Lectures in Macroeconomics- Charles W. Upton Fiscal Policy-Part 2.
1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Fiscal Policy and the Role of Government 2 nd...
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Transcript of 1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Fiscal Policy and the Role of Government 2 nd...
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MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT
Fiscal Policy and the Role of Government
2nd 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
10-5Government Spending% of GDP, 2002
0
10
20
30
40
50
60
70A
ustr
alia
Austr
ia
Belg
ium
Canada
Czech R
epublic
Denm
ark
Fin
land
Fra
nce
Germ
any
Gre
ece
Hungary
Icela
nd
Irela
nd
Italy
Japan
Kore
a
Luxem
bourg
Neth
erlands
New
Zeala
nd
Norw
ay
Pola
nd
Port
ugal
Slo
vak R
epublic
Spain
Sw
eden
United K
ingdom
United S
tate
s
Euro
are
a
Tota
l O
EC
D
Source: OECD online database
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
Rev
enue
Tax Rate0% 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
10-14
Source: OECD Economic Outlook
0
20
40
60
80
100
120
140
160A
ust
ralia
A
ust
ria
Be
lgiu
m
Ca
na
da
De
nm
ark
F
inla
nd
Fra
nce
Ge
rma
ny
Gre
ece
Ice
lan
dIr
ela
nd
Italy
Jap
an
bK
ore
aL
uxe
mb
ou
rgN
eth
erl
an
ds
Ne
w Z
ea
lan
dN
orw
ay
Po
lan
dP
ort
ug
al
Slo
vak
Re
pu
blic
Sp
ain
S
we
de
nU
nite
d K
ing
do
mU
nite
d S
tate
s E
uro
are
aT
ota
l OE
CD
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
10-18
Deficit = Negative Savings
OutputI0
5%
6%
I1
Private Savings
Investment
Private Savings + Government Savings
S1
Inte
rest
Rat
e
Deficit
10-19
Dynamic ResponseSuppose savings increases with the deficit
OutputI0 = S1
5%
6%
I1
Private Savings
Investment
Private Savings + Government Savings
Inte
rest
Rat
e
I0 = I1 S1
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
GDP
Deficitimary
GDP
Debtgr
GDP
Debt Pr)(
GDP
Surplusimary
GDP
Debtgr
Pr)(
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 2006Suppose debt is paid off in Year 2006
Year 2006: T(2006) = G(2006) + D(2005)x(1+R)
Hence, taxes are higher in 2006Hence, 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)
10-24
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