Fiscal policy and government debt - Coursework Example

Fiscal Policy and Government Debt Fiscal policy is a part of economic policy of the government related to government income andexpenditure. It entails public expenditure policy, taxation policy, public debt policy and debt financing. The main aim of fiscal policy is to achieve particular objectives mainly rapid economic development (AUERBACH, 1997), bridging income inequalities and encouraging capital formation amongst other economic related goals. Interest on fiscal policy has always been evident; however, it seems to have assumed greater urgency following the recent financial crisis that has forced governments to come forward with expansionary fiscal policy measures in a bid to revive the affected sectors. Such interest though one dimensional highlights the critical role of fiscal policy (AUERBACH, 1997). This study looks at several aspects of fiscal policy, first it examines theory and empirical work on the effects of tax policy on economic activity, secondly, the study also implores on the main theoretical ideas and evidence on government debt sustainability, lastly, it looks at the main considerations that governments could/should take into consideration when determining the maturity of their debt structure. Much of the focus in this study will be given to countries such as the US considered as mature economies. A close look at the interest people take in these polices explains the fierce debates such as those heralding the 2001 and 2003 tax cuts. The debate is always founded on the likely effects resulting from the implementation of various tax policies. Some policy makers are of the view that such cuts would improve or even heighten normal input in the long run (Alesina and Roberto, 1997). Another school argues that tax cuts affects rates of interest negatively affect confidence, the effect of this would be reduced output both in the short run as well as in the long run. The variability of these views goes a long way into indicating that measuring or determining the effects of changes in tax policy are indeed very difficult. It should be noted that tax policy changes happen due to a variety of reasons. Some are passed for philosophical reasons or to cut on inherited budget deficits while others are instituted when an economy is performing dismally and is expected to suffer further. There are other tax policy changes that are not legislated, these occur automatically as an economy’s basal level of tax is variant and is a factor of income or because of varying stock prices, inflation as well as other non-policy forces. The complexity of understanding effects arising from a change in tax policy emanate from the fact that factors leading to tax changes are often separating these effects from effects arising from underlying actors is complex. There are definitely many empirical studies on the effects of tax policy changes on the economy. This study makes observations and conclusions largely based on Romer and Romer (2010) empirical review under their study. The formula utilized is represented below; Y represents the real output and ΔT measures tax changes. A second formula is introduced to help examine the effects of having several control variables, the variable introduced is lagged output growth. The argument as per the scholars is that by introducing lagged output growth as a variable helps control for the normal dynamics of output. Additionally, since most of the factors that affect growth are correlated, including lagged growth is an easy way to control for a variety of other elements (781). Another factor considered in the formula is control of past growth which provides for a critical test of hidden motivation. It is believed that even though policymakers may argue that changes in tax policy are not concerned with the current macroeconomic situation it is apparent that the democratic process brings about changes correlated with economic performance. An example of this argument is that individuals supporting tax cuts have a higher chance of being elected during weak economic times. Following this, it is safe to maybe argue that tax cuts are common during times of low output, therefore, what may look like tax cuts maybe in someway motivated by the usual reversion of output to normal. Therefore, looking at the above representation, controlling for the state of the economy by including lags of output growth addresses this possibility (781). Through empirical tests, guided by the above representations, Romer and Romer (2010) conclude that irrespective of the given legislation, significant changes in an economy’s tax policy brings about a dominant motivation that fits into the following categories making up for increases in government expenditure, addressing an inherited government deficit and spurring long-term growth (799). Further, the findings illustrate that tax changes largely influence output. The baseline specification implies that one percent of GDP will lower real GDP by almost three percent. Additionally, changes in taxation are very much related on future changes, further, investments decline significantly following exogenous tax increases (Alesina and Roberto, 1997). Lastly, the study concluded that tax increases to reduce an inherited budget deficit do not have the large output costs associated with other exogenous tax increases. The observation, which point to the fact that improved welfare results from tax cuts is largely a position confounded