Understanding the World Economy Master in Economics and Business Fiscal policy Lecture 9 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr
Lecture 9 : Fiscal policy 1. Public spending 2. Taxation 3. Debt and deficits 4. Fiscal policy as a stabilization tool
UK public spending (% of GDP), 1900-2009 % 70 60 50 40 30 20 10 0 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 Source: UK National Income and Expenditure. ONS (Public Expenditure Statistical Analyses, 2009) Upward trend over time with major increases during war time
Government spending (% of GDP) France Germany Netherlands UK Japan US 1913 8.9 17.7 8.2 13.3 14.2 8.0 1938 23.2 42.4 21.7 28.8 30.3 19.8 1950 27.6 30.4 26.8 34.2 19.8 21.4 1974 39.3 44.6 47.9 44.8 24.5 32.1 2013 57.0 44.1 46.2 45.5 42.4 38.7 Common international pattern although level of spending varies across countries. Source: Maddison (1991) updated from OECD (2015) and DataStream international sources
Korea Estonia United States Russia Ireland Slovak Republic Israel Czech Republic Japan Luxembourg Norway Iceland Germany Spain United Kingdom Netherlands Hungary Portugal Italy Austria Sweden Belgium France Denmark Finland 70 60 50 40 30 20 10 0 Total Government Spending (% of GDP) (sample of OECD countries) Source OECD
Motives for government spending 1. Collective provision of goods and services, e.g. Defence Law and order Education and health Roads Current expenditure on goods and services and public investment. Part of value added = GDP. 2. Redistribution of income between individuals Pensions Unemployment benefits Support for families Transfer payments. Do not contribute to GDP.
U.S. Federal Government Spending, by Category (2011) National Defense Health (including Medicare) Expenditure on goods and services Other expenditures Social Security Income Security Transfer payments Net interest payment In the U.S., transfers account for almost half of the federal budget. This number is even higher in Europe (almost 60 %).
Why do some governments spend more than others? Public spending is 30% in Korea, 35-40% in US, 45-60% in Europe. Certain level of spending required for national defence, law and order, basic education, etc Beyond that, the level of spending is a matter for political choice about the level of collective provision. Collective spending appears to be a luxury good - as incomes rise, we tend to spend an increasing proportion of it collectively. Tax revenue is a key constraint for developing countries.
The Fiscal Problem of the 21 st Century Annual average growth in real per capita expenditure on health and GDP, 1995 to 2005 Source: Health Data, OECD (2007)
Is big government bad for growth? Not necessarily. Stupid government is bad for growth. Big government can be stupid on a bigger scale. No simple correlation between government size and economic growth or investment rate - at least among OECD countries. It is what the government spends money on and how it delivers services that matter.
Government spending and growth - 8% is there a relationship? (OECD Countries, 1970-2007 ) ) 7% SVK GDP growth (annual, per capita 6% 5% 4% 3% 2% 1% KOR MEX JAP IRE ESP POR ICE GRE AUS USA SWI LUX UK IT CAN NWZ POL CZE NOR FIN AUT BLG FRA GER NET DEN HUN SWE 0% 15% 20% 25% 30% 35% 40% 45% 50% 55% Source: OECD (2009) Government spending (% GDP)
Lecture 9 : Fiscal policy 1. Public spending 2. Taxation 3. Debt and deficits 4. Fiscal policy as a stabilization tool
60 50 40 30 20 10 0 Total Government Revenues (% of GDP) (OECD countries) Mexico Korea United States Switzerland Japan Australia Ireland Israel Spain Canada Estonia Poland Slovak Republic New Zealand United Kingdom Russia Czech Republic Iceland Luxembourg Netherlands Germany Portugal Slovenia Hungary Greece Italy Austria Belgium Sweden France Finland Norway Denmark Source OECD
Relative importance of different taxes (Average across OECD countries) Other taxes Specific consumption taxes General consumption taxes Personal income tax Corporate income tax Property and wealth taxes Payroll taxes Social security contributions: employer Social security contributions: employee Source: OECD Economic Outlook 2008
Principles of taxation Pigouvian taxes market prices are socially undesirable and need to be altered to improve outcomes (e.g pollution externality when buying gas so impose petrol taxes). Ramsey Taxes need to raise revenue to finance desired government expenditure and want to raise taxes in a way that distorts the economy the least. Which goods to tax? Tax items lightly where peoples decisions are very responsive to tax rates. Tax heavily when they do not respond (alcohol, petrol and cigarettes). Redistribution marginal utility of an extra dollar higher for the poor.
Taxation and revenue While low taxes lead to low distortions they don t produce much revenue. But do high taxes necessarily produce high revenue? High rates of tax on earned income discourage productive effort because: - People work less hard - They spend their time trying to avoid tax - Brightest people leave the country If supply effects strong then cutting taxes may increase revenue VOODOO economics!
