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Download Lecture 1.Principles of Public Debt
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Lecture outline Crowding out effect Closed and open economies Ricardian equivalence revisited Debt burden and dead weight loss Fiscal Crowding out effect The effect of public debt depends on time frame: long run and short run For example, let us assume that the government cut taxes by 5 percent and attracted the debt equal to the sum of lost tax revenue This move will cause 5 percent increase in current disposable income Fiscal Crowding out effect Tax cut also causes an increase in consumption: 𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒅𝒆𝒎𝒂𝒏𝒅 = 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 + 𝒈𝒐𝒗𝒆𝒓𝒏𝒎𝒆𝒏𝒕 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 +𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 + (𝒆𝒙𝒑𝒐𝒓𝒕𝒔 − 𝒊𝒎𝒑𝒐𝒓𝒕𝒔) In the short run economy is Keynesian Short run – period when companies observe actual prices to be greater than expected and therefore get motivation to supply more products. In the long run economy is classical. Prices are not sticky. Tax cut policy will cause the crowding out of private investment. For example: 𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 = 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + (𝒕𝒂𝒙𝒆𝒔 − 𝒕𝒓𝒂𝒏𝒔𝒇𝒆𝒓𝒔) Then 𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 = 𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒅𝒆𝒎𝒂𝒏𝒅 gives 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 + 𝒏𝒆𝒕 𝒆𝒙𝒑𝒐𝒓𝒕𝒔 where: 𝒏𝒆𝒕 𝒆𝒙𝒑𝒐𝒓𝒕𝒔 = 𝒆𝒙𝒑𝒐𝒓𝒕𝒔 − 𝒊𝒎𝒑𝒐𝒓𝒕𝒔 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒕𝒂𝒙𝒆𝒔 − 𝒈𝒐𝒗𝒆𝒓𝒏𝒎𝒆𝒏𝒕 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 − 𝒕𝒓𝒂𝒏𝒔𝒇𝒆𝒓𝒔 Since 𝑬𝒙𝒑𝒐𝒓𝒕𝒔 − 𝒊𝒎𝒑𝒐𝒓𝒕𝒔 = 𝒏𝒆𝒕 𝒆𝒙𝒑𝒐𝒓𝒕𝒔 = 𝒏𝒆𝒕 𝒇𝒐𝒓𝒆𝒊𝒈𝒏 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 We can rewrite 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 + 𝒏𝒆𝒕 𝒇𝒐𝒓𝒆𝒊𝒈𝒏 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 Level of public and private savings determines the level of domestic and net foreign investment Closed economy: 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 Cut in taxes causes public savings to decrease and private savings to increase But this increase in private savings will not compensate for the decrease in public savings. Therefore, domestic investment falls. Interest rate will increase because productivity of the capital increased due to the increase of output per capital. Open economy: 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 + 𝒏𝒆𝒕 𝒇𝒐𝒓𝒆𝒊𝒈𝒏 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 Cut in taxes causes public savings to decrease and private savings to increase Like in the closed economy, total of savings will decrease. So will total investment. This time there is net foreign investment since this is open economy. Fall in net foreign investment is explained by less properties abroad owned by citizens and more assets in the country owned by foreigners. In other words, foreign savings will be “imported” Fiscal crowding out in the liquidity model S- savings i -interest rate i1 i0 D + Public debt D- demand for money I1 I0 I- investment Implications of crowding out For example, in the US extra dollar of investment is associated with 9,5 percent growth in GNI. This means that if extra dollar of government bond sold crowds out one dollar of investment, then selling 1 dollar worth bond will cut GNI growth by 9,5 percent. Debt burden will be transferred the future generations because the decrease in investments will lower the future output and the level of income. Ricardian equivalence revisited Ricardo saw taxes and debt to be the same in their impact on economy. This is because people know that to finance the tax cut the government will attract debt. They also assume that this debt will be paid by increased taxes in the future. Since people are rational and expect taxes to increase in the future they will save extra disposable income due to tax cut. In the end, according to Ricardo, taxes will be equal to debt. Budget constraints Budget constraints can be divided into two categories: Hard budget constraint (e.g. market economy) Soft budget constraint (e.g. planned economy) Permanent income hypothesis People base their decisions on permanents income, not current one. If current income is below permanent income, people cover their income by attracting deficit. If current income is above permanent income, people use surplus