examine the effects of deficits in small and large economies.

HK Spending by Category 1998/99

Government Expenditure (%GDP) 2000

Sources of Revenue Direct Taxes: Taxes on Income such as Corporate Profits, Salary, Estate Taxes Indirect Taxes: Taxes on Spending, Gambling Revenues, Stamp Duties, Motor Vehicle Registration Fees Fees for Service Investment Income

Sources of Revenue for Hong Kong

Why do we have government? For economic activity, marketplace is the baseline allocation mechanism. Government may step in when market (arguably) fails. Types of market failure Public Goods: Goods whose shared benefits cannot be charged for including police, fire services, national defense. Externalities: Some goods may produce costs or benefits not borne by the purchasers including parks, tourist sites or pollution (negative externalities). Coordination Failure: Some systems may work well only if everyone uses them the same way, i.e. traffic.

Social Insurance Individuals in a society face certain risks such as unemployment or poor health or long life which are unpredictable at individual level but predictable at a social level. Various risks may be uninsurable in private markets due to imperfect information. Example: Lazy people might be most likely to buy unemployment insurance, preventing insurance companies from making a profit. Government often will offer social insurance.

Expenditures: Transfer Payments vs. Government Consumption Economists think its important to classify government expenditures into two categories. Government consumption is spending on actual goods and services Transfer Payments are payments to individuals for welfare or other social purposes which does not require the recipients to offer anything of value to the government.

HK September 2002

Tax Distortions Taxes are necessary to raise revenues for public goods. Taxes reduce ability of taxpayers to consume private goods. Taxes also have distortionary effects which may affect the quantity of goods produced and result in a loss of efficiency for economic allocation.

Capital and the Tax Wedge An increase in the tax wedge (the excess taxes paid on investing in capital equipment) increases the cost of capital and reduces optimal capital. The difference between the marginal product of capital and the cost of capital is the economic surplus value of the capital The value of the efficiency loss for the economy is specified by the triangle.

MPK Distortion K K** K*

Tax Distortions The size of tax distortions grows faster than the size of the tax rate. Intuition: Diminishing Marginal Returns. Small tax wedges eliminate only those investment projects which are slightly more profitable than the cost of capital. The larger the tax rate, the more valuable will be the projects that are eliminated. Simple models assume that distortions are proportional to the square of the tax wedge. Two implications “Laffer Curve” Tax Smoothing

MPK Original Distortion K K*** K** K*

Laffer Curve Revenue generated is not monotonically increasing in the tax rate. Mental experiment. Consider if tax rate on investing in physical capital were 0%. This would generate no revenues. Consider if the tax rate were 100%. No one would invest in capital and capital taxation would generate zero revenues. Cutting taxes a little would generate more revenue. Laffer Curve represents relationship between tax rates and total revenue. Most economists believe that all developed economies are on the left-hand side of the Laffer Curve.

Laffer Curve Revenues Tax Rate

Tax Smoothing Distortions increase rapidly in the size of the distortionary tax rate. This means that it is better to have a smooth tax rate over time. Example. Distortions are proportional to the square of tax wedge. Distortion = A∙tw2. Consider the government chooses tax wedges in two periods, periods zero and 1. Choice 1. tw0 = 0 and tw1 = .02. Average Distortion Choice 2. tw0 = 0 and tw1 = .02 Both choices produce the same average tax wedge, but the smooth tax wedge produces a lower average distortion (and more revenue).

Tax Policy Government should raise revenues from “inelastic” activities. These have low distortions since taxes have little effect on economic behavior. Consumption may be less elastic than investment suggesting it may be more efficient to impose a Government should distinguish between average tax rates and marginal tax rates. Marginal tax rates are taxes on marginal activity which affect activity. Poll taxes may not cause inefficiency. Problem: Most efficient types of taxes demand equal payments from rich and poor people. Is this fair?

Deficit and Debt Budget surplus is very simply the difference between government revenues and government expenditure. When a government spends more than it earns through revenue it runs a deficit. If expenditure is measured excluding interest payments then it is called a primary surplus. Including interest payments it is called the total surplus. Surpluses seem to be counter-cyclical as government tax revenues fall when the economy is in a slump. To adjust for business cycle variation in tax collection, macroeconomists construct a full-employment surplus, which is how large the surplus would be if output, income, and taxes were at trend levels.