A simple model of the labour supply Suppose the government taxes labour income at rate. Government revenues: = With the aggregate supply of labour and the average wage. Workers earn 1. Suppose that the supply of labour of workers is jncreasing in the wage net of taxes as follows ( and positive numbers): = [ 1 ] measures the elasticity of labour supply to the wage rate (net of taxes). Revenues are non monotonic w.r.t the tax rate : () = 1 ( )
Taxes and revenues: Laffer Curve Revenues R() Low elasticity High elasticity 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Tax rate
The Laffer curve Is there any truth behind the Laffer curve? - Yes, beyond a certain point higher tax rates bring in less revenue. - But this is likely to be very high - estimates suggest above 75% Politicians love voodoo economics Reagan tried it out in practise: - Tax cuts led to huge deficit - supply side effects small - However for very wealthy/high income earners a Laffer curve does operate (e.g. football players)
Lecture 9 : Fiscal policy 1. Public spending 2. Taxation 3. Debt and deficits 4. Fiscal policy as a stabilization tool
Government revenues and spending(% of GDP) (OECD countries, 2013) 60 NOR DEN Total Government Revenues (% of GDP) 50 40 FRA KOR U.S. 30 30 40 50 60 Total Government Spending (% of GDP) Most countries have higher spending than tax revenues.
Fiscal deficit Each period, the government earns revenues through taxation and has some public spending. Taxation and spending do not have to balance since government can borrow (or accumulate assets). The primary fiscal deficit is the difference between spending and tax revenues (government surplus the opposite) Primary deficit = = Government surplus The (total) fiscal deficit also includes interest payment from previously accumulated debt Total fiscal deficit = + Net interest payments Ex: A country with a 3% total deficit but debt of 100% GDP and an interest rate of 7% has interest payments of 7% of GDP. Therefore it will have a primary deficit of -4% e.g it will be running a primary surplus.
Total Government Surplus (% GDP) 8 4 Germany 0 France -4 US -8 Japan -12 UK -16 2011 2012 2013 2014 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: OECD Economic Outlook 2015
Fiscal deficit over time Why do fiscal deficit change from year to year? Automatic Stabilisers: As economy expands and contracts so does the tax revenue. Also more modest effect on expenditure unemployment benefits rise in downturn. Therefore deficit becomes larger in recession and falls in a boom Discretionary Policy: In response to an economic slowdown the government may deliberately choose to cut taxes and increase expenditure. Once again this makes the deficit countercyclical. Government spending shock : war, natural disaster
Debt and deficits Every period the government runs a deficit its debt increases. Consider a government entering periodwith debt Pays net interests on existing debt and runs a fiscal deficit. Thus next period debt: = + + = (1+ ) + Total fiscal deficit
How does government debt accumulate? = (1+ ) + Debt tomorrow at end of period is high if: Higher debt yesterday at date 1 Higher interest rate on debt Higher fiscal deficit Useful to compute debt over GDP. Divide previous expression by! --- assuming GDP grows at rate":! = (1+")! # $ %#& $ = (')# $() %#& $ + % $* $ %#& $ = ( ' + ) # $() %#& $() + % $* $ %#& $
Sustainable debt = ( 1+! 1+" ) +!! ( # $ %#& $ # $() %#& $() ) ( ") # $() %#& $() + % $* $ %#& $ Suppose debt over GDP is constant equal to # %#& : # %#& " = * $% $ %#& $ = Primary surplus over GDP In other words the government needs to run a primary surplus to cover the excess of interest payments over GDP growth. Intuition? The debt is said sustainable if," and the primary surplus such that the debt over GDP stays constant.
Sustainable debt To keep debt levels constant fiscal policy needs to generate primary surplus/gdp = #. " If > " government has to run a primary surplus in order to control the Debt/GDP ratio. If < " then government can run a deficit (of a certain size) without seeing Debt/GDP ratio increase. Shifts in interest rates and growth rates have big impact on government debt dynamics. If r increases with Debt/GDP and higher r leads to lower g then countries can rapidly find their public finances deteriorating.
Application --- Debt sustainability in Greece in 2010 r-g Primary Balance 2010 Debt GDP 2010-0.12-0.08-0.04 0-14.80-9.86-4.93 0.00 Greece -9.8 123.3 0.04 0.08 0.12 0.16 Source: OECD Economic Outlook, 2010 4.93 9.86 14.80 19.73 Table shows primary surpluses needed (for different values r-g) to stabilise Greece s debt level at 2010 value.
180 160 140 120 100 80 60 40 Government debt, interest rate and growth in Greece Public debtover GDP in % GrowthRate and InterestRate (in %) 1995 1995 1996 1996 2012 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2013 2014 2013 2014 25 20 15 10 5 0-5 -10-15 GDP growth Long term interest rate (10 y)
160 140 120 100 80 60 40 Government debt, interest rate and growth in Portugal 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 15 10 5 0-5 Public debtover GDP in % GrowthRate and InterestRate (in %) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 GDP growth Long term interest rate (10 y)
Lecture 9 : Fiscal policy 1. Public spending 2. Taxation 3. Debt and deficits 4. Fiscal policy as a stabilization tool
Fiscal policy as stabilization tool Previous lecture we saw how monetary policy can be used to stabilize output. Similarly, the government can rely on fiscal policy: in period of recession, increase government spending or reduce taxes to boost aggregate demand. Less used than monetary policy for practical reasons: (1)Recognition lag. Economic info. about yesterday, not today (2)Decision/implementation lag. Making up your mind (3)Impact lag. It takes time before a change in policy affects demand. (2) particularly important for fiscal policy. Might end up fuelling the next expansion. Fiscal policy still used in desperate times (last recession).
