Download MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

MACROECONOMICS
AND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition
Fiscal Policy and the Role of Government
1
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
0
Spain
Sweden
United Kingdom
United States
Euro area
Total OECD
Netherlands
New Zealand
Norway
Poland
Portugal
Slovak Republic
Ireland
Italy
Japan
Korea
Luxembourg
Finland
France
Germany
Greece
Hungary
Iceland
Australia
Austria
Belgium
Canada
Czech Republic
Denmark
10-5
Government Spending
% of GDP, 2002
70
60
50
40
30
20
10
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
Tax Revenue
 Eventually, tax collections will fall
0%
100%
Tax Rate
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
Debt
10-13
Debt
Debt
Surplus
0
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japanb
Korea
Luxembourg
Netherlands
New Zealand
Norway
Poland
Portugal
Slovak Republic
Spain
Sweden
United Kingdom
United States
Euro area
Total OECD
10-14
Debt as a percentage of GDP, 2002
160
140
120
100
80
60
40
20
Source: OECD Economic Outlook
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
Generational Accounts
Present value of net tax payments (until death) by different generations
indexed by age in 1995 (Thousands $).
10-17
Interest Rate
Recall Saving-Investment Model
Private Savings
5%
Investment
I0
Output
10-18
Deficit = Negative Savings
Interest Rate
Private Savings + Government Savings
Private Savings
Deficit
6%
5%
Investment
I1
I0
S1
Output
Dynamic Response
Suppose savings increases with the deficit
Private
Savings +
Government
Savings
Interest Rate
10-19
Private Savings
6%
5%
Investment
I1
I0 = IS11
S1
Output
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
 Debt 
 Debt  Pr imary Deficit

  ( r  g )

GDP
 GDP 
 GDP 
r = real interest rate
g = real growth rate of GDP
 Debt  Pr imary Surplus
( r  g )

GDP
 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