Fiscal Policy

Chris EdmondNYU Stern

Spring 2007

1

Agenda

• Fiscal policy indicators

– revenue: taxes, issuing debt– expenditure: purchases, transfers and interest payments

• Fiscal policy principles

– government’s ‘intertemporal’ budget constraint– deficits and debt sustainability– principles of taxation, debt management

2

Fiscal policy concepts

• Fiscal policy

– government decisions to spend, raise revenue, and issue debt

• Expenditure

– purchases of goods and services (consumption + investment)(schools, police, courts, military, roads)

– transfers to households and firms(social security outlays, health care)

– interest payments to holders of government debt

• Revenue

– personal and corporate income taxes, tari!s, etc– social security contributions

3

Government budget constraint

• Period-by-period

expenditure = income

• In particular

Gt + Vt + rBt = Tt + (Bt+1 !Bt)

where

Gt = government purchases of goods and servicesVt = transfer payments from government to householdsTt = tax revenueBt = government debt (‘bonds’)

4

US government

CATEGORY AMOUNT (BILLIONS)

Total receipts 3,208.2

Tax receipts 2,169.9

Social insurance 822.2

Other 216.1

Total expenditure 3,620.6

Government consumption 1,843.4

Government investment 372.5

Transfers 1,423.4

Interest payments 310.3

Balancing item -329.0

Deficit -412.4

Source: Bureau of Economic Analysis, 2004

5

Government receipts

0.00

0.05

0.10

0.15

0.20

0.25

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

share of GDP

tax receipts

social insurance

other

Source: Bureau of Economic Analysis, 2004

6

Federal receipts

Category Billions of dollars Percentage of total

2000 2004 2000 2004

Individual income taxes 1,004.5 765.4 50 43

Corporate income taxes 207.3 168.7 10 9

Social insurance & retirement 652.9 732.4 32 41

Excise taxes 68.9 70.8 3 4

Other 91.6 60.8 5 3

Total revenue 2,025.2 1,798.1 100 100

Source: Statistical Abstract of the United States, 2004-2005

7

Government expenditure

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

share of GDP

govt consumption

govt investment

transfers

interest payments

Source: Bureau of Economic Analysis, 2004

8

Federal expenditure

Component Billions of dollars Percentage of total

2000 2004 2000 2004

National defense 294.5 453.7 17 20

Health 154.5 243.5 9 11

Medicare 197.1 270.5 11 12

Income security 253.6 339.5 14 15

Social security 409.4 496.2 23 21

Net interest 223.0 156.3 13 7

Other 256.7 359.3 14 15

Total outlays 1,788.8 2,319.0 100 100

Source: Statistical Abstract of the United States, 2004-2005

9

Receipts vs. expenditure

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

share of GDP

expenditure

receipts

Source: Bureau of Economic Analysis, 2004

10

Government deficit

• Government deficit equals increase in government debt

Bt+1 !Bt = Gt + Vt ! Tt + rBt

• ‘Primary deficit’ equals government deficit less interest payments

government deficit = Gt + Vt ! Tt + rBt

primary deficit = Gt + Vt ! Tt

interest payments = rBt

11

Government deficit

-0.15

-0.10

-0.05

0.00

0.05

0.10

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

share of GDP

govt deficit

Source: Bureau of Economic Analysis, 2004

12

Interest payments

-0.15

-0.10

-0.05

0.00

0.05

0.10

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

share of GDP

interest payments

govt deficit

Source: Bureau of Economic Analysis, 2004

13

Primary deficit

-0.15

-0.10

-0.05

0.00

0.05

0.10

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

share of GDP

primary deficit

govt deficit

interest payments

Source: Bureau of Economic Analysis, 2004

14

Federal debt

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1938 1943 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003

share of GDP

debt

Source: Bureau of Economic Analysis, 2004

15

Cross-country comparisons

• Which countries are

– big spenders? big taxers?– borrowing a lot?– very indebted?

• Fiscal policy indicators

– spending, revenue, deficit, debt (all scaled by GDP)

16

Fiscal indicators (all as percentage of GDP)

Country Spending Revenue Deficit Debt

Canada 39.4 40.6 +1.1 70.6

Czech 46.1 41.7 -4.3 39.1

France 54.5 50.7 -3.7 74.0

Germany 47.8 43.9 -3.9 67.0

Japan 36.7 30.2 -6.5 163.5

Korea 27.9 31.3 +3.4 19.3

Sweden 57.5 58.0 +0.5 61.2

UK 44.4 41.2 -3.2 43.4

US 35.6 31.2 -4.4 63,5

OECD 40.6 37.1 -3.5 76.8

Source: OECD Economic Outlook, 2005

17

What have we learned so far?

