Transcript Lecture 1: Macroeconomic Management and Fiscal Policy

Thorvaldur Gylfason
Joint Vienna Institute/IMF Institute
August 24–September 4, 2009
1. Objectives and uses of fiscal policy
 Stabilization
 Allocation
 Distribution
2. Risks associated with fiscal policy
 Sustainability
of public debt
 Role of fiscal policy in crises
 Exit strategies when things go wrong
3. Fiscal reforms
1. The term fiscal policy refers to the use
of public finance instruments to
influence the working of the economic
system to maximize economic welfare
2. Effects of fiscal policy reflect not only
the impact of the fiscal balance, but
also various elements of taxation,
spending, and budget financing
3. Assessing the stance of fiscal policy
requires taking account of the activities
of all levels of government
1. Stabilization


Fiscal policy influences aggregate demand

Directly because Y = C + I + G + X – Z

Indirectly because C depends on income after tax
Through demand, fiscal policy affects output,
employment, inflation, balance of payments
2. Allocation

Fiscal policy also influences aggregate supply
 Public
infrastructure, education, health care
3. Distribution

Through taxes, transfers, and expenditures
 Progressive,
neutral, regressive
Fiscal policy can be used to several ends


To achieve internal balance



To promote external balance



By ensuring sustainable current account balance
By reducing risk of external crisis
To promote economic growth


By adjusting aggregate demand to available supply
By achieving low inflation, potential output
E.g., through more and better education and health care
Fiscal policy needs to be coordinated with
monetary, exchange rate, and structural –
i.e., supply-side – policies
Demand management
E.g., lower income taxes
Price level
Aggregate supply
in short run
B
A
Aggregate
demand
Output
Demand management
Supply management
E.g., lower income taxes
E.g., lower import tariffs
Price level
Price level
Aggregate supply
in short run
B
Aggregate supply
in short run
A
A
Aggregate
demand
Output
B
Aggregate
demand
Output
National income accounts




Y=C+I+G+X–Z
S = Y – T – C = I + G – T + X – Z, so
G–T=S–I+Z–X

Y = GDP
C = Consumption
I = Investment
G = Government expenditure
(plus lending minus repayments)
T = Taxes (plus grants)
X = Exports
Z = Imports
B = Government bonds outstanding
DG = Credit from banking system
DF = Credit from foreigners
Government budget deficit must be financed either by
(a) having private saving in excess of private investment
or (b) by accumulating foreign debt through a deficit in
the current account of the balance of payments, or both
Alternative formulation


G – T = B + DG + DF

Government budget deficit must be financed by
borrowing either at home or abroad, i.e., from (a) the
public, (b) the banking system, or (c) foreigners
 Central

Inflation tax: Most inflationary form of financing
 Bond



bank financing involves money creation
finance is less inflationary
Removes financial resources from circulation
Increases real interest rates
Crowds out investment
 External

Especially if it leads to currency depreciation
 Evidence


financing can be inflationary
from cross-country data
Strong links between budget deficits and inflation in
developing countries, but not in industrial countries
Bond finance, not money finance, is the rule in
industrial countries
Conventional budget surplus


T–G


Large in upswings when tax base (Y) is strong
Small in downswings when tax base is weak
Full-employment surplus


TFE – G




Use tax revenue as it would be
at full employment
Independent of business cycles
A budget in deficit could be in
surplus with full employment
Deficit can be consistent with
a tight fiscal stance (see chart)
T, G
T
G
Y < YFE
YFE
Y
Public sector borrowing requirement


Broad measure of public sector deficit, including
central, state, and local government
Primary budget balance


Leaves out interest payments


Conventional deficit = G – T = GN + GI – T = GN + iDG - T
Primary deficit = GN – T = G – T – iDG
GN = Noninterest expenditure
GI = Interest expenditure
i = Nominal interest rate
DG = Government debt outstanding
Operational deficit


