MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 11/29/2018 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Fiscal Policy and the Role of Government PowerPoint by Beth Ingram University of Iowa Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Key Concepts Debt and deficits Fiscal Finance Debt versus taxes Ricardian Equivalence Intergenerational equity Debt sustainability and the primary surplus

Government Spending Types Considerable variation in spending Consumption of goods and services Investment Transfer payments Considerable variation in spending

Fiscal Policy Components Financing Taxes Deficit Composition of spending (G) Current goods and services Public investment Debt payment Includes interest payments on debt. G = Taxes + Deficit

Government Spending % of GDP, 2002 Source: OECD online database

US Government Spending 2003 Source: Economic Report of the President, 2004

Value of government spending Opposition to government spending Pareto efficiency: Market forces produce efficient use of resources Taxation produces distortions Support for public spending Public goods Redistribution Informational issues

Public Goods Non –Rivalry Non – Excludability Free rider problem says that a rational person will not contribute to the provision of public good because he does not need to contribute to the benefit from it. 

Type of Goods

Pareto Optimality Pareto efficiency or Pareto optimality is a state of allocation of resources from which it is impossible to reallocate so as to make any one individual or preference criterion better off without making at least one individual or preference criterion worse off.

Pareto Optimality

Level of Spending What proportion of GDP should be allocated to public spending? Does this depend on the purpose of the expenditures? Should spending be countercyclical?

Spending and taxation appear positively correlated

11/29/2018 Percentage of GDP, 2000

Government Receipts % of GDP, 2002 Source: OECD online database

Taxation Purpose Revenue Behavioral Correction (tax on tobacco and alcohol) Tax Wedge: gap between what seller receives and what buyer pays

Methods of Taxation Non-distortionary Distortionary Head tax (a uniform tax imposed on each person.) Distortionary Income tax Capital gains tax Sales tax

Effect on labor market Real Wage Employment Labor Supply (tax >0) Labor Demand N1 N0 Employment

Effect on labor market Real Wage Employment Labor Supply (tax >0) Tax wedge W0 Labor Demand N1 N0 Employment

Effect on labor market Real Wage Employment Labor Supply (tax >0) Cost of distortion W0 Labor Demand N1 N0 Employment

Laffer Curve Taxes collected = Tax rate x Wage x N Two competing effects Tax rate x Wage is rising N is falling Eventually, tax collections will fall Tax Rate Tax Revenue

Laffer Curve The Laffer Curve is a theory developed by supply-side economist Arthur Laffer to show the relationship between tax rates and the amount of tax revenue collected by governments. The curve is used to illustrate Laffer’s main premise that the more an activity such as production is taxed, the less of it is generated. Likewise, the less an activity is taxed, the more of it is generated

Laffer Curve

Government Borrowing Deficit: debt issued in a particular fiscal year An aside on the government debt market Debt: accumulation of past deficits and surpluses

Deficit Debt Debt

Debt Debt Surplus

Surplus or Deficit % of GDP, 2002 Source: OECD online database

US Deficit

US Deficit

Debt as a percentage of GDP, 2002 Source: OECD Economic Outlook

Ownership of Treasury Securities, 1989

Ownership of US Treasuries, 2000

Recall ‘cost of capital’ model 11/29/2018 Recall ‘cost of capital’ model Private Savings Interest Rate Note: This is not in the book, but it draws on material in chapter 3 to explain how deficits can affect the interest rate. I would cover this. 5% Investment I0 Output

Deficit = Negative Savings Private Savings + Government Savings Private Savings Deficit Interest Rate 6% 5% Investment I1 S1 I0 Output

Intertemporal Budget Constraint 11/29/2018 Intertemporal Budget Constraint Year 2005: D(2005) = G(2005) - T(2005) Suppose debt is paid off in Year 2006 Year 2006: T(2006) = G(2006) + D(2005)x(1+R) Hence, taxes are higher in 2006 I think its easier to talk about intergenerational issues if the budget constraint is sitting in front of the students. Why do future taxes increase? T(2006) - G(2006) = D(2005)x(1+R) Year 2005: G(2005) = T(2005) + T(2006)/(1+R)

Spending in year must be supported by current and future taxes. = Government spending taxing and deficit financing reallocate resources within people of same generation and across generation

Implications Countries with high debt must Default Run tighter fiscal policy in future Debt levels should vary across countries Purpose of spending (consumption versus public investment) Role of expected future liabilities (pensions) Intergenerational equity

Generational Accounts Present value of net tax payments (until death) by different generations indexed by age in 1995.

Sustainability of Debt p=(r-g)d p = primary surplus required to stabilize the debt/GDP ratio r = real interest rate g = real growth rate of GDP d = debt/GDP ratio

Sustainability of Debt p=(r-g)d If r > g, must have primary surplus at some point If r < g, can run deficit indefinitely Abstracts away from cyclical movements in deficit

Sustainable Debt example Case 1: Interest rate r= 3%= 0.03 Growth rate g = 5% =0.05 and deficit/gdp=0.05 Since g >r it is sustainable but where p=(r-g)d Or -0.05 = (0.03- 0.05) d Or d= -0.05/(-0.02) d= 2.5 That is debt to gdp ratio should be 250% if government want s to run deficit of 5%

Sustainable Debt example 11/29/2018 Sustainable Debt example Case 2: Interest rate r= 3%= 0.03 Growth rate g = 5% =0.05 and deficit/gdp=0.01 Since g >r it is sustainable but where p=(r-g)d Or -0.01 = (0.03- 0.05) d Or d= -0.01/(-0.02) d= 0.5 That is debt to gdp ratio should be 50% if government want s to run deficit of 1%

Intertemporal budget Constraint At first end of first period D(0)= G(0)- T(0) I,e: D(0): deficit at first period, G(0) govt spending ant first period and T(0) tax at first period At end of Second period of surplus to pay off debt of first period T(1)-G(1)=D(0) *(1+r) where r is intrest

Pension pension to the current generation of retirees are paid by contribution of current generation of labor Two types of pension plan defined contribution (Pay as you Go) – based on how much money has been paid into your pension pot defined benefit (final salary or career average) or Fully Funded Pensions – based on your salary and how long you’ve worked for your employer

Optimal Budget Deficits For what purpose is spending being used? Consumption Investment War and shock

Optimal Budget Deficit Cyclical considerations Recessions mean low tax collections, high payouts Should taxes increase during recessions? Distortionary effects of taxation Tax smoothing: Barro's (1979) tax smoothing model is based on the idea that the government minimises the distortion from taxation by allocating taxes over time. The theory is analogous to the permanent income theory of consumption.

Summary Effect of deficit spending Debt sustainability Government spending is a significant fraction of economic activity Role of government spending Financing Taxes, and their distortionary effects Deficits Effect of deficit spending Debt sustainability Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.