Fiscal Policy: A Summing Up

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Fiscal Policy A Summing Up
A Summary

• Short Run Budget deficits increase AD Y
• Medium Run Y returns to YN i? I?
• Long Run Lower I ? lower K ? lower Y

The Chapter Ahead

• The governments budget constraints
• Do deficits matter?
• Canadian budget issues

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Fiscal Policy A Summing Up
The Government Budget Constraint
Defining the Budget Deficit

• Deficit rBt-1 Gt - Tt
• All variables in real terms
• Bt-1 Government at end of year t-1
• r Real interest rate (constant)
• rBt-1 Real interest payments on existing
  governmental debt
• Gt Government spending on goods and services
  during year t
• Tt Taxes minus transfers during year t

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Fiscal Policy A Summing Up
The Government Budget Constraint
Defining the Budget Deficit

• Deficit rBt-1 Gt - Tt
• Two characteristics
• Inflation-adjusted deficit
• G does not include transfers
• The government budget constraint The change in
  government debt in year t is equal to the deficit
  in year t or...

Bt - Bt-1 deficitt Bt-Bt-1 rBt-1Gt-Tt
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Fiscal Policy A Summing Up
The Government Budget Constraint
Defining the Budget Deficit
Bt - Bt-1 rBt-1 Gt-Tt
OR
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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
A Scenario In Year 1

• The governments debt is equal to zero
• The government decreases taxes by 1 for one year
• Thus, the debt, B1, equals 1
• The impact on debt and taxes
• Full Repayment in Year 2

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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
Budget Constraint

• B2 (1r)B1 (G2-T2)
• B2 0 and B1 1
• T2-G2 (1r)
• To repay debt in year 2, the government must run
  a primary surplus equal to (1r) or T2? by (1r)

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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
Full Repayment in Year t
Year 2 Primary deficit is zero Year 2 debt
B2(1r)B101r Year 3 debt B3(1r)B20(1r)(
1r)(1r)2 Year t debt Bt-1(1r)t-2 Year t
Budget Constraint Bt(1r)Bt-1(Gt-Tt)
Bt0 Bt-1(2r)t-2 0(1r)(1r)t-2(Gt-Tt)
Tt-Gt (1r)t-1
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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
Observation
A decrease in taxes must be offset by an increase
in taxes in the future. The longer the
government waits orthe higher the real interest,
the higher the eventualincrease in taxes.
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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
Debt and Primary Surplus
Stabilizing the Debt (Year 2)
Budget Constraint
B2(1r)B1(G2-T2)
B2 B1 1
1 (1r)(G2-T2)
T2-G2 (1r) - 1 r
To stabilize the debt Primary surplus real
interest on existingdebt.
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Fiscal Policy A Summing Up
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Fiscal Policy A Summing Up
The Government Budget Constraint
Current vs. Future Taxes
Debt and Primary Surpluses
Observation
The legacy of past deficits is higher debt.To
stabilize the debt, the government must runa
primary surplus equal to the interest paymentson
existing debt.
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Fiscal Policy A Summing Up
The Government Budget Constraint
The Evolution of the Debt-to-GDP Ratio
And
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Fiscal Policy A Summing Up
The Government Budget Constraint
The Evolution of the Debt-to-GDP Ratio (Continued)
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Fiscal Policy A Summing Up
The Government Budget Constraint
The Evolution of the Debt-to-GDP Ratio
Observation
The change in the debt ratio is equal to the sum
oftwo terms. The first is the difference between
thereal interest rate and the growth rate times
theinitial debt ratio. The second is the ratio
of theprimary deficit to GDP.
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Fiscal Policy A Summing Up
The Government Budget Constraint
The Evolution of the Debt Ratio
The equation implies the debt ratio will be
larger

• the higher the real interest rate
• the lower the growth rate of output
• the higher the initial debt ratio
• the higher the ratio of the primary deficit to
  GDP.

