Budget Deficits and Natioanl Debts

Question 1

Current budget deficit/surplus

Answer 1

A current budget deficit/surplus is the difference between current
expenditure and total revenue receipts – a deficit implies the need to
borrow to finance current consumption, such as the payment of
government officials’ salaries, welfare benefits etc. A surplus would
allow the redemption of part of the national debt.

Question 2

Fiscal or budget deficit/surplus

Answer 2

A fiscal or budget deficit/surplus is the difference between current

plus capital expenditure and current receipts – government accounts
may not distinguish between current and capital spending, which
may result in ‘fiscal illusion’ (reducing the deficit throught accounting changes or keeping liaiblites, e.g. public sector pensions, off balancesheet )and gives rise to situations where, for example, the sale of assets is treated as current revenue.

Question 3

Cyclically-adjusted budget balance

Answer 3

Economies show a cyclical pattern of expansions and recessions. These fluctuations have implications for the budget balance.

The cyclically adjusted budget balance is an estimate of the budget balance if GDP were equal to the level of potential output in the economy and thus is an attempt to remove the effects on the budget balance of these automatic stabilisers.

Question 4

Structural budget balance

Answer 4

This is an estimate of the underlying budget balance after removing the effects of the economic cycle. It is calculated on the basis that the economy is at its potential output, although calculation of this potential output is difficult and uncertain. It thus reflects the discretionary fiscal policies of governments.

If the structural budget balance is in deficit, to achieve balance would require additional tax rises and/or expenditure reductions.

Question 5

Primary balance

Answer 5

This is the difference between revenues less expenditures less interest payments.

This is a useful measure in analysing the sustainability of a
government’s fiscal policy in terms of its borrowing and level of debt.

Question 6

Why do governments run deficits?

Answer 6

• Investment—borrowing to finance the purcase of capital assets suc has schools roads, etc. They require large initial expenditures that would otherwise requires large tax incease Captial assets may also provide direct (tolls) or indirect (economic growth) returns to help service the debt.
• Inter-generational fairness—future generation benefris from long-term capitals assets and should share the cost of buying them.
• Tax and revenue smoothing—countries dependent on resource revenues may need short-term borrowing to cover revenue shortfalls.
• Stabilisation—fiscal policies may be used to counter the effect of downturns and reduce the effect of unemployment and inflation. (Keynesian economics)

Question 7

Fiscal policy (1)

Answer 7

If aggregate demand in the economy is falling and the actual level of output (GDP) is slowing down and the economy is heading into a recession, then the government should cut taxes (as well as raising its own expenditure) in order to increase aggregate demand to offset the recessionary tendencies in the economy. Such policies will worsen the budget balance, the difference between government spending and revenues.

Their effect on output (GDP) is called the fiscal multiplier (the ratio between the size of the stimulus and its resultant impact on GDP). Different types of stimulus can also have different multiplier effects; a tax cut can be offset by an increase in savings whereas an infrastructure project would feed straight into the economy; tax cuts targeted at the less well-off will have a bigger impact as poorer people spend more of their income.

Question 8

Fiscal policy (2)

Answer 8

Critics of Keynesian economics argue that fiscal policy may have destabilising effects on the economy. They argued that Keynesian economics is asymmetrical in that governments find it easier to cut
taxes and increase government expenditures than to do the reverse, particularly near election times, and this gives the policy an inflationary bias.

The high inflation and low economic growth of the 1970s led to a disillusionment with Keynesian economics, which was reinforced by theoretical developments, most notably monetarism, which played down the role of fiscal policy and led to an emphasis on monetary policy.

Question 9

Fiscal rules

Answer 9

Fiscal rules (limits on bugetary postions) are used to signal a credible
commitment by a government to sound fiscal policies and to reassure financial markets and companies that it will not indulge in fiscal practices that would result in high interest rates, high inflation and financial crises. Their main drawback is they reduce flexibility to use fiscal policy as a counter-cyclical policy and may even hamper the work of automatic stabilisers.

They can be broken, amended or circumvented. Private Public Partnerships (PPPs) have been used as a vehicle for governments to push transactions ‘off-balance sheet’ to avoid the rules.

Question 10

Why do deficits matter?

Answer 10

When a government has to borrow, it is in competition for funds with other borrowers, especially companies, in the financial markets. Companies are seeking to raise finance to fund their investment projects, which should have beneficial effects on the long-run rate of economic growth of an economy. This competition will drive up interest rates in the economy, especially if the government has a large borrowing requirement. Higher interest rates will lower the investment spending of profit-seeking companies with, it is argued, deleterious effects on economic growth. This is called crowding out.

Question 11

Deficit financing

Answer 11

Deficit financing refers to that part of government expenditure financed through borrowing as opposed to revenue and/or sales of capital assets—in other words, its budget deficit.

Governments finance their budget deficits by borrowing and thus they accumulate debt. Governments have to pay interest on their debt and in the future, either the debt has to be paid off or refinanced.

Question 12

Internal (domestic) debt

Answer 12

Internal or domestic debt arises when governments borrow in domestic currencies from domestic residents or institutions.

Internal debt does not reduce the net worth of the country.

Question 13

Ricardian equivalence (fiscal neutrality)

Answer 13

David Ricardo argued that taxation and government borrowing are logically equivalent. If the government borrows to finance public spending, rational individuals will anticipate that their taxes will have to increase in the future to repay the loan and interest. Therefore debt finance merely postpones the tax burden onto the next generation.

The current generation, it is argued, will not want their dependants to be worse-off and will therefore increase their savings in order to bequeath to their descendants the same amount as before the increase in the tax burden of the next generation.