• Fiscal policy

– decisions to spend, raise revenue, issue debt

• Deficit

– government expenditures less revenues– change in government debt– ‘primary’ deficit + interest payments

18

Fiscal policy principles

• Intertemporal budget constraint

– implications of rolling over the period-by-period constraint

• Deficits and debt sustainability

– how much government debt is sustainable?

• Principles of taxation and debt management

– how do taxes a!ect incentives to work and save?– who/what should be taxed? how high should taxes be?– should taxes respond to war? business cycle? demographics?

19

Can governments keep running up debt?

• Government budget constraint

Gt + Vt + rBt = Tt + (Bt+1 !Bt)

• Government borrowing today implies interest cost tomorrow

• To get complete complete picture, ‘rollover’ these period-by-period budget constraints

• Result is the government’s intertemporal budget constraint

20

Digression on present values

• If interest rate is r > 0, present value of a dollar in t periods!

11 + r

"t

• Present value of a flow that pays Xt at t is

!#

t=0

!1

1 + r

"t

Xt

• Simple example: if Xt = X all t, then

!#

t=0

!1

1 + r

"t

X =1 + r

rX

21

Debt dynamics

• Define primary government surplus

Xt " Tt !Gt ! Vt

• Then government budget constraint is

Bt+1 !Bt = rBt !Xt

22

Debt dynamics

• Define primary government surplus

Xt " Tt !Gt ! Vt

• Then government budget constraint is

Bt+1 !Bt = rBt !Xt

• Rearrange to get

Bt =1

1 + r(Bt+1 + Xt)

23

Debt dynamics

• Define primary government surplus

Xt " Tt !Gt ! Vt

• Then government budget constraint is

Bt+1 !Bt = rBt !Xt

• Rearrange to get

Bt =1

1 + r(Bt+1 + Xt)

• And next period

Bt+1 =1

1 + r(Bt+2 + Xt+1)

24

Iterating forward

• This period

Bt =1

1 + r(Bt+1 + Xt)

• And next period

Bt+1 =1

1 + r(Bt+2 + Xt+1)

25

Iterating forward

• This period

Bt =1

1 + r(Bt+1 + Xt)

• And next period, etc,

Bt+1 =1

1 + r(Bt+2 + Xt+1)

• Iterate forward

Bt =1

1 + r

!1

1 + r(Bt+2 + Xt+1) + Xt

"

• Keep doing this many times

26

Intertemporal budget constraint

• After some S + 1 iterations, we get

Bt =!

11 + r

"S+1

Bt+S+1 +1

1 + r

S#

s=0

!1

1 + r

"s

Xt+s

27

Intertemporal budget constraint

• After some S + 1 iterations, we get

Bt =!

11 + r

"S+1

Bt+S+1 +1

1 + r

S#

s=0

!1

1 + r

"s

Xt+s

• As S #$, we get . . .

Bt =1

1 + r

!#

s=0

!1

1 + r

"s

Xt+s

28

Discussion

• Intertemporal budget constraint

Bt =1

1 + r

!#

s=0

!1

1 + r

"s

Xt+s

• Implications

– debt is present value of future primary surpluses– debt is current promise to make future payments– current deficit must be o!set by future surpluses– so a deficit-financed tax cut now means . . . ?

29

Problems

• Intertemporal budget constraint

Bt =1

1 + r

!#

s=0

!1

1 + r

"s

Xt+s

• Implications:

– can we always rollover period-by-period budgets?– what if government promise to repay is not credible?– other problems?

30

Debt sustainability

• Simple model

– government budget constraint

Bt+1 !Bt = rBt + Gt + Vt ! Tt

– real output grows at rate g

Yt+1 = (1 + g)Yt

– primary deficit/surplus is given exogenously

bt " Bt

Yt

xt " Gt + Vt ! Tt

Yt

31

Debt sustainability

• Debt/output dynamics

bt+1 ! bt =r ! g

1 + gbt !

