1. Chapter 15 Government Spending and Its Financing Copyright © 2009 Pearson Education Canada

2. 15-2 The Government Budget: Facts and Figures The main aspects of the budget: expenditure; tax revenues, or receipts; the budget deficit or surplus.

3. Copyright © 2009 Pearson Education Canada15-3 Defining the Government Sector The government sector in Canada: the federal government; provincial and territorial governments; local governments; the Canada and Quebec Pension Plans.

4. Copyright © 2009 Pearson Education Canada15-4 Defining the Government Sector (continued) These definitions exclude “government business enterprises”, e.g. the Bank of Canada or publicly-owned utilities

5. Copyright © 2009 Pearson Education Canada15-5 Government Expenditure Government expenditure, the total spending by the government during a period of time, include: government purchases; transfer payments; interest payments.

7. Copyright © 2009 Pearson Education Canada15-7 Revenue The main components of revenue are: direct taxes; indirect taxes; investment income. Direct taxes is the largest category of tax receipt.

9. Copyright © 2009 Pearson Education Canada15-9 The Composition of Revenue and Expenditure About 80% of government spending on goods and services in Canada is done by provincial and local governments. An important component of federal spending is interest payments.

11. Copyright © 2009 Pearson Education Canada15-11 Revenue and Expenditure (continued) The federal government spends a larger share of its budget on transfers to individuals than provincial governments. 24% of federal government spending is a transfer to provincial and local governments, making up 14% of their revenue.

12. Copyright © 2009 Pearson Education Canada15-12 Revenue and Expenditure (continued) About 57% of federal government revenue comes from personal taxes. About 36% of provincial and local revenue comes from indirect taxes.

14. Copyright © 2009 Pearson Education Canada15-14 Surpluses or Deficits TR is transfers INT is net interest payment

17. Copyright © 2009 Pearson Education Canada15-17 Spending, Taxes, and the Macroeconomy Three ways by which government spending and taxing decisions influence macroeconomic variables: aggregate demand; government capital formation; incentives.

18. Copyright © 2009 Pearson Education Canada15-18 Fiscal Policy and Aggregate Demand Fiscal policy can affect economic activity by influencing the aggregate demand. In either the classical or Keynesian view, an increase in government purchases reduces desired national saving and raises aggregate demand.

19. Copyright © 2009 Pearson Education Canada15-19 Fiscal Policy and Aggregate Demand (continued) In the classical view lump-sum taxation does not affect desired national saving (Ricardian equivalence) and has no impact on aggregate demand.

20. Copyright © 2009 Pearson Education Canada15-20 Fiscal Policy and Aggregate Demand (continued) Classical economists generally reject attempts to smooth business cycles. Keynesians generally argue that using fiscal policy to stabilize the economy is potentially desirable.

21. Copyright © 2009 Pearson Education Canada15-21 Fiscal Policy and Aggregate Demand (continued) In the Keynesian view a tax cut reduces desired national saving and raises aggregate demand. Keynesians admit though that to use fiscal policy to smooth business cycles is difficult.

22. Copyright © 2009 Pearson Education Canada15-22 Automatic Stabilizers Automatic stabilizers are provisions in the budget that cause government spending or tax revenues to change automatically.

23. Copyright © 2009 Pearson Education Canada15-23 Automatic Stabilizers (continued) An important automatic stabilizer is the income tax system. A side effect is that budget surpluses drop in recessions.

24. Copyright © 2009 Pearson Education Canada15-24 Automatic Stabilizers (continued) The full-employment surplus or deficit measures what the government surplus would be were the economy operating at its full- employment level. The full-employment surplus is also called the cyclically adjusted or structural surplus.

25. Copyright © 2009 Pearson Education Canada15-25 Government Capital Formation Government capital is long-lived physical assets owned by the government. Government investment in infrastructure, expenditure on health and education affect the rate of economic growth.

26. Copyright © 2009 Pearson Education Canada15-26 Government Capital Formation (continued) Capital spending is not included as a part of government spending. The measure in the national accounts is called “saving”

27. Copyright © 2009 Pearson Education Canada15-27 Government Capital Formation (continued) The measure of government spending including investment is:

28. Copyright © 2009 Pearson Education Canada15-28 Government Capital Formation (continued) Public investment (I govt ) usually exceeds depreciation (dK govt ), so net lending is less than saving (S govt ).

29. Copyright © 2009 Pearson Education Canada15-29 Incentive Effects of Fiscal Policy: Tax Rates The average tax rate is the total amount of taxes paid by a person, divided by that person’s before tax income. The marginal tax rate is the fraction of an additional dollar of income that must be paid in taxes.

30. Copyright © 2009 Pearson Education Canada15-30 Tax Rates (continued) An increase in the average tax rate, the marginal tax rate held constant, will increase the amount of labour supplied. An increase in the marginal tax rate, the average tax rate held constant, will decrease the amount of labour supplied.

31. Copyright © 2009 Pearson Education Canada15-31 Tax Rates (continued) High marginal tax rates combined with low average tax rates should act to discourage labour supply. The situation is known as the poverty trap.

32. Copyright © 2009 Pearson Education Canada15-32 Tax-Induced Distortions and Tax Rate Smoothing Tax-induces deviations from efficient, free-market outcome are called distortions. A policy of maintaining stable tax rates so as to minimize distortions is called tax rate smoothing. Financing the war through borrowing is tax smoothing.

