Transcript 1+ r

The government budget constraint and the
scope for fiscal policy
École des Hautes Études
Commerciales (HÉC)
January 2001
The public sector accounts
The primary balance and the debt
service
Introduction


In most countries, the government sector takes a large
share of gross national disposable income and accounts
for an important part of domestic absorption.
In this context, the government ’s decisions to tax and
spend are bound to have macroeconomic repercussions.
 If personal income taxes are increased, the
households’ disposable income falls and so should do
consumption and absorption, other things equal.
 If corporate income taxes are decreased, the firms’
after-tax earnings are higher and other things equal,
this should affect positively investment and domestic
absorption.
 At the same time, the government may affect
absorption directly by choosing to increase or decrease
its own investment and consumption spending.
The government’s budget balance




Before examining the macroeconomic repercussions of
these decisions, it is useful to look at the basics of
government budget accounting.
The government ’s overall budgetary balance (BB) is equal
to the difference between total revenues (TR) and total
expenditures (TE):
 BB = TR - TE
However, the government has little (if any) control over the
debt service in the short-run. This is why we usually
distinguish between program spending (PS) and debt
service (DS):
 BB = (TR - PS) - DS
The difference between total revenues and program
spending (TR-BS) is called the primary balance (PB), so
we write:
 BB = PB -DS
The main items of the government budget
Total revenues (R)

Tax revenue
>
>

Total expenditures (TE)

Direct taxes (household
and corporate income
taxes)
Indirect taxes (VAT,
import taxes, etc.)
Other revenue
>
Dividends paid by the
state-owned enterprises
>
Investment income (ex.:
interest on the foreign
reserve assets)

Program Spending (PS)
>
Goods and services (G
and IG)
>
Transfers and subsidies
Debt service (DS)
>
Interest paid to the
holders of government
debt (treasury bills,
bonds and other
government debt
instruments)
Surpluses and deficits

Interpretation:

The government budgetary balance would be equal to
the primary balance if the government had no debt.

The government budgetary balance is positive (and
there is a budget surplus)


when the primary balance is positive and higher than the debt
service (PB  DS).
The government budgetary balance is negative (and
there is a budget deficit)

when the primary balance is negative

or when the primary balance is positive but smaller than the
debt service (PB  DS).
A primer on fiscal policy
Keynesian fiscal policy
A primer on fiscal policy



In the short-run, only the primary balance can be affected
by government decisions.
In principle, the primary balance could be an intermediate
target by which the government aims to influence
aggregate demand and the macroeconomic equilibrium of
the economy (final target).
The instruments would be government spending and
taxes:
 If the government wants to stimulate aggregate
demand, it may reduce taxes and/or increase spending
(G and IG).


PB deteriorates and AD is higher, other things equal.
If the government wants to slow aggregate demand, it
may increase taxes and/or decrease spending (G and
IG).

PB improves and AD is lower, other things equal
P
AS
P+
AD(PB down)
P0
P-
AD0
AD(PB up)
Y-
Y0 Y+
AD = AS = Y
A primer on fiscal policy

The idea that we might use the primary balance as an
intermediate target for macroeconomic stabilization is at
the heart of what is called keynesian fiscal policy.

The keynesian idea was that the government should be
prepared to run a primary deficit in times of recession and
should revert to a primary surplus in better times.

This way, the primary balance would be zero on average
and there would be no growth in the public debt over the
economic cycle.

The problem has been that many governments have for
too long applied only the first half of the keynesian recipe
and their debt has grown at an unsustainable pace.
Keynesian fiscal policy
Primary
surplus
Booming times
0
Primary
deficit
Recessive times
Irresponsible fiscal policy
Primary
surplus
Booming times
0
Primary
deficit
Recessive times
The government budget constraint
What is sustainable and what is not
The government budget constraint


When PB < DS, the government budgetary balance is
negative, there is a budget deficit and this deficit must be
financed somehow.
Aside from monetary financing (we’ll see that later), there
are three basic sources of government deficit financing:
 The government may borrow from the domestic
residents and its domestic debt will increase (D > 0)
 The government may borrow from the foreign residents
and its foreign debt will increase (D* > 0)
 The government may sell its assets.
Deficit = D + D* - Assets
The government budget constraint
Let ’s define the total net debt (D + D* - Assets) as B.
 Since the budget deficit is equal to DS - PB, we can write:
 B = DS - PB
 Suppose there is a constant average interest rate i on the
net public debt.
 Then the debt service DS will be equal to i B and we write:
 B = i B - PB ,which in discrete time can be written as
 Bt - B t-1 = i B t-1 - PBt ,or
 Bt = (1+ i ) B t-1 - PBt
The government budget constraint


