16.4 Formal Fiscal Rules Flashcards
It would be extremely difficult to balance the budget on an annual basis. Why?
The reason is that a significant portion of the government budget is beyond its short-term control, and a further large amount is hard to change quickly.
Even if it were possible for the government to control its spending and revenues perfectly on a year-to-year basis, it would probably be undesirable to balance the budget every year. Why?
Recall that tax revenues naturally rise in booms and fall in recessions; and many expenditures on transfers fall in booms and rise in recessions.
With a balanced budget, government expenditures would be forced to adjust to the changing level of tax revenues.
In a recession, when tax revenues naturally decline, a balanced budget would require either a reduction in government expenditures or an increase in tax rates, thus generating a major destabilizing force on real GDP.
Similarly, as tax revenues naturally rise in an economic boom, a balanced budget would require either an increase in government expenditures or a reduction in taxes, thus stimulating aggregate demand when an inflationary gap may already exist.
What would an annually balanced budget cause?
An annually balanced budget would eliminate the automatic fiscal stabilizers and accentuate the swings in real GDP.
What is an alternative to the extreme policy of annually balanced budgets?
Cyclically Balanced Budgets
One alternative to the extreme policy of requiring an annually balanced budget is to require that the government budget be balanced over the course of a full economic cycle.
Budget deficits would be permitted in recessions as long as they were matched by surpluses in booms. In this way, the automatic stabilizers could still perform their important role, but there would be no persistent build-up of government debt. In principle, this is a desirable treatment of the tradeoff between the short-run benefits of deficits and the long-run costs of debt.
Despite its appeal, the idea of cyclically balanced budgets has its problems as well. What are they?
In order to have a law that requires the budget to be balanced over the business cycle, it is necessary to be able to define the cycle precisely. which there will be disagreement about.
Politicians will have a stake in the identification of the cycle. Those who favour increased deficits will argue that this year is an unusually bad year and thus an increase in the deficit is justified; deficit “hawks,” in contrast, will always tend to find this year to be unusually good and thus a time to run budget surpluses.
Suppose one government runs large deficits for a few years during a recession and then gets replaced in an election. Would the succeeding government then be bound to run budget surpluses after the recovery? What one government commits itself to in one year does not necessarily restrict what it (or its successor) does in the next year.
In a nutshell, what is the concenssus on a cyclically baleneced budget?
Balancing the budget over the course of the business cycle is in principle a desirable means of reconciling short-term stabilization with long-term fiscal prudence. The difficulty in precisely defining the business cycle, however, suggests that governments could best follow this as an approximate guide rather than as a formal rule.
How do most economists view as an indicator of appropriate fiscal prudence?
Most economists view a low and relatively stable debt-to-GDP ratio as the appropriate indicator of fiscal prudence. Their view permits a budget deficit such that the stock of debt grows no faster than GDP.
What is a further problem with any policy that required a balanced budget?
A further problem with any policy that requires a balanced budget—whether over one year or over the business cycle—is that the emphasis is naturally on the overall budget deficit.
But, as we saw earlier in this chapter, what determines the change in the debt-to-GDP ratio is the growth of the debt relative to the growth of the economy. With a growing economy, it is possible to have positive overall budget deficits—and thus a growing debt—and still have a falling debt-to-GDP ratio.