Critics argue that individuals are not as rational as assumesd, nor are they as altruistic.
In addition, with capital expenditure, future generations benefit as well and debt finance helps to spread the burden over the present and future generations and thus avoids an excessive burden on the present generation.

Question 14

External (foreign) debt

Answer 14

External or foreign debt arises when governments borrow from overseas governments, residents or institutions, usually in foreign currencies (of course, overseas residents can also purchase domestic debt). Such debt has balance-of-payments and exchange-rate implications. When a government incurs foreign debt, this does constitute a reduction in the net wealth of the government and therefore of the nation, because foreign debt increases the claims that other nations have on the resources and assets of the country.

Question 15

Seigniorage

Answer 15

When governments finance a deficit by printing money, this is called ‘seigniorage’. When money is printed, what happens? There is inflation – at least if the economy is at or close to its potential output. This causes a fall in the real value of the incomes and savings of all economic agents.

Question 16

Debt sustainability

Answer 16

When government debt is substantial, other things being equal, the consequent large payments of interest means governments must raise more revenues from taxation (or spend less) in the future, or it must borrow even more. In the latter case, these additional borrowings add to the debt interest, which in turn increases the need to borrow, and so on. A distinction is often made in this context, between the primary budget balance or deficit, and the overall budget balance or deficit.

To ascertain the ability of governments to pay their debt, the debt/GDP ratio is frequently used – that is, public or government debt as a percentage of GDP.

Question 17

Primary deficit

Answer 17

The primary deficit is defined as the deficit before interest payments. A government that has to borrow to pay interest on its debt pushes itself even deeper into debt. This process can eventually drive a government to the point where lenders question its solvency and demand higher interest payments or even refuse to lend any more.

A government’s debt burden is sustainable if it can pay the interest without borrowing more. Otherwise, it will fall into a debt trap, where it is borrowing ever more just to service earlier debt.

Question 18

Austerity (1)

Answer 18

There was resurgence in the use of fiscal policy and Keynesian economics following the financial and economic crisis of 2008–09. This resulted from the collapse in property and assets prices and the resultant impacts on the banking systems in many countries.

Most advanced countries introduced some kind of stimulus programe,
increasing spending and/or cutting taxes. Highly expansionary monetary policy was also employed, intended to counter the fall in economic activity, but it resulted in interest rates at or close to
zero, which obviously couldn’t be lowered any further, especially when inflation too is close to zero.

Question 19

Austerity (2)

Answer 19

Larger budget deficits together with the bailing out of failing
banks caused a substantial rise in the national debt of many governments,
particularly in the advanced countries. Concern about the size of these deficits and public debt ratios led to demands for tighter fiscal policies (often called fiscal consolidation).

Austerity supporters argue that it is necessary to reduce deficits and debts because of fears about the sustainability or future costs of deficits and debts. Keynesians argue that deficits and debts are the consequence of the recession and depressed business expectations, and not the cause. Critics of austerity argue that austerity is self-defeating; any cuts in spending cause the economy to slow down, and debt as a proportion of the (now lower) GDP rises.

Question 20

Fiscal policy in developing countries (1)

Answer 20

In developing countries, the proportion of total tax revenues relative to GDP is much lower, and there are differences in the sources of revenues from different taxes – especially lower levels of direct tax revenues, reflecting the subsistence and informal economies in these countries and inefficient tax administration.

The lower level of tax revenues to GDP and the relatively greater reliance on indirect taxes tends to mean that, at least on the tax side, the impact of automatic stabilisers is much lower than in developed countries. In developing countries, unemployment and welfare programme transfers are typically small, and the biggest share of government spending is represented by consumption of goods and services – particularly by government wages.

Question 21

Fiscal policy in developing countries (2)

Answer 21

There may also be more limited scope for the sale of public debt to the domestic private sector in those countries where incomes are low, banks are mainly confined to urban areas, and capital markets are not well developed. Consequently, such countries often have much higher levels of foreign debt, denominated in hard currencies, and this makes them more vulnerable to a loss of confidence by overseas investors and the risk of collapse in their exchange rates. Some of those countries find it difficult to finance their debts and others pay substantial risk premia, reflecting their perceived poor creditworthiness. Thus, there may be greater reliance on seigniorage revenues.

Question 22

Fiscal policy in developing countries (3)

Answer 22

Fiscal crises are common in developing countries due to such factors as weak budgetary and revenue institutions, which result in poor expenditure control and poor quality public investment. Debt service (interest payments) typically accounts for a large share of revenues and aid flows are often highly unstable, leading in turn to expenditure instability.

Political instability is another deterrent to external finance. The IMF may act as the lender of last resort but it imposes conditions on the funds it lends to these countries, most notably in the fiscal context. However, IMF conditionality has been seen as excessively rigid and showing insufficient concern for the poor.

Question 23

Fiscal adjustment and fiscial illusions (1)

Answer 23

Where governments are under pressure from their legislatures or from outside influences to reduce their deficits, they may respond in some
combination of three ways:

• reduce expenditures
• increase revenues
• change accounting and other arrangements to make the deficit appear smaller than it was.

Such changes are referred to as fiscal illusion.

Question 24

Fiscal adjustment and fiscial illusions (2)

Answer 24

Ways in which governments can apparently reduce their deficits include the following:

• privatisation and the sale of other public assets
• reducing current spending in a way that actually increases spending in future, e.g. cutting back on maintenance spending
• reducing public investment: this reduces government spending and thus the budget deficit, but it reduces net worth too as it lowers future assets and revenues, either from user charges and fees, or from lower economic growth
• substituting private for public investment, e.g. PPPs
• postponing expenditure to a future fiscal year or bringing forward tax receipts to the current fiscal year; e.g.delaying the payment of salaries to government employees