However, the size of the debt B tells us very little unless
we know the size of the economy.
Since the debt is in nominal terms, we have to compare it
to nominal GDP (YN). Let ’s define B/YN as b, PB/YN as
pb and the growth rate of nominal GDP as ng. Then we
have:
bt = (1+ i ) B t-1 - pbt
YNt
Which can be simplified to
bt = (1+ i ) b t-1 - pbt
(1+ng)
The government budget constraint

We could (but will not) show that this relationship is also
true in real terms (using r instead of i and rg - the growth
rate of real GDP - instead of gn:
bt = (1+ r ) b t-1 - pbt
(1 + rg)
Conclusion: When the real rate of interest is
higher than the real growth rate of the economy,
the debt to GDP ratio grows exponentially unless
the government runs a sufficiently high primary
balance surplus.
An exemple of explosive debt dynamics

Canadian public finances in the
middle of the 1990 ’s
At the beginning of the 1990 ’s

The government ’s financial situation was rapidly
deteriorating.

The deficit and the public debt were rising to an extent
such that raised the question of the government ’s
financial credibility.

The government ’s budgetary balance had become
extremely vulnerable to a rise in the level of interest
rates.

Financial markets were getting nervous.
The deficit was rising
The federal deficit
(public accounts, end of fiscal year)
billions $
42
37
32
27
1990
1991
1992
1993
1994
The net public debt was exploding
Public administrations net debt
(national accounts)
% of GDP
70
65
60
55
50
45
40
35
1988
1989
1990
1991
1992
1993
Year
Canada
USA
1994
1995
Debt service was taking a large share of total tax
revenues leaving little to program spending
Debt service
(% of tax revenues)
36%
Debt service
Program
spending
65%
The origin of the problem




For two decades, the government ’s net debt (ND) had
increased more rapidly than nominal GDP, that is, more
rapidly than the government ’s tax base.
Consequently, debt service had come to take a large
share of total tax revenues.
The situation was clearly unsustainable in the long run
(debt service cannot absorb 100 % of total tax revenues
- nothing would then be left for program spending -) but
in the meanwhile, the government was keeping on
borrowing.
The goodwill of financial markets had become critical
but this had some limits.
Public debt and interest rates
The analytical model
1/r
Supply = B = outstanding
stock of government bonds
r = rate of return on
government bonds
1/r0
D = Demand
Nominal
value
1/r
Supply = B = Public debt
With BB>0
With BB <0
1/r0
D = f (Sp, ra, a,  )
Nominal value
Note: Sp = private savings (depends on GDP), ra = expected rate of return on alternative assets, a=
expected rate of inflation (depends on monetary policy and other things),  = other factors , r = rate of return.
1/r
B
B’
1/r0
1/r1
D
Nominal value
Other things equal, an increase in the stock of
government bonds (from B to B’)cause an increase
in their rate of return (1/r falls)
1/r
B’
B
1/r1
1/r0
Other things equal, a fall in the stock of
government bonds (from B to B’) reduces their rate
of return (1/r increases).
D
Nominal
value
In normal times, nominal GDP grows every
year

If nominal GDP grows at the same speed as net debt
(e.g. growth rates are the same), the debt to GDP
ratio is constant.

If nominal GDP grows at a higher speed than net
debt, the debt to GDP ratio declines.

If nominal GDP grows at a lower speed than net
debt, the debt to GDP ratio increases.
The growth in nominal GDP feeds into a
higher demand for government bonds

When nominal GDP grows, so do aggregate
revenues and savings.


For a constant saving rate, savings and GDP
would grow at the same percentage rate.
With an increase in savings, the demand for all
financial assets is stimulated.