Leaves out inflation component of interest payments




Operational deficit = conventional deficit minus inflation
component of interest payments = primary deficit plus
real component of interest payments
GN = Noninterest expenditure
Conventional deficit:
GI = Interest expenditure
N
G
N
G
 G – T = G + iD – T = G + (r + p)D – T
r = Real interest rate
DG = Government debt
Operational deficit:
p = Inflation rate
 G – T - pDG = GN – T + rDG
Hence, operational deficit includes only real part of
interest payments, leaves out the inflation part
Before Great Depression 1929-39, many
thought that governments needed to
balance their budgets from year to year



Even so, US had built is railways through
borrowing, for example
Keynes revolted (General Theory 1936)
If private sector failed to consume and invest,
government could fill the gap
Y = C + I + G + X – Z
 C and I and G appear side by side
 Guns or butter? Makes no difference
 Also, could reduce taxes to encourage C and I

Multiplier analysis




It could be shown that, with unemployed
resources, an increase in G would raise Y by an
amount greater than the original increase in G
Active fiscal policy was used consciously
in Sweden even before Keynes …
… and adopted in US and elsewhere after
1960 (Kennedy-Johnson administration)
Coincided with buildup of US as a welfare state
with greater emphasis on public services and
social security, like in Europe
 Active fiscal policy came naturally to Europe

Fiscal policy can affect





Aggregate demand, output, and price level
 Cut taxes: Consumption, output, and prices rise
Rate of monetary expansion and inflation
 Increase spending financed by credit expansion:
Money expands (M = D + R), so inflation goes up
Aggregate supply and economic growth
 Boost education and health care: Efficiency and
long-run growth go up
Current account of balance of payments

Raise taxes: Disposable income and imports fall, so
current account improves unless currency appreciates
Fiscal multipliers are positive, but small
Impact of fiscal policy actions depends on






Whether economy is open or closed (import leakage)
Exchange rate regime (fixed or floating)
Type of budget financing (money creation or debt)
Degree of confidence in economic policy





Level of government debt
Financing constraints
Risk premia on debt
Whether fiscal changes are considered temporary or
permanent
How close the economy is to full employment
(-)
Gov’t Budget
Balance
(+)
RE
(+)
(-)
Tax
revenue
(-)
Consumption
(+)
(+)
Expenditure
(+)
Income
(+)
Fiscal Policy
(-)
(+)
Interest Rate
(-)
Investment
(+)
(+)
Capital
Labor

Monetary survey
M
=R+D
 D = DG + DP

M = Money supply
R = Reserves (NFA)
D = Domestic credit (NDA)
DG = Domestic credit to government
DP = Domestic credit to private sector
Fiscal policy determines government’s demand
for bank financing (DG), which, in turn, affects
total domestic credit (D), i.e., net domestic
assets (ignoring other items net), and money (M)
 Increased
budget financing requires
greater monetary expansion unless credit
to private sector (DP) is cut or foreign
reserves (R) go down, reflecting weaker
balance of payments position

In times of financial and economic
crisis, fiscal policy plays key role in
government’s response
 Fiscal
policy played a role during Great
Depression, even if theory behind it was
poorly understood, or even disputed
 Fiscal policy plays key role in current crisis
Monetary policy is ineffective if real interest
rates cannot be reduced without igniting
inflation
 Fiscal policy is more effective



Massive fiscal stimulus in US, Europe, and Asia: it works!
Fiscal stimulus is assisted by automatic stabilizers
Fiscal stimulus packages need to
include an exit strategy to ensure that
solvency is not at risk, and should





Not have permanent effects on budget deficits
Provide a commitment to fiscal correction, once
economic conditions improve
Include structural reforms to enhance growth
Should firmly commit to clear strategies for health
care and pension reforms in countries facing
demographic pressures



Need for financing tends to lift
interest rates, so capital flows in and
currency tends to appreciate
Central Bank must offset incipient
