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

10-2 Key Concepts Debt and deficits Fiscal Finance Debt versus taxes Ricardian Equivalence Intergenerational equity Debt sustainability and the primary surplus

10-3 Government Spending Types Consumption of goods and services Investment Transfer payments Considerable variation in spending

10-4 Fiscal Policy Components Financing Taxes Deficit Composition of spending (G) Current goods and services Public investment Debt payment G = Taxes + Deficit Includes interest payments on debt.

10-5 Government Spending % of GDP, 2002 Source: OECD online database

10-6 US Government Spending 2003 Source: Economic Report of the President, 2004

10-7 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

10-8 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?

10-9 Spending and taxation appear positively correlated

10-10 Percentage of GDP, 2000

10-11 Government Receipts % of GDP, 2002 Source: OECD online database

10-12 Methods of Taxation Non-distortionary Head tax Distortionary Income tax Capital gains tax Sales tax

10-13 Effect on labor market Real Wage Employment Labor Demand Labor Supply (tax = 0) W0W0 N0N0 Labor Supply (tax >0) W1W1 N1N1

10-14 Effect on labor market Real Wage Employment Labor Demand Labor Supply (tax = 0) W0W0 N0N0 Labor Supply (tax >0) W1W1 N1N1 Tax wedge

10-15 Effect on labor market Real Wage Employment Labor Demand Labor Supply (tax = 0) W0W0 N0N0 Labor Supply (tax >0) W1W1 N1N1 Cost of distortion

10-16 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

10-17 Government Borrowing Deficit: debt issued in a particular fiscal year An aside on the government debt market Debt: accumulation of past deficits and surpluses

10-18 Deficit Debt

10-19 Surplus Debt

10-20 Surplus or Deficit % of GDP, 2002 Source: OECD online database

10-21 US Deficit

10-22 US Deficit

10-23 Source: OECD Economic Outlook Debt as a percentage of GDP, 2002

10-24 Ownership of Treasury Securities, 1989

10-25 Ownership of US Treasuries, 2000

10-26 Recall ‘cost of capital’ model Interest Rate Output I0I0 5% Private Savings Investment

10-27 Deficit = Negative Savings Output I0I0 5% 6% I1I1 Private Savings Investment Private Savings + Government Savings S1S1 Interest Rate Deficit

10-28 Perfect Crowding Out Output I 0 = S 1 5% 6% I1I1 Private Savings Investment Private Savings + Government Savings Interest Rate Deficit

10-29 Dynamic Response Suppose savings increases with the deficit Output I 0 = S 1 5% 6% I1I1 Private Savings Investment Private Savings + Government Savings Interest Rate I 0 = I 1 S1S1

10-30 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 T(2006) - G(2006) = D(2005)x(1+R) Year 2005: G(2005) = T(2005) + T(2006)/(1+R)

10-31 Spending in year 2005 must be supported by current and future taxes. =

10-32 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

10-33 Present value of net tax payments (until death) by different generations indexed by age in Generational Accounts

10-34 Ricardian Equivalence Only G matters, not T or D Thought experiment …. G 1 = $1000, G 2 = 0 Year 1: T 1 + D 1 = $1000 Year 2: T 2 = (1 + r)D 1 C 1 + S 1 = Y 1 – T 1 C 2 = Y 2 + S 1 (1+r) – T 2 C 1 + S 1 = Y 1 – T 1 C 2 = Y 2 + S 1 (1+r) – T 2

10-35 Ricardian Equivalence C 1 + S 1 = Y 1 – $1000 C 2 = Y 2 + S 1 (1+r) C 1 + S 1 = Y 1 – $1000 C 2 = Y 2 + S 1 (1+r) T 1 = 1000 T 2 = 0 C 1 + (S 1 +$1000) = Y 1 C 2 = Y 2 + (S 1 +$1000)(1+r) - $1000(1+r) C 1 + (S 1 +$1000) = Y 1 C 2 = Y 2 + (S 1 +$1000)(1+r) - $1000(1+r) D 1 = $1000 T 2 = (1+r)D 1

10-36 Ricardian Equivalence Savings expands to match the deficit Holds when Taxation is non-distortionary Fiscal debt is held domestically The savers are the same people that get taxed – intergenerational equity What is the sustainable level of debt?

10-37 Optimal Budget Deficits For what purpose is spending being used? Consumption Investment Cyclical considerations Recessions mean low tax collections, high payouts Should taxes increase during recessions? Distortionary effects of taxation Tax smoothing

10-38 Sustainability of Debt p = primary surplus required to stabilize the debt/GDP ratio r = real interest rate g = real growth rate of GDP d = debt/GDP ratio p(1+g)=(r-g)d

10-39 Sustainability of Debt If r > g, must have primary surplus If r < g, can run deficit indefinitely Abstracts away from cyclical movements in deficit p(1+g)=(r-g)d

10-40 Summary 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.