by the New Keynesian multipliers which indicates that a tax cut should increase welfare mainly because it frees up private resources for spending. This thought is only countered by the initial Keynesian multipliers which have since been replaced by the more contemporary thought (Tsoukis, 2010). Therefore, it seems safe to base thoughts of tax policy changes on the view represented in this study. The main argument in this regard is that higher taxation acts as a disincentive to individuals and firms to work and invest. Government debt sustainability Government debt is effectively the amount of outstanding credit that government has drawn over the years from the private sector (Tsoukis, 2010). The private sector lends to the government on the premise that the debt will be properly serviced, where properly alludes to time and amount. In this case, the private sector hopes that the government will pay interest on the outstanding amount and that the entire debt value will seize to exist on a certain future date. Government debt is represented by such items as government bonds which vary on maturity which is the time between issuance and eventual payment. At the centre of government fiscal policy is government budget constraint which basically means that every government faces a challenge in meeting its budgetary items. It represents a significant dilemma in every government or players in the public sector in the conduct of respective fiscal policies and most critically aggregate demand. It is a fact that every government would want to increase its spending, however, such an increase would need to be within a certain threshold and must be manageable (Horne, 1991). Managing spending involves thinking of how the government can raise the money to make up for increased spending. There are several options, these include, a change in tax policy which was discussed in the previous section, this would entail an increase in taxes, the other option would be printing more money which raises real concern due to the level of inflation and the last option is acquiring more debt. Each of these resources generating options has a host of effects both favorable and unfavorable on the overall status of the economy. However, this section focuses on government debt defined earlier. Raising more debt entails issuing and putting into circulation more government bonds this is considered a prudent way of meeting government expenditure but only if it is prudently done. The problem arises when a government continuously increases its debt (Tsoukis, 2010). This is a situation where for a single period the government seeks additional debt to meet its expenditure. The borrowed amount compounds the already existent debt. Subsequently this also means an increased amount of interests to be paid on the outstanding debt. Holding other factors constant, this will mean an enlarged deficit which again may require a larger debt issue in future this is even in a situation where spending falls back to its original levels. The overall implication is that debt will quickly sore by its own dynamic. It is at this point that two critical factors emerge the first is the limit of government’s ability to raise loans and debt from the private sector whereas the second factor regards the level of debt. The effects of debt cost are two fold, distributional and efficiency related. The distributional implications results from the fact that the people who receive interests from the debt and the individuals who pay taxes to finance the debt are not the same. Mostly, the individuals benefiting from the debt are often the wealthier and the older whereas the debt financiers are the younger persons. In the case where the majority of debt holders are foreigners then the interest paid up for the debt is wasted rather than being spent on public projects. Additionally, the bulk of the debt will be serviced by the future generation who will bear the burden yet they did not benefit from the corresponding services (Mendoza, Enrique and Ostry, 2008). The efficiency cost results from the fact that the debt eats into private investments as they both compete for the rather limited savings. Additionally, government debt allows the government to continue with the normal service level event in situations where the economy is slumping or is already in recession, these periods are characterized by a decline in the tax levels. It is at these times that greater need for government income surfaces as the government tries to spur the economy by expanding government demand. The other fundamental role of the debt is actualizing projects whose only benefit would be felt after a while such as investment in infrastructure, education and other projects classified as long-term. Due to the long-term nature of these projects, it is prudent that the repayment of the outstanding debt takes place gradually, meaning that it is inevitable having a debt at the moment (Mello, 2008). Under these situations, the government’s main role is balancing the benefits and uses of debt as well as the expenditure going into servicing the established level of debt. As long as the government is able to strike this balance without jeopardizing investment in public services and expenditure in long term projects with the arising need to meet the debt obligations then the government debt can be regarded as sustainable. In looking at sustainable government debt and the various definitions put across for the same, it is possible to