Debt And Fiscal Policy Notes

Debt and Fiscal Policy

• Theories of public debt with critiques of Ricardian equivalence and how it actually works in practice

• Theory of tax smoothing

• Theories of public debt with budget deficits, debt accumulation and delated stabilization

• Costs of deficits

• Fiscal councils

• What is fiscal policy:

  • Decisions the government makes about taxation and redistributing that money

  • Why does fiscal policy play a role: needs to be used to meet certain government requirements eg. Income distribution, resource allocation, provision of public goods

  • Discretionary policy for stabilisation: still widely used as a stabilisation tool eg. Coordinated fiscal stimulus programmes widely used during the GFC. Could be particularly important when MP limited eg. At ZLB

  • Automatic stabilisers: in times of strife, automatically a fiscal spending increase because social spending will go up and tax burdens reduced. Also means budget deficit automatically enlarges when there’s a recession

  • Debt: affects burden of debt = big downside of discretionary fiscal policy. Advanced countries tend to have ageing populations + rising health costs = increasing debt ratio.

• Ricardian equivalence:

  • Links to PIH – how will effects of fiscal policy change if households are rational and fully forward looking

  • Assume households RE and fully forward looking = they internalise the gov’s intertemporal budget constraint

  • Model economy over infinite time horizon – households indifferent between taxes now and in future

  • Depends on assumptions:

    • No credit constraints

    • Households and gov face same rates

    • Households have children and incorporate them into utility (last forever)

    • If gov borrowing cheaper than household, or households more myopic = place more weight on their own utility, they will prefer gov to finance through borrowing rather than higher current taxation

• Effects of discretionary fiscal policy

  • Multipliers

    • Relationship between change in gov spending and change in output – short-run Keynesian multiplier is greater than 1

    • The larger the multiplier, the greater the argument for continuing with stimuli during recessions rather than austerity

    • Eg. Deep recession: CB can’t use MP due to ZLB, gov can use fiscal stimulus package to shift up IS curve, so then can gradually reduce it to move economy back to inflation and output at target = new medium-run equilibrium where gov spending up and private sector spending down = benefit of stabilising private sector expectations

    • But outcome could be different: effect of G depends on context, model and behaviour of CB. In economy with spare capacity, gov can boost output and AD = welfare enhancing. However, if economy at equilibrium and CB keeps r unchanged, economy will end up at new MRE with inflationary bias and debt

  • Effects of fully tax-financed expenditure:

    • Depends on relative marginal propensities to consume between groups it would redistribute funds between eg. Redistributing spending power from taxpayers to those who provide goods and services. If same marginal propensity to consume, then multiplier of 1 between amount of gov spending and change to output, as aggregate consumption remains unchanged. If MPCs different, ‘balanced budget multiplier’, could raise AD

    • With RE: if people consumption smooth, will still lead to permanent income, just a lower one due to the taxation

    • Ramer (2011): size of multiplier depends on the country. Larger in developed than developing (more waste in developing, less efficient). Larger in closed economies (leaks of AD in open). Large with fixed excnage rates but zero in flexible (MP offsets effect of fiscal stimulus). Neg multiplier in high debt countries due to anticipated macro effects

• Automatic stabilisers:

  • Cyclically adjusted budget deficit – shows what deficit would be if economy at equilibrium. So if current deficit above/below, this indicated where we are in business cycle

  • Larger gov spending = larger automatic stabilisers = less discretionary fiscal policy necessary

• Debt

  • Stock of gov bonds that have been sold to private sector in the past

  • Budget deficit = money spent on interest on debt

  • Primary deficit = difference between gov spending and tax revenue

  • Financial crisis undermined certainty govs would repay their debts and keep paying the interest, there’s now sovereignty default risk

  • Does high debt matter?

    • Unless RE holds, gov debt crowds out productive capital in the long-run, implies higher interest rates and therefore lower output. It would crowd out if higher debt didn’t lead to an equal rise in private savings, which it would if there was RE and so private sector anticipated that increased spending now = higher taxes later so saved to pay for these

    • Gov may choose to default if political costs associated with raising taxes or cutting spending are too high – gov may also be forced to default if it is unable to refinance existing debt or ‘roll over’, as market will no longer lend to it. CB can act as lender of last resort in this situation, problem in Eurozone as ECB refused to do this

  • Why is there a deficit bias:

    • Tendency for deficits to rise during recessions, but not fall in a sufficiently offsetting way during booms = gov prefers to finance through borrowing rather than taxation

Normative theories of public debt:

• Ricardian Equivalence: given a stream of government spending, rational intertemporal people know tax cut today = tax increase in future, so unless stream of public spending changes, consumption won’t change. Financing by taxes or debt should make no difference

  • Budget constraints:

    • Basic idea is that consumption smoothing means that consumption will drop by less than output drops, so savings drops to account for consumption not dropping as much (investment drops)

    • Consumers/households: d(B+E)/dt = r (B+E) +Y – T – C with initial bond holdings B(0) and initial equity holdings E(0) given (B + E is bonds + equity = financial assets)

    • Government: dB = r B + G – T with initial debt B(0) given

    • Integrate these from...

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