Download The Role of Governemnt, Fiscal Policy

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
Community Affairs
3%
Support
11%
District and
Community
Relations
1%
Recreation, Culture
and Amenities
3%
Economic
8%
Social Welfare
10%
Others
1%
Education
17%
Internal Security
7%
Immigration
1%
Environment
2%
Infrastructure
9%
Housing
15%
Health
12%
30
%
Government Expenditure (%GDP) 2000
60
50
40
20
10
US
UK
Sweden
Spain
Portugal
Poland
Norway
New Zealand
Netherlands
Luxembourg
Korea
Japan
Italy
Ireland
Iceland
Hong Kong
Greece
Germany
France
Finland
Denmark
Czech Rep
Canada
Belgium
Austria
Australia
0
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
Funds
16%
Direct Tax
35%
Investment Income
15%
Fees and Charges
5%
Miscellaneous
11%
Indirect Tax
18%
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
Categories of Government Expenditure
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Government Consumption
Transfer Payments
% of Expenditure
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


r    g p  tw p K
K
r    g  p
pK
Distortion
K
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
1.
2.
“Laffer Curve”
Tax Smoothing
MPK
r    g

Original
Distortion
K**

K

K*

 2tw p K
r    g p  tw p K
r   g p
K
K***
pK
K
p
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.Atw0  Atw1  A 02  .022   A .0004
 2
2
2
Average Distortion
Choice 2. tw0 = 0 and tw1 = .02Atw2  Atw2 A
A
2
2
0
1



.01

.01

Average Distortion
 2 .0002
2
2
2
2
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
.08
.06
.04
%
.02
.00
-.02
-.04
-.06
-.08
1985
1990
Surplus (as % of GDP)
1995
2000
Detrended GDP
HK Budget Surplus
120000
Millions HK$
80000
40000
0
-40000
-80000
1985
1990
1995
Government Surplus
2000
Turkey
Thailand
Singapore
Poland
Peru
Mongolia
Israel
India
Cote d'Ivoire
Chile
Botswana
Belarus
Albania
180
160
140
120
100
80
60
40
20
0
%
Most Economies Have Positive
Government Debt.
Debt/GDP
Hong Kong Has Traditionally had negative Debt.
.36
.32
% of GDP
.28
.24
.20
.16
.12
.08
1985
1990
1995
Government Wealth
2000
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
Dt  (1  i) Dt 1  ( PG  PT )t
Dt
D
( PG  PT )t
 (1  i ) t 1 
PYt
PYt
PYt

(1  i ) Dt 1 ( PG  PT )t

PY
1  g PYt 1
PYt
dt 

Solve for ratio of
deficit to debt which
keeps debt constant.
(1  i )
dt 1  pt
PY
1 g

(1  i)
(1  i)
d
d  p  1 
PY
PY
1 g
1

g


d  p

p 
(1  i)   (1  r ) 
  1 
 1 
PY 
d  1  g   1  g Y 
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
1 r
1.02
1


1

rates, then 1  g 1.03  .01 . This would imply a
sustainable deficit per GDP, p = -.0029. HK
government must run a small deficit to
maintain wealth per GDP level.
Implications

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
d<0
Government
is a debtor
Government
is a creditor
i > gPY/ p < 0
p>0
Government
Government
Y
r>g
must run
may run
Surplus
Deficit
i < gPY/ p > 0
p<0
Government
Government
Y
r<g
must run
may run
Sustainable
Deficit
Surplus
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
r
S
r**
r*
S’
I
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
r
S
r**
r**
S’
I
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
1.
2.
3.
Private savings (Y-C-T)
Public Savings (T-G)
Net Foreign Investment NFI
Open Economy
r
S
NFI’
rW
NFI
I
Open Economy

Savings Equation



Goods Equation



(Y-C-T)+(T-G)+ NFI = I
NFI = Y – C – G - I
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 wealthto-GDP ratio if interest rates are high.
Conclusion Pt. 2

Effect of deficits on national savings depends on counterresponse 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.