conclude that any government’s borrowing strategy is considered neither efficient not sustainable if government is overspending and no additional value results from future generations which will have to cover cost of the present borrowing. The opposite, sustainable debt, is considered one where debt ration being stable or falling over time. In this regard, an increasing government debt denotes an unsustainable debt. Another measure of debt sustainability is public debt to GDP, according to IMF; a rising debt ratio is an indicator of not only an unsustainable debt but also of deeper weaknesses in fiscal systems such as weak revenue base, weak collection mechanisms and constant resort to tax amnesties (Mendoza, Enrique and Ostry, 2008). Under normal circumstances, the extent of government debt is based on the stability of a country’s economy and the ability of the government to manage a sustainable debt. Subsequently, these capabilities are subject to particular characteristics of a country such as economic policy and the size of the economy. One of the most referred to measures of debt sustainability is the level of gross or net government debt as a share of the country’s GDP. This measure is not full proof but represents one of the easily applicable measures (AUERBACH, 1997). According to most economists, a prudent measure of debt sustainability must look at or be based on minimization of debt, and managing government spending as well as constant control of budget and trade deficits. The following section represents one of the debt sustainability model advanced by the IMF. The underlying assumption is that nominal external debt increases because of financing of the budget. The model: Dt represents nominal external debt in period t, Ct represents the value of stock exchange in the budget, NFDIt represents the level of foreign direct investment, rt represents nominal interest rate whereas Zt represents other factors. The presented model represents only one of multiple models developed by different bodies and scholars in a bid to try and establish levels of debt sustainability. It is important to note that they all vary and none represents a particularly full proof approach. The effectiveness of each will in most cases depend on the factors being observed. All the same, it should be noted that all the approaches of determining debt sustainability fall into two categories, those which adopt a ration approach either comparing debt servicing costs to government income, ratio of domestic debt to external debt and other similar approaches. The other approach is use of models with complex variables, representing both macroeconomic indicators and directly debt describing indicators. In determining the maturity structure of government debt, sound reasoning is offered by Greenwood, Hanson and Stein (2010) who through an empirical approach illustrate that low-risk short term debt securities provide significant monetary services to investors. Additionally, the study observers that both the government and private-sector intermediaries have the ability to come up with such money-like claims, however, from a social perspective the private sector’s incentive to engage in money creation is more excessive as intermediaries do not adequately internalize first sale costs linked to the reliance on short-term funds. The researchers point out that these observations can be used as a basis of determining government debt maturity policy (Cottarelli and Moghadam, 2010). One of the worthy considerations arising from the study’s observations is that proper structuring of government debt mature can be a fundamental aspect to prudent financial regulation. This observation is founded on the finding that the government can address private-sector financial fragility by reducing the incentives leading to excessive private money creation by creating shorter term debts. However, the determination of the sustainable maturity (debt term) period the government will have to put into consideration the two aforementioned factors. Bibliography AUERBACH, A. J. (1997). Fiscal policy: lessons from economic research. Cambridge, Mass. [u.a.], MIT Press. Alesina, Alberto, and Roberto Perotti. 1997. “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects.” International Monetary fund staff Papers, 44(2): 210–48 Cottarelli, C. and Moghadam, R. (2010). Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis. International Monetary Fund-Fiscal Affairs Department and the Strategy, Policy, and Review Department. Escolano, J. (2010). A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates. International Monetary Fund Fiscal Affairs Department. Greenwood, R., Hanson, G.S. and Stein, J.C. (2010). A Comparative-Advantage Approach to Government Debt Maturity. Harvard Business School, Working Paper 11-035. HORNE, J. (1991). Indicators of fiscal sustainability. [Washington, D.C.], International Monetary Fund. MELLO, L. R. D. (2008). Monetary policies and inflation targeting in emerging economies. Paris, OECD. http://site.ebrary.com/id/10245582. Mendoza, Enrique G. & Ostry, Jonathan D., (2008). "International evidence on fiscal solvency: Is fiscal policy "responsible"?" Journal of Monetary Economics, Elsevier, vol. 55(6), 1081-1093. Romer, C.D., and Romer, D.H. (2010). The macroeconomic effects of tax changes: Estimates based on an new measure of fiscal shocks. American Economic Review 100, 763-801. Tsoukis, C. 2010. A toolkit of static (Keynesian?) multipliers. Read More