1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Fiscal Policy and the Role of Government 2 nd 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

10-5 Government Spending % of GDP, 2002 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 Revenue Tax Rate 0%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 Deficit Debt

10-13 Surplus Debt

10-14 Source: OECD Economic Outlook 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 Model Interest Rate Output I0I0 5% Private Savings Investment

10-18 Deficit = Negative Savings Output I0I0 5% 6% I1I1 Private Savings Investment Private Savings + Government Savings S1S1 Interest Rate Deficit

10-19 Dynamic Response Suppose savings increases with the deficit Output I 0 = S 1 5% 6% I1I1 Private Savings Investment Private Savings + Government Savings Interest Rate I 0 = I 1 S1S1

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