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Fiscal Policy A Summing Up
The Government Budget Constraint
The Evolution of the Debt Ratio in the OECD

• 1960s - high growth, (r-g) was negative and debt
  ratios fell without running large primary
  surpluses
• 1970s - lower growth and low to negative r, (r-g)
  was negative. Further decrease in the debt ratio
• 1980s - lower growth and high r and debt ratios
  increased rapidly
• 1990s - low growth and high r. To stabilize debt
  ratios, countries are running primary surpluses

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Fiscal Policy A Summing Up
The Government Budget Constraint
The Evolution of the Debt to GDP Ratio
Debt and Primary Surpluses, Selected Countries,
1985-2001(of GDP)
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Fiscal Policy A Summing Up
Four Issues in Fiscal Policy
Ricardian Equivalence

• The position--
• Neither deficits nor debt has an effect on
  economic activity!
• The logic--
• Given the budget constraint, a decrease in public
  saving (deficit) is offset by an equal increase
  in private saving
• Counterpoint
• Consumers may ignore the possibility of a future
  tax increase. If so, deficits will in the--
• Short Run stimulate economic activity
• Long Run reduce capital accumulation and growth

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Fiscal Policy A Summing Up
Deficits, Output, Stabilization, and the
Cyclically Adjusted Deficit

• The Cyclically Adjusted Deficit
• Adjusting the deficit to the natural level of
  output
• Interpretation
• If the actual deficit is larger but the
  cyclically adjusted deficit is zero, there will
  not be a systematic increase in debt over time
• Calculating the Cyclically Adjusted Deficit
• Step 1 Calculating the relationship between
  output and the deficit
• 1 decrease in output will automatically increase
  the deficit of 0.5 of GDP
• Step 2 Calculate the natural level of
  unemployment and output
• If un is underestimated, the cyclically adjusted
  deficit will be too optimal

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Fiscal Policy A Summing Up
Four Issues in Fiscal Policy
Deficits, Output, Stabilization, and the
Cyclically Adjusted Deficit
Actual and Cyclically Adjusted Deficits in
Canada, 1970-2000
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Fiscal Policy A Summing Up
Wars and Deficits

• Benefits of Deficit Financing
• Passing on the Burden of War
• Two ways to finance a war--
• Deficit r ? ? ? I
• Future generations bear some of the burden of
  financing the war
• Taxes ? T ? ?C and the change in r and I will be
  less
• Current generation bears a greater share of the
  burden of financing the war
• Financing the war with tax collections requires
  very high taxes which distort economic decisions
• Deficit financing maintains relatively constant
  tax rates (tax smoothing) over time and less
  distortions

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Fiscal Policy A Summing Up
The Dangers of Very High Debt

• Lower capital accumulation
• Higher tax rates and distortions
• Vicious circles reducing the effectiveness of
  fiscal policy

Vicious Circles...
The Setting
Assume Debt ratio 100 r 3 g 2 Gt-Tt
1
Then (3 - 2) x 100 1 of GDP
And 1 (-1) 0 The debt ratio will
remain constant
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Fiscal Policy A Summing Up
The Dangers of Very High Debt

• Assume investors require higher interest rates
  to hold government bonds and r increases from
  3 to 6

Then (r-g) 6 - 2 4 an increase from 1

• And primary surplus must increase from 1 to 4
  of GDP to keep debt-to-GDP ratio
  constant
• Maintaining the debt-to-GDP ratio
• ?T ?G? ?AD ?? Y
• Recession ?(r-g) making it harder to maintain the
  debt ratio
• The primary surplus does not increase and the
  debt ratio worsens
• and the risk of a catastrophic debt crisis
  increases
• CONCLUSION The higher the ratio of debt to GDP,
  the larger the potential for catastrophic debt
  dynamics.

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Fiscal Policy A Summing Up
The Twin Deficits
What do you think Is debt repudiation a good
alternative to the long fiscal austerity required
to reduce a high debt ratio?
Private sector saving
Primary Investment surplus
Current Account surplus

• If government runs a primary deficit and the
  private sector does not increase its saving by
  the same amount, the sum of new investment and
  the current account surplus must fall (likely
  both)
• In a very open economy like Canada, it is likely
  that a government deficit will lead to a current
  account deficit.

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Fiscal Policy A Summing Up
The Twin Deficits
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Fiscal Policy A Summing Up
A Decade of Canadian Fiscal Policy, 1993-2002,
the Twin Deficits

• The proportion of GDP in Canada devoted to paying
  interest on the national debt increase from 2 in
  1970 to 5.3 in 1993
• Finance Minister Paul Martin engineered from 1994
  to 1998 a series of federal budgets that
  significantly reduced the federal deficit and
  moved to a substantial surplus.
• In 1994 transfers to the provinces were reduced.
• The 1995 budget was the turning point. Federal
  spending reduced and taxes raised.
• By 1997 there was a budget surplus and debt to
  GDP ratio significantly reduced.