Public Finance and Inter-Generational Equity - Essay Example

Public finance and Inter-generational equity Overview Inter-generational equity recommends that current generation should not impose a debt on the next generation for the benefits that current generation enjoys. Inter- generational equity demands fairness of fiscal management. The principle of ‘fairness, one of the codes of fiscal stability (others are transparency, stability, responsibility, and efficiency) adopted by the government for the framework of formulation and implementation of its fiscal policy, implies that the government seeks to operate its fiscal policy, as far as possible, in a way that takes into account not only the financial effects on future generation but also its distributional impact on the current population. In other words those generations that take benefit from public spending should also bear the cost of such benefit. The rule of fairness matches the cost and benefits of public spending between generations. In 1997 a golden rule of public finance, that over the cycle, government borrowings should not exceed net government capital formation and hence current spending should be financed by current receipts, was adopted by the government. Application of this golden rule draws a distinction between Capital and current spending. It is clearly understood that the benefit of ‘Capital’ spending may spread over the generations, whereas ‘Current’ spending is for current consumption to be benefited only by current generation. Therefore the current consumption or expenditure must be controlled tightly so that its financial burden does not spread to next generation. This principle works only in approximation as certain overflows are not ruled out. Not all but some benefits of expenditure on infrastructural, institutional and cultural capital investments will pass on to next generation. The ‘benefiter-pays’ rationale of inter-generational equity requires that each generation should pay for the resources it uses. The principal of fairness coupled with ‘benefiter pays’ rule suggests that the entire capital expenditure should not be financed through borrowings, as some benefits of capital expenditure are also being derived by current generation. Accordingly some burden of capital expenditure should be shared by current generation in order to meet the objectives of ‘inter-generational equity’. Contents 1. Inter-generational equity 2. Distinction between current and capital expenditure 3. Golden rule of public finance and its repercussions 4. The rationale of ‘benefiter-pays’ 5. Conclusion 1. Inter-generational equity While defining ‘Inter-generational equity’, Earth & Peace Educational Associates International (EPE) has observed that, ‘each generation has the right to inherit the same diversity in natural and cultural resources as enjoyed by previous generations and to equitable access to the use and benefits of these resources. At the same time, the present generation is custodian of the planet for future generation, obliged to conserve this legacy so that the future generations may also enjoy these same rights. In this way intergenerational equity extends the scope of social justice into the future.1’ Three principles form the base of the concept of ‘inter- generation equity’. These principals are: i) Conservation of option- each generation should be required to conserve the diversity of natural and cultural resource base. ii) Conservation of quality- each generation should be required to maintain the quality of planet so that it is passed on in no worse condition than it was received. iii) Conservation of access- each generation should provide its members with equitable right of access to the legacy of past generation and should conserve and access for next generation. Public finance plays an important role in following these basic notions of inter-generational equity; and the government’s fiscal policy with regard to financing of current and capital spending can provide the much needed motivation to attain the objectives of inter- generation equity. 2 Distinction between current and capital expenditure Earlier governments used to set limits for total expenditure while framing budgets. No distinction used to be made in capital and current spending. As a result economic growth used to suffer because of inadequate level of capital investments. Similarly many services used to get inadequate budgetary allocation and thereby depriving the public of their legitimate benefits as tax contributions. On realization of this short- coming, government changed its fiscal policy in order to recognize the important distinction between capital and current spending. Capital expenditure is spending for purpose of acquiring new assets. Also the expenditure that adds value or useful life to existing assets is capital expenditure. Capital expenditure is also called investments. The purpose of capital expenditure is to create or acquire assets for rendering services and benefits to taxpayers. The benefits of capital expenditure accrue over the life time of assets and accordingly cover current and coming years. ‘Capital Expenditure can be understood in several other ways described as under: In national accounts capital expenditure is usually understood to mean capital formation, the net acquisition of land, and expenditure on capital grants. Capital formation is expenditure, net of sales, on fixed assets (such as buildings, vehicles and machinery) and net stock building and can be measured gross or net of depreciation. There are some borderline cases, for example in national accounts all assets with a purely military use are defined as current; but assets that can be used for civil and military purposes count as capital. Certain types of significant computer software development are treated as capital expenditure. Under resource accounting, and in various presentations of local authority finances, capital expenditure also includes loans that are given and net acquisition of shares2.’ On the other hand, current expenditure is the regular cost of keeping the business running. It is expenditure on goods and services consumed within the current year. Now-a-days Government’s fiscal policy treats current expenditure separate from capital expenditure; and there the current expenditure is meant to provide benefit mainly to current generation. It reflects continuing programs that are financed each year. In national accounts ‘Current expenditure on goods and services is the sum of expenditure on pay, and related staff costs, plus spending on goods and services. It excludes capital expenditure, but includes expenditure on equipment that can only be used for military purposes since that is counted as current expenditure3.’ 