11 + g

xt

(see notes for details)

• Simple example, xt = x all t

bt+1 ! bt =r ! g

1 + gbt !

11 + g

x

• Steady state debt/output ratio

b =1

r ! gx

(‘sustainable’)

32

Example

• Steady-state debt/output ratio

b =1

r ! gx

• Example: US debt/output ratio is 0.60. If g = 0.02 and r = 0.05, what surplus isneeded to sustain this indefinitely? Answer:

x = (r ! g)b= (0.05! 0.02)0.60= 0.018

A primary surplus of 1.8% of GDP.

• Question: what if g > r?

33

Taxation

• Tax instruments

– labor income taxes– capital income taxes– consumption taxes, sales taxes, value-added taxes– others?

34

Incentive e!ects

• Most taxes a!ect incentives

– taxes on labor income a!ect decisions to work– taxes on capital income a!ect decisions to save/invest– distort allocations of scare resources, ine"cient

• ‘Lump-sum’ or ‘poll’ taxes do not a!ect incentives

– how much does that matter?– e"ciency vs. equity?

35

London, May 1990

poll tax protests/riotsTrafalgar Square

36

Principles of taxation

• What causes the least ine"ciency?

– tax things with relatively ‘inelastic’ demand or supply(cigarettes, alcohol, etc)

– use large base to keep tax rates low(minimize deductions, exceptions)

• Should we tax capital?

37

Principles of taxation

• What causes the least ine"ciency?

– tax things with relatively ‘inelastic’ demand or supply(cigarettes, alcohol, etc)

– use large base to keep tax rates low(minimize deductions, exceptions)

• Should we tax capital?

– as little as possible: very elastic supply in long run– problem: very inelastic supply in short run, so governments are tempted

38

Sources of tax revenue, share of total

Country Personal Corporate Social sec. Property Sales/VAT

Canada 35.0 10.1 17.2 9.8 26.3

Czech 12.8 11.8 44.1 1.5 29.7

France 17.3 6.6 39.5 7.5 25.4

Germany 25.1 2.9 40.3 2.3 29.2

Japan 18.4 12.2 38.3 10.8 20.1

Korea 12.8 12.8 19.1 12.7 38.8

Sweden 30.4 4.8 34.4 3.2 26.4

UK 29.8 8.1 17.0 12.0 32.7

US 37.7 6.7 26.1 11.9 17.6

OECD 25.7 9.4 26.3 5.5 31.9

Source: OECD Economic Outlook, 2005

39

War finance

• How should wars be financed?

– raise taxes?– issue debt?

40

War finance

• How should wars be financed?

– raise taxes?– issue debt?

• Should run deficit during war, issue debt

– tax smoothing– repay debt by running surpluses in peacetime

• Problems?

41

Business cycles

• How should fiscal policy react to business cycle?

– cut taxes in recession?– raise taxes in boom?

42

Business cycles

• How should fiscal policy react to business cycle?

– cut taxes in recession?– raise taxes in boom?

• Fiscal policy is too clumsy for ‘active’ management

– takes time to pass legislation– instead rely on ‘automatic stabilizers’ and monetary policy

43

Demographics

• What are the fiscal implications of demographic changes?

• How should government respond to aging population?

• Issues

– increasing dependency ratio (more retirees per working person)– unfunded liabilities (social security, medicare obligations)– what are our intergenerational obligations?

• What are the right policy responses?

– tax increases?– benefit cuts?– more debt?– immigration?

44

Talking points

• The longer the deficit continues, the larger the tax burden on future taxpayers.

• Do you agree?

45

Talking points

• The longer the deficit continues, the larger the tax burden on future taxpayers.

• Do you agree?

– yes, if you mean Tt, not necessarily if you mean Tt/Yt

– if you mean the latter, answer depends on r vs. g

46

Talking points

• Social security

– a social insurance program (e.g., disability)– not a retirement account– if so, should we compare ‘returns’ on social security with returns on other

investments?

47

What have we learned today?

• Government deficit

– change in government debt, ‘primary’ deficit + interest

• Intertemporal budget constraint

– debt is present value of future primary surpluses– implications for debt sustainability

• Principles of taxation

– tax inelastic goods and services to minimize e"ciency losses– use large base to keep tax rates low– tax smoothing: run deficits in wartime, don’t use fiscal policy to actively manage

business cycle

48