If there are no change in the way people diversify
their portfolio between bonds, stocks and other
assets, the demand for government bonds should
grow at the same speed as savings and thus at
the same speed as GDP.
When net debt grows at the same speed as
nominal GDP
1/r
B
B’
1/r0
D’
D
Nominal value
In this case, the debt to GDP ratio is constant. The
demand for bonds grows at the same speed as the
supply of bonds. Other things equal, the rate of
return on government bonds would stay constant.
What about if net debt grows more rapidly than
nominal GDP ?
1/r
B
B’
1/r0
1/r1
D’
D
Nominal value
In this case, the debt to GDP ratio increases. The
demand for bonds increases by less than the supply
of bonds. The rate of return on government bonds
must go up to clear the market.
And if net debt grows less rapidly than nominal GDP ?
1/r
B
B’
1/r1
1/r0
D’
D
Nominal value
In this case, the debt to GDP ratio decreases. The
demand for bonds increases by more than the
supply of bonds. The rate of return on government
bonds must go down to clear the market.
Eliminating the deficit

How can this be achieved ?
The equation

The budgetary balance(BB) is
equal to the difference between
the primary balance (PB) and
the debt service (DS):

For the deficit to be eliminated
(BB<0), the primary balance
(PB) must thus become equal to
or higher than the debt service
(DS).
Billions $
50
Debt service
40
30
Primary balance
20
10
0
-10
1993-1994
1994-1995
1995-1996
1996-1997
1997-1998
Predict and decide





In order to reach a budgetary target, the
government must thus reach a target
for the primary balance..
Of course, budget decisions will have
an impact on the trajectory of the debt.
They can even influence the level of
interest rates.
However, these two variables will affect
debt service payments only over time.
Predicting how much will be spent on
debt service is very important but then,
decisions have to be taken (given the
predicted growth rate of nominal GDP)
so as to reach the primary balance
target.
Predict and decide



Since the primary balance is equal to
the difference between total budget
revenues (TR) and program spending
(PS):
For the primary balance to be positive,
total revenues have to be higher than
program spending.
Given the predicted growth rate of
nominal GDP, the government has no
other choice than raising tax rates and
reducing program spending, if it wants
to eliminate the deficit.
Paul Martin’s strategy
A strategy emphasizing reductions in spending
% of GDP
18,0
17,0
Revenues
16,0
15,0
14,0
Program spending
13,0
12,0
1993-1994
1994-1995
1995-1996
1996-1997
1997-1998
The fiscal dividend


Where it comes from?
What can be done with it ?
The fiscal dividend



When the government is running a
budget surplus (BB>0), net debt (B)
falls and other things equal, the debt to
GDP ratio declines.
In nominal GDP increases, the ratio
declines even more rapidly.
Debt service (DS) can be approximated
by the following expression:
 DSt = it • Bt-1

where i represents the average interest
rate paid on the net debt
The fiscal dividend




Other things equal then, when the debt to
GDP ratio goes down so does the debts
service to GDP ratio
Since BB/YN = PB/YN - DS/YN:
 The primary balance (in % of GDP)
required to reach a given budgetary target
(in % of GDP) declines.
This means that the same budgetary balance
can be maintained while relaxing the pressure
on the primary balance. In other words, tax
rates can be reduced and/or program
spending (in % of GDP) can be increased.
Of course, the same primary balance (in % of
GDP) could be maintained but then, the
budgetary balance would keep on growing in
percentage of GDP.
Choosing among three alternatives


Three ways of allocating the fiscal dividend are
thus possible. The government can choose to:
 reduce tax rates
 increase program spending
 accelerate debt reduction through a growing
budget surplus
Each one has its set of advantages and its
opportunity costs.
 By reducing taxes and increasing program
spending, the government can reach a
number of objectives in the present but at the
expense of a lower fiscal dividend in the
future.
 By accelerating debt reduction, the
government can reach more ambitious goals
in the future but at the expense of current
objectives.
Choosing among three alternatives


The allocation of the fiscal dividend responds to
a choice between spending (reducing taxes
and/or increasing program spending) and saving
(increasing the budget surplus).
Choosing among the three alternatives is
choosing between the present and the future
trading off between short term and long term
objectives.
 Do we want to stimulate the economy in the
short run ?
 Do we want to provide more funding to
programs ranking very high in the list of
priorities ?
 Do we want to reach particular taxation
objectives ? How quickly do we want to
reach these targets ?
 Do we want to set up a cushion in the
anticipation of future spending or simply
because the future is uncertain ?
 These are some of the questions raised by
the existence of a fiscal dividend.
The government budget constraint and the
scope for fiscal policy
École des Hautes Études
Commerciales (HÉC)
January 2001