3 Golden rule of public finance and its repercussions Now-a-day the priority for the Government is to operate its fiscal policy in a way that meets the economic approach of current and capital spending. As explained above, the economic nature and approach of capital and current spending are clearly different. Based on this distinction the government has set out a golden rule that it will borrow only to invest and not to fund current spending. That clearly suggests the point of view of the government. Following the code of fairness the government wants present generation to bear its own burden of current spending. This golden rule is associated with a ‘sustainable investment rule’ in order to prevent over investment in capital stocks and to limit a net public debt below a certain percentage of GDP. The golden rule of public finance and the incidence of public investments on economic growth has remained a controversial issue. There has been a lot of advocacy and criticism of this rule as has been analyzed hereunder in this paper. Advocacy of Golden rule iv) The golden rule allows the government to spread the cost of capital investments during the useful life of those investments and thereby the burden of capital formation falls only on generation of taxpayers benefiting from such investments. v) Adoption of golden rule in fiscal policy gives boost to potential and actual economic growth through public investments. ‘Promoting economic growth via public investments stems from two channels. First, public investments provide public goods like transport infrastructures which benefit users and directly or indirectly improve total factor productivity. Second, public investment also raises overall welfare when it participate in the protection of environment or enhance the fairness in resource distribution5.’ vi) The pre requisition of separation of capital expenditure from current expenditure renders proper accountability and transparency of the government decisions. Political accountability is further improved with capital budgeting. vii) Fiscal planning of every economy lays a sizeable emphasis on capital investment for uninterrupted future development of the economy. A distinction between capital and current spending provides a control process whereby it can be ensured that there is no discrimination against capital spending. Criticism of Golden rule i) From a general point of view ‘the definition of “Public investments” in national statistics includes transactions that lead to changes in the stock of physical capital (like the construction of infra structure and purchase of computer hardware), but excludes large amount of expenditures related to accumulation of human capital, like training or R & D. Hence golden rule may only result in a bias in favor of physical assets at the expense of health and education expenditure4.’ ii) ‘The golden rule promotes public capital, though it is overall capital from public and private sectors that should be prompted. Thus as long as public capital crowds out private investments, no positive effect can be expected6.’ iii) The roots of golden rule lie with generational accounting, which is relatively new way of analyzing fiscal policy. Seasoned politicians tend to ignore the needs of future generations in order to win the support of current generation; for example to borrow heavily to meet the current spending. iv) Whenever there is threat to the success of the golden rule, the government tries to raise taxes to meet current expenditure. It is found that generally government is unable to resist current expenditures. 4. The rationale of ‘benefiter-pays’ ‘The ‘benefiter-pays’ rationale, which requires that each generation pays for the resources it uses is, from a deeper theoretical point of view, best underwritten by the conceptions of justice that emphasize what people are entitle to, or people would agree to give in return for what they get from social arrangements(mutual advantage)7 It is true that ‘inter-generational equity’ does not require a burden to be transferred to next generation for the benefits it would not receive from the present set of spending. These benefits will certainly not accrue from current spending as those are meant for current generation. It is capital spending that creates infra-structural facility to be made available to next generation. Capital expenditure incurred during the time of current generation may also render some benefits to current generation as well. Following the rationale of ‘benefiter-pays’ policy, it is not prudent to pass the entire burden of capital expenditure to coming generation. The burden needs to be shared between the generations enjoying the benefits. Accordingly all capital expenditure need not be financed through borrowings. At the same time it is not possible to proportionate exactly the benefit between present and next generations. Under such situation the key is with present generation’s well being ness and affordability. Capital expenditure should not be fully financed by loans. The contributions of present generation be weighed in terms of their affordability (i.e. budget surpluses); and rest of capital expenditure should be financed by loans in order to meet the objectives of ‘inter-generational equity’. 5. Conclusion The principles of inter-generation equity impose a responsibility on present generation to pass on only those liabilities to next generation for which next generation would be reaping benefits. The adoption of golden rule of public finance has rightly emphasized that current expenditure should find its way only from current recourses and need not be met from borrowings, unless current resources are capable to satisfy such borrowings. As regard capital expenditure, the solution lies with the policy of ‘benefiter- pays’. Therefore, capital expenditure may be financed through loans and borrowings, but only those liabilities should pass on to next generation those are in an approximate proportion to the benefits. 7. References: 1 EPE values- Intergenerational Equity, http://www.globalepe.org/values_ie.html 2 ‘Public Expenditure Statistical Analyses 2001-02’, Glossary of Terms http://www.archive.official-documents.co.uk/document/hmt/5101/5101-gls.htm 3 ibid 4 ‘Has the Golden Rule of Public Finance Made a Difference in The UK’ by Jerome Creel (OFCE), Paola Monperrus-Veroni (OFCE), and Francesco Saraceno (OFCE), April 2007, page 6 http://www.ofce.sciences-po.fr/pdf/dtravail/WP2007-13.pdf 5 ‘Ranking Fiscal Policy Rules’ by Jerome Creel (OFCE), July 2003, page 15 http://www.ofce.sciences-po.fr/pdf/dtravail/wp2003-04.pdf 6 ibid, page 18 7 ‘Inter-generational Equity: Issues of Principles in the Allocation of Social between this Generation and the Next’ by Assoc. Professor Janna Thompson, Consultant Social Policy Group, 15 May 2003, page 17 http://www.aph.gov.au/library/Pubs/rp/2002-03/03RP07.pdf Read More