33. Copyright © 2009 Pearson Education Canada15-33 Government Deficits and Debt: the Growth of Debt The government budget deficit is the difference between expenditures and tax revenues in any fiscal year. The government debt is the total value of government bonds outstanding at any particular moment of time.

34. Copyright © 2009 Pearson Education Canada15-34 The Growth of Debt (continued) Nominal government budget deficit ( Δ B) is the change in the nominal value of government bonds outstanding. We are referring to government net debt – the value of all government financial liabilities less the value of all financial assets.

35. Copyright © 2009 Pearson Education Canada15-35 The Growth of Debt (continued) The debt-GDP ratio – the quantity of government debt outstanding divided by the GDP.

37. Copyright © 2009 Pearson Education Canada15-37 The Growth of Debt (continued) The change in the debt-GDP ratio is: i is the nominal interest rate paid on government bonds g is the growth rate of GDP

38. Copyright © 2009 Pearson Education Canada15-38 The Growth of Debt (continued) The debt-GDP ration can change from a year to the next because of: a primary deficit; an interest rate on outstanding government debt can exceed the growth rate of GDP.

39. Copyright © 2009 Pearson Education Canada15-39 The Growth of Debt (continued) The combination of slow economic growth and a high interest payable on government debt can have serious consequences for debt accumulation.

40. Copyright © 2009 Pearson Education Canada15-40 The Government Debt and Future Generations There is a view that high rates of government borrowing amount to “robbing the future” to pay for government spending that is too high or taxes that are too low in the present.

41. Copyright © 2009 Pearson Education Canada15-41 The Government Debt (continued) Most Canadian government bonds are owned by Canadian citizens, so it is not as large a burden as is the case when it is owed entirely to outsiders.

42. Copyright © 2009 Pearson Education Canada15-42 The Government Debt (continued) The government debt can be come a burden if: tax rate have to be raised substantially in the future to pay off debts;

43. Copyright © 2009 Pearson Education Canada15-43 The Government Debt (continued) The government debt can become a burden if: most people hold small amount of bonds; government deficits reduce national saving.

44. Copyright © 2009 Pearson Education Canada15-44 Budget Deficit and National Saving All economists agree that an increase in the government deficit caused by a rise in government purchase reduces national saving. Whether a deficit caused by a cut in current taxes or an increase in current transfers reduces national saving is much less clear.

45. Copyright © 2009 Pearson Education Canada15-45 Budget Deficit and National Saving (continued) S=Y-C-G Advocates of Ricardian equivalence assert if G is unchanged a tax cut will not affect C and S. The government will have to borrow and people will save in govt bonds.

46. Copyright © 2009 Pearson Education Canada15-46 Ricardian Equivalence Across Generations In theory, Ricardian equivalence may still apply even if the current generation receives the tax cut and the future generations bear the burden of repaying the government debt.

47. Copyright © 2009 Pearson Education Canada15-47 Ricardian Equivalence (continued) People care about future generations and leave bequests or, say, pay university tuition fees for children.

48. Copyright © 2009 Pearson Education Canada15-48 Departures from Ricardian Equivalence The main arguments against Ricardian equivalence are: existence of borrowing constraints; consumer’s shortsightedness; the failure of some people to leave bequests; the non-lump-sum nature of most tax charges.

49. Copyright © 2009 Pearson Education Canada15-49 The Deficit and the Money Supply A deficit owing to increased government purchases reduces desired national saving, shifting the IS curve upward and causing aggregate demand to rise.

50. Copyright © 2009 Pearson Education Canada15-50 The Deficit and the Money Supply (continued) Keynesians believe that tax cuts will also lead to increases in aggregate demand and the price level.

51. Copyright © 2009 Pearson Education Canada15-51 The Deficit and the Money Supply (continued) High rates of inflation are linked to high rates of national money growth. A government could print money to finance its spending if it cannot do so by taxes or borrowing from public.

52. Copyright © 2009 Pearson Education Canada15-52 The Deficit and the Money Supply (continued) The revenue that a government raises by printing money is called seignorage. The money is created by the central bank buying out newly issued bonds from the government.

53. Copyright © 2009 Pearson Education Canada15-53 The Deficit and the Money Supply (continued) ΔB p = government debt held by the public ΔB cb = government debt held by the central bank

54. Copyright © 2009 Pearson Education Canada15-54 The Deficit and the Money Supply (continued) The increase in M equals the money multiplier times the increase in the monetary base.

55. Copyright © 2009 Pearson Education Canada15-55 The Deficit and the Money Supply (continued) Heavy reliance on seignorage usually occurs in in war-torn or developing countries. It depends on the independence of the central bank whether the government bonds will be bought out by the central bank or not.

56. Copyright © 2009 Pearson Education Canada15-56 Real Seignorage Collection and Inflation Real seignorage revenue, R, is the real value of the newly created money:

59. Copyright © 2009 Pearson Education Canada15-59 Real Seignorage Collection and Inflation (continued) Seignorage is the inflation tax and is paid by anyone who holds money. There is some optimal rate of inflation that maximizes the real seignorage revenue.

60. Copyright © 2009 Pearson Education Canada15-60 Real Seignorage Collection and Inflation (continued) Whether real seignorage revenue increases when the money growth rate increases depends on whether the rise in inflation overweighs the decline in real money holdings M/P.

61. Copyright © 2009 Pearson Education Canada15-61 Real Seignorage Collection and Inflation (continued) If a government continues to increase the rate of money creation the economy will experience a high rate of inflation. The inflation will continue until the government reduces the rate of money creation.