MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

1
MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition

• Fiscal Policy and the Role of Government

2
Key Concepts

• Debt and deficits
• Fiscal Finance
• Debt versus taxes
• Intergenerational equity
• Debt sustainability and the primary surplus

3
Government Spending

• Types
• Consumption of goods and services
• Investment
• Transfer payments
• Considerable variation in spending

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

5
Government Spending of GDP, 2002
Source OECD online database
6
Looming Issues
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
  sectorlack of incentive
• Redistribution
• Paternalistic view
• People will not always act in own best interest
• Subsidize education, force savings (retirement)
• Social Welfare
• Stabilization Policy (later)

8
Public Goods

• Goods produced in the market have two
  characteristics rivalry excludability
• rivalry ones use of good makes it unavailable
  for others (e.g. if I eat the snickers candy bar,
  you cant)
• excludability those unwilling to pay do not have
  access to benefits of product (e.g. if you dont
  pay for the snickers candy bar, you cant 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

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 firms 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
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 Revenue
0
100
Tax Rate
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

12
Deficit
Debt
Debt
13
Debt
Debt
Surplus
14
Debt as a percentage of GDP, 2002
Source OECD Economic Outlook
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

16
Generational Accounts
Present value of net tax payments (until death)
by different generations indexed by age in 1995
(Thousands ).
17
Recall Saving-Investment Model
Private Savings
Interest Rate
5
Investment
I0
Output
18
Deficit Negative Savings
Private Savings Government Savings
Private Savings
Deficit
Interest Rate
6
5
Investment
I1
S1
I0
Output
19
Dynamic ResponseSuppose savings increases with
the deficit
Private Savings Government Savings
Private Savings
Interest Rate
6
5
Investment
I1
I0 S1
I0 I1
S1
Output
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

21
Sustainability of Debt

• r real interest rate
• g real growth rate of GDP

• If r g, must have primary surplus
• If r

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(1R)
Hence, taxes are higher in 2006
T(2006) - G(2006) D(2005)x(1R)
Year 2005 G(2005) T(2005) T(2006)-G(2006)/(1
R)
23
Spending in year 2005 must be supported by
current and future taxes.

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

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

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