to buy government bonds Debt and bonds are means of smoothing consumption over time Milton Friedman’s permanent income hypothesis Permanent income is the average of past incomes. Form example, assume that last four year annual income was equal to 1000,2000,3000 and 4000. Then permanent income (1000+2000+3000+4000)/4=2500 Current income= permanent income + variable income Expected variable income is equal to zero. Consumer expenditures= k* permanent income where k- marginal propensity to consume Tax cut does not affect permanent income Assume that the government cuts taxes by 1000 dollar and finances budget deficit by 1000 dollar worth government bond with 10 percent interest. Therefore, every year government should pay 100 dollar interest payments out of taxes. Consumers do not use 1000 dollar for consumption. Instead, they save and get 100 dollar interest payments annually. If the government collects extra 100 dollar taxes to cover this interest rate payment, consumers pay for tax by interest income. In the end, tax cut policy of the government does not change their permanent income and consumption. Ricardian equivalence S- savings i -interest rate i0 D + Public debt D- demand for money I0 I1 I- investment Barro’s view of Ricardian equivalence Robert Barro in his “Are Government Bonds Net Wealth?” (Journal of Political Economy, 1974) claims that by cutting taxes in Ricardian equivalence the government simply reallocated taxes in time He pointed to generational altruism, which means that even if taxes are increased in future generation, the current generation still saves tax cut funds so that not to leave any burden to the future generation. In this context, the generations form immortal family Barro’s view of Ricardian equivalence Therefore, in Ricardian equivalence private investment increases to the amount of tax cut (i.e. decrease in public savings) and domestic investment does not change. 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 In sum, this reaction of private sector to tax cut makes the government efforts to stimulate economy through tax cut or expenditures ineffective. The government does not have reason to attract debt or even pay back debt since debt is not an issue. Barro’s view of Ricardian equivalence However, if households believe that tax cut is not financed by the bond issue, but through decreasing expenditures then 𝑷𝒖𝒃𝒍𝒊𝒄 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 + 𝒑𝒓𝒊𝒗𝒂𝒕𝒆 𝒔𝒂𝒗𝒊𝒏𝒈𝒔 = 𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 In sum, expectations of cut in expenditures lead to lower savings, increased private consumption and lower domestic investment Problems with Ricardian equivalence Households are not rational Pressing issues such as mortgage and other liabilities Burden to the future generations is difficult to measure Current generation might not be altruistic! Nevertheless, Ricardian equivalence is still useful in interpretation of the consequences of public debt Distortionary effect of taxation Taxes decrease incentive to invest, production, labor and consumption. High rates of taxation lead to tax evasion practices 98 percent taxes have distortionary effect and cause tax burden Alan Auerbach and James Hines in their “Taxation and Economic Efficiency,” (NBER Working paper 8181, March 2001) point that taxes decrease economic effectiveness know as dead weight loss or excessive tax burden. Ricardian equivalence p -price S- supply Consumer surplus p0 Producer surplus D- demand Q0 Q- quantity Ricardian equivalence S- supply p -price Fair tax burden Dead weight loss p1 p0 Producer surplus D- demand Q1 Q0 Q- quantity Dead weight loss in economies In the US, the dead weight loss is about 20 cents per dollar of government expenditures, in Canada- 30-50 cents (Ballard, Charles, John Shoven and John Walley, “The Total Welfare Cost of the United States Tax System: A General Equilibrium Approach,” National Tax Journal, June 1985) Moreover, if tax rate is doubled, the dead weight loss will quadruple. This is called the “rule of square” Rule of square S- supply p -price Fair tax burden Dead weight loss p1 p0 Producer surplus D- demand Q2 Q1 Q0 Q- quantity Summary of debt burden Debt is burden for economy in the form of deadweight loss Public debt differs from private debt by dead weight loss Internal and external public debts have the same dead weight loss. However, in the case of external debt national wealth decreases. Thank you for your attention!