Hong Kong Surplus and the Business Cycle

HK Budget Surplus

Most Economies Have Positive Government Debt.

Hong Kong Has Traditionally had negative Debt.

Deficits and Sustainable Debt A government may want to know what kind of deficit it would be possible to run and still maintain the same level of wealth or debt. What kind of debt level & deficit is sustainable for an economy over time? Define: Dt – Nominal Debt Level PYt – Nominal GDP Level (PG-PT)t: Nominal Deficit Di: Nominal Interest Rate gPY : Growth Rate of Nominal GDP Dt: Debt to GDP Ratio Pt : Deficit to GDP Ratio

Sustainable Debt Debt Accumulation Equation Divide by Output Solve for ratio of deficit to debt which keeps debt constant.

Example: What primary deficit in Hong Kong is consistent with stable wealth? At the end of 2001, Fiscal Reserves in Hong Kong were measured at HK$375,346 Million → d = -.293. Assume 3% Growth and 2% real interest rates, then . This would imply a sustainable deficit per GDP, p = -.0029. HK government must run a small deficit to maintain wealth per GDP level.

Implications d > 0 d < 0 i > gPY/ r > gY p < 0 p > 0 Sustainability of debt depends on the interest payments on outstanding deficits plus the level of growth. A government that has outstanding debt must run primary surplus if interest rate is high. A government that has outstanding wealth can run a primary deficit if the interest rate is high. d > 0 Government is a debtor d < 0 Government is a creditor i > gPY/ r > gY p < 0 Government must run Surplus p > 0 Government may run Deficit i < gPY/ r < gY Government may run Sustainable Deficit

Deficits and National Savings National Savings are the combination of private savings (which is the sum of household savings and retained earnings by the corporate sector) and public savings (which is the negative of the primary deficit). The effect of a deficit on national savings depends on whether there is any offsetting effect on private savings.

What impact will an increase in the budget deficit have on national savings? Keynesian View Consumer spending is largely driven by current income (i.e. mpc is high). An increase in the deficit will result in little change in private savings. Deficits will reduce national savings. Ricardian View If consumers are forward looking they know that high deficits today will mean high taxes in the future. They will start saving today to help pay for future taxes. If perfectly forward looking, private savings will increase to offset deficits. Deficits will have no effect on national savings.

Deficits in Large Economies Keynesian View

Do Budget Deficits in Large Countries Lead to High Interest Rates Many economists find that it is difficult to find positive relationship between deficits and real interest rates. Not surprising since low productivity of capital might lead to low demand for funds, low interest rates, low output, high deficits. Conversely, high government profligacy might lead to high deficits and high interest rates. Exogenous shifts in debt in UK do not seem to be associated with changes in real interest rate. Recent research shows deficits in the US are associated with relatively high long-term real interest rates, though this remains controversial.

Change in Productivity S r** r** I S’

Small Open Economy In a small economy, the real interest rate is set by world financial markets, rw . Define Private Savings S = Y – C – T T ≡ Taxes Less Transfer Payments Define Government savings as T – G Investment can be financed through 3 sources Private savings (Y-C-T) Public Savings (T-G) Net Foreign Investment NFI

Open Economy r S NFI’ rW I NFI

Open Economy Savings Equation Goods Equation (Y-C-T)+(T-G)+ NFI = I NFI = Y – C – G - I Goods Equation Y = C + I + G + EX – IM NX ≡ EX – IM = Y – C – I – G Net Foreign Investment = - Net Exports

Conclusion Government has a role in the economy due to market failure. Government taxation creates distortions which reduce the efficiency of the economy. Distortions are increasing in the size of the tax wedge. Smooth taxation over time is most efficient dynamic path. Government should tax activities which are inelastic. Extremely large tax rates may have such negative impacts on output that increasing taxes reduce revenue. This is more theoretical than real. A debtor economy may be possible to have sustained deficits without increasing the debt-to-GDP ratio if the interest rate is low. May be possible to have deficits and maintain a wealth-to-GDP ratio if interest rates are high.

Conclusion Pt. 2 Effect of deficits on national savings depends on counter-response of private savings. Keynesian View: An increase in deficits has no effect on private savings. Ricardian View: An increase in deficits is completely offset by private savings. Most economists believe the truth lies somewhere in between. Reduction in national savings increases real interest rates and reduces investment in a large economy. Reduction in national savings increases trade deficit in a small economy.