Fiscal Policy. Fiscal policy concepts. Chris Edmond NYU Stern. Today. Government budget constraint. Fiscal policy. Expenditure. Spring 2008.
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1 Fiscal policy concepts Fiscal policy Fiscal Policy Chris Edmond NYU Stern Spring 2008 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, tariffs, etc social security contributions 1 3 Today Government budget constraint 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 Period-by-period expenditure = income In particular G t + V t + rb t = T t +(B t+1 B t ) where G t = government purchases of goods and services V t = transfer payments from government to households T t = tax revenue B t = government debt ( bonds ) 2 4
2 Category US government amount (billions) Total receipts 4,180 tax receipts 2,949 social insurance 979 other 252 Total expenditure 4,413 government consumption 2,222 government investment 468 transfers 1,742 interest payments 401 balancing item -420 Federal receipts Category billions share Individual income taxes 1,005 1, Corporate income taxes Social insurance & retirement Excise taxes Other Total revenue 2,026 2, Deficit Government receipts Government expenditure tax receipts govt consumption social insurance transfers other interest payments govt investment 6 8
3 Federal expenditure Government deficit Category billions share National defense Health Medicare Income security Social security Net interest Other Total revenue 1,789 2, Government deficit equals increase in government debt B t+1 B t = G t + V t T t + rb t Primary deficit equals government deficit less interest payments government deficit = G t + V t T t + rb t primary deficit = G t + V t T t interest payments = rb t 9 11 Receipts vs. expenditure Government deficit expenditure receipts govt deficit 10 12
4 Interest payments Federal debt interest payments gross federal debt govt deficit Primary deficit Cross-country comparisons interest payments primary deficit Which countries are big spenders? big taxers? borrowing a lot? very indebted? Fiscal policy indicators spending, revenue, deficit, debt (all scaled by GDP) govt deficit 14 16
5 Fiscal indicators (all as percentage of GDP) Fiscal policy principles Country Spending Revenue Deficit Debt Canada Czech France Germany Japan Korea Sweden UK US ,5 OECD 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 affect incentives to work and save? who/what should be taxed? how high should taxes be? should taxes respond to war? business cycle? demographics? What have we learned so far? Can governments keep running up debt? Fiscal policy Deficit decisions to spend, raise revenue, issue debt government expenditures less revenues change in government debt primary deficit + interest payments Government budget constraint G t + V t + rb t = T t +(B t+1 B t ) Government borrowing today implies interest cost tomorrow Get complete complete picture, rollover period budget constraints Result is the government s intertemporal budget constraint 18 20
6 Digression on present values If interest rate is r>0, present value of a dollar in t periods ( 1 ) t Present value of a flow that pays X t at t is t=0 ( ) 1 t X t Simple example: if X t = X all t, then t=0 ( ) 1 t X = X r This period (B t+1 + X t ) And next period Iterating forward B t+1 = 1 (B t+2 + X t+1 ) Iterate forward Keep doing this many times ( 1 ) (B t+2 + X t+1 )+X t Debt dynamics Intertemporal budget constraint Define primary government surplus X t T t G t V t Then government budget constraint is B t+1 B t = rb t X t Rearrange to get (B t+1 + X t ) And next period After some S +1iterations, we get B t = As S, we get... ( ) 1 S+1 B t+s s=0 ( ) 1 s X t+s S s=0 ( ) 1 s X t+s B t+1 = 1 (B t+2 + X t+1 ) 22 24
7 Discussion Debt sustainability Simple model Intertemporal budget constraint Implications s=0 ( ) 1 s X t+s debt is present value of future primary surpluses debt is current promise to make future payments current deficit must be offset by future surpluses so a deficit-financed tax cut now means...? Government budget constraint B t+1 B t = rb t + G t + V t T t Real output grows at rate g Y t+1 = (1 + g)y t Primary surplus/deficit is given exogenously b t B t Y t x t T t G t V t Y t Problems Debt sustainability Intertemporal budget constraint Implications s=0 ( ) 1 s X t+s can we always rollover period-by-period budgets? what if government promise to repay is not credible? other problems? Debt/output dynamics b t+1 b t = r g 1+g b t 1 1+g x t Simple example, x t = x all t b t+1 b t = r g 1+g b t 1 1+g x Sustainable steady-state debt/output ratio b = 1 r g x 26 28
8 Example Incentive effects Steady-state debt/output ratio b = 1 r g x Example: US debt/output ratio is If g =0.02 and r =0.05, what surplus is needed to sustain this indefinitely? Answer x = (r g)b = ( )0.60 = Most taxes affect incentives taxes on labor income affect decisions to work taxes on capital income affect decisions to save/invest distort allocations of scare resources, inefficient Lump-sum or poll taxes do not affect intensive margin how much does that matter? efficiency vs. equity? A primary surplus of 1.8% of GDP Question: what if g > r? Taxation London, May 1990 poll tax protests/riots Trafalgar Square Tax instruments labor income taxes capital income taxes consumption taxes, sales taxes, value-added taxes others? 30 32
9 Labor supply redux Individual i works or not l i =1, 0 Utility function over consumption c i and work l i u(c i,l i ) = log(c i ) θ i l i, θ i > 0 Budget constraint c i = (1 t)wl i + A i T labor income tax t lump-sum tax T Substitute into utility function Principles of taxation What causes the least inefficiency? 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? very elastic supply in long run very inelastic supply in short run u(l i ) = log[(1 t)wl i + A i T ] θ i l i Utility from working Reservation wages redux u(l i ) = log[(1 t)wl i + A i T ] θ i l i Work if utility from l i =1is higher than from l i =0 log[(1 t)w + A i T ] θ i log[a i T ] Implies a reservation wage, work if where w i w w i = 1 1 t (eθ i 1)(A i T ) Individuals work if wage w is higher than their reservation w i higher reservation w i if labor income tax t high lower reservation w i if lump sum tax T high lump-sum taxes do affect extensive margin 34 Sources of tax revenue, share of total Country Personal Corporate Social sec. Property Sales/VAT Canada Czech France Germany Japan Korea Sweden UK US OECD
10 War finance Demographics What are the fiscal implications of demographic changes? How should wars be financed? raise taxes? issue debt? Run deficit during war, issue debt tax smoothing but repay debt by running surpluses in peacetime Problems? 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? Business cycles Talking points 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 The longer the deficit, the larger the tax burden in future Do you agree? yes, if you mean T t, not necessarily if you mean T t /Y t if you mean the latter, answer depends on r vs. g 38 40
11 Talking points Social security a social insurance program, e.g., disability not a retirement account can we compare returns on social security with other returns? 41 Government deficit What have we learned today? 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 efficiency 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 42
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