Fiscal policy and aggregate demand Prices Aggregate Demand Curve Short Run Supply Curve Fiscal expansion Output
Fiscal Response to the crisis Source OECD
Keynesian Fiscal Multiplier Keynes advocated used of fiscal policy to boost demand in the economy. Based around National Accounts Identity: Y = C + I + G + X M Lets ignore for now I and X-M and assume that C = a +b(y-t) in other words consumption depends on disposable income after tax. Therefore: Y = a/(1-b) bt/(1-b) + G/(1-b)
Keynesian Fiscal Multiplier Y = a/(1-b) bt/(1-b) + G/(1-b) Therefore raising G by $1bn would boost GDP by $[1/(1-b)]bn. If b=0.6 this is $2.5bn. Huge impact. Cutting taxes by $1bn would boost GDP by $[b/(1-b)]bn. If b=0.6 this is $1.5bn. Famous fiscal multiplier. If I spend $1 this appears as someones income. They then spend $b which appears as someones income and so they spend $(b 2 ) etc Total impact on economy is $(1+b+ b 2 +b 3 +...) = $1/(1-b)
Fiscal Multiplier Estimate
Fiscal Multiplier Estimate Range for US cumulative fiscal multipliers
Why might fiscal multiplier not work? Crowding out - Higher fiscal deficits crowds out consumption consumers save in expectation of future tax increases (Ricardian Equivalence). - Government Expenditure crowds out investment as increased borrowing leads to higher borrowing costs and less investment. Higher G Higher debt Higher Lower I(r) - Government expenditure crowds out net exports (external demand). Cf. next lectures.
Ricardian equivalence Modigliani-Miller for governments economy not affected by way government finances its activities Government can either finance its expenditure through current taxes or issuing debt but debt is just postponed taxes. When governments cut taxes consumers are not better off just face a delay in when they pay taxes. Therefore in response to government borrowing consumers save more possible for multiplier to be zero.
Ricardian equivalence Remember the 2-period model of lecture 7 (no financial frictions). U = log(c) +β log(7 8 ) with 0 < β < 1 Intertemporal budget constraint (consumer): 7 + 78 1+ = : + :8 8 1+ = ; Consumption path assuming β(1+r)=1 7 8 = 7 = ;/(1+β) Add government expenditure " (period 1) and " 8 (period 2). Intertemporal budget constraint (government): " + "8 1+ = + 8 1+ 7 8 = 7 = 1 1+β : + :8 8 1+ = 1 1+β : " + :8 " 8 1+
Ricardian equivalence 7 8 = 7 = 1 1+β : " + :8 " 8 1+ Permanent income consumer: path of taxes does not matter for consumption. Only their discounted sum matter = Ricardian equivalence A fall in public savings due to a tax cut is fully offset by a rise in private savings. Aggregate demand unchanged. Potential failure of Ricardian Equivalence? - Myopic consumers. - Future generations pay the burden of current deficits. - Financial frictions (borrowing constraints)
Ricardian Equivalence Is it True? Private and public saving: raw correlations 1 Data suggests around 50% crowding out on average Source: OECD 2002
Fiscal austerity Fiscal plans during the last financial crisis typical of a countercyclical fiscal policy. Fiscal tools used to stimulate aggegate demand in a slump. Still implies reducing deficits later as government cannot run very large deficits forever and needs to pay back the debt. = Fiscal austerity. Fiscal austerity when a country has recovered from the recession is not so painful. Lowers aggregate demand when it is high. Fiscal austerity very costly if country still in a slump. Output and demand are already low and governments are reducing further aggregate demand to reduce debt and deficits in order to stabilize public finance.
Fiscal austerity and sovereign debt crisis in Eurozone In Southern Europe, procyclical fiscal policy. Output and demand are low but governments searching to reduce debt and deficits to stabilize public finance. e.g. in Greece, primary deficit improved by 10% of GDP since 2009. This leads to even lower output and lower growth. Countries facing high interest rate and low growth see their debt quickly exploding (e.g. Greece).
Summary Government expenditure can be justified by market failure. Richer countries tend to spend more through their government and mainly on transfer payments. Taxes are used to correct for market failures or to raise revenue. Efficient taxes avoid taxing elastic commodities. Depending upon interest rates and growth governments can continually run a deficit without seeing debt to GDP increase. Fiscal tools can be used to stabilize output fluctuations. Fiscal deficits can have an expansionary effect on economy but controversies around the value of the fiscal multiplier.