16 Government Debt and Budget Deficit

Question 1

4 measurement problems with government debt and budget deficits

Answer 1

• Inflation
• Capital Assets
• Uncounted Liabilities
• The Business Cycle

Question 2

How does inflation cause problems with measurement?

Answer 2

If real debt is not changing, nominal debt must be rising at the same rate as inflation. Govt looks at the change in nominal debt and reported budget deficit, this is why it might be overstated.

Question 3

What is capital budgeting?

Answer 3

A budget procedure that accounts for assets as well as liabilities, taking into account changes in capital.

Question 4

How do capital assets cause a measurement probelm?

Answer 4

Many economists believe that we should measure total indebtedness as government assets minus government debt.

Therefore budget deficit should be measured as the change in debt minus change in assets.

It would make reported figures lower.

Question 5

Difficulty with incorporating capital assets into reported figures

Answer 5

Ambiguity over which expenditures should count as capital expenditures.

E.g. highways, nuclear stockpiles, education??

Question 6

For and against capital budgeting

Answer 6

Against: although superior, it is too difficult to implement in practice

For: even an imperfect treatment of capital assets would be better than ignoring them altogether.

Question 7

How do uncounted liabilities cause a measurement problem?

Examples?

Answer 7

Some economists argue that the measured budget deficit is misleading because it excludes some important government liabilities.

Government workers as a liability. Social Security system.

Question 8

Define contingent liability

Answer 8

The liability that is due only if a specified event occurs.

Question 9

Example of a contingent liability

Answer 9

Student loans - not considered a liability if paid by the student, but if the borrower defaults, then the government makes the repayment.

Question 10

How does the business cycle cause a measurement problem?

Answer 10

Many changes in the government’s budget deficit occur automatically in response to a fluctuating economy.

As these changes occur automatically, they do not represent a change in fiscal policy.

Question 11

Impact of government budgeting in a recession?

Answer 11

Households: incomes fall → tax revenue falls. Unemployment rises → more claimed on welfare benefits. Government revenue falls whilst expenditure rises → increase in deficit.

Firms: profits fall → corporate tax falls. Government revenue falls.

So, without any changes to laws, the budget deficit increases.

• Not a problem with measurement as this is truly the case.

Question 12

How can the business cycle measurement problem be resolved?

Answer 12

Using a cyclically adjusted budget deficit (full-employment budget deficit).

Useful as it reflects policy changes regardless of the current stage of the business cycle.

Question 13

Traditional view of government

What effect would we expect a tax cut to have in the long-run?

Answer 13

Tax cut → stimulates consumer spending and reduces national saving.

Reduction in saving → increases interest rate and crowds out investment.

Solow model: lower investment → lower steady-state capital stock and lower level of output.

As developed economies tend to have less capital than Golden Rule, fall in capital means lower consumption and reduced economic well-being.

Question 14

Traditional view of government

What effect would we expect a tax cut to have in the short-run?

Answer 14

Tax cut → stimulates consumer spending → expansionary shift in the IS curve.

No change to monetary policy, IS shift → expansionary shift in AD.

Short-run: prices are sticky, expansion in AD → higher consumption and less unemployment.

Question 15

Traditional view of government

What effect would we expect a tax cut to have on international trade?

Answer 15

Tax cut → national saving falls → financing investment from borrowing abroad → trade deficit.

Inflow of capital → lessens effect of fiscal policy on capital accumulation → but makes the country indebted to foreign nations.

Fiscal-policy change → domestic currency appreciates → foreign goods relatively cheaper and exports relatively more expensive abroad.

Fall in net exports → reduces short-run expansionary impact of the fiscal policy change on output and employment.

Question 16

Ricardian view of government

Assumption made about consumer behaviour in the Ricardian view

Answer 16

Consumers are forward-looking → spending decisions not only on their current income but also on their expected future income.

So changes in fiscal policy today will cause the reverse change in the future (tax burden is merely rescheduled).

Question 17

Ricardian view of government

What implication does Ricardian equivalence make?

Answer 17

Debt-financed tax cuts leaves consumption unaffected.

Increases in private saving exactly offset by decreases in public saving, national saving remains the same.

Question 18

Arguments for and against Ricardian equivalence: myopia

Answer 18

For:

• Ricardian view assumes rational decision making when choosing consumption and saving.
• When government decreases taxes or borrows money, they plan ahead for future taxes.
• Presumes that people have substantial knowledge and foresight.

Against:

• People are short-sighted, perhaps do not fully comprehend implications of govt. budget deficits.
• They may think that taxes will not change, or that the change is permanent, making them think they are richer.
• Tax cut will therefore lead to higher consumption and lower national saving.

Question 19

Arguments for and against Ricardian equivalence: borrowing constraints

Answer 19

For:

• Ricardian view assumes consumers base consumption on both current income and lifetime income.
• Tax cut increases current income, but has no effect on lifetime income or consumption.

Against:

• Traditional view argues that current income is more important than lifetime income for those facing binding borrowing constraints.
• If they cannot borrow, or only to a certain amount, current income affects current consumption.
• Tax cut raises the current income, even though it decreases future income - it is essentially a loan. Hence, it expands their opportunities and stimulates consumption.

Question 20

Arguments for and against Ricardian equivalence: future generations

Answer 20

Against:

• Consumers expect implied future taxes to fall on future generations instead.
• Meaning, the tax cut raises lifetime resources of current generation to consume.
• Allows the current generation to consume more at the expense of future generations.

For:

• Robert Barro: future generations are the children not grandchildren, so cannot be seen as independent economic actors.
• His analysis - decision-making unit is not the individual (finite lifetime), but the family (which continues forever).
• Evidenced by altruism between generations such as bequests and wills.

Question 21

Three reasons economists oppose strict rules on balanced budgets

Answer 21

Stabilisation: A budget deficit or surplus can help stabilise the economy.

Tax smoothing: A budget deficit or surplus can reduce the distortion of incentives caused by the tax system.

Intergenerational redistribution: A budget deficit can shift a tax burden from current to future generations.

Question 22

Stabilisation argument against strict rules on balanced budgets

Answer 22

A strict rule would revoke automatic stabilisation powers.

In a recession, automatic responses push the budget into deficit. To balance, tax raises are required → depressing AD and deepening the recession.

Question 23

Tax smoothing argument against strict balanced budget rules

Answer 23

High taxes impose a cost on society by discouraging economic activity. High taxes on labour discourage working long hours.

Hence, by borrowing and running a deficit, the government can delay the tax, or impose smaller taxes until the economy has recovered.