1. MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT
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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.

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

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

4. 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

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

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

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

8. 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. 

9. Type of Goods

10. 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.

11. Pareto Optimality

12. 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?

13. Spending and taxation appear positively correlated

14. 11/29/2018
Percentage of GDP, 2000

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

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

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

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

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

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

21. 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

22. 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

23. Laffer Curve

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

25. Deficit
Debt
Debt

26. Debt
Debt
Surplus

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

28. US Deficit

29. US Deficit

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

31. Ownership of Treasury Securities, 1989

32. Ownership of US Treasuries, 2000

33. Recall ‘cost of capital’ model
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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

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

35. Intertemporal Budget Constraint
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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)

36. 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

37. 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

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

39. 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

40. 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

41. 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 = ( ) 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%

42. Sustainable Debt example
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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 = ( ) 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%

43. 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

44. 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

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

46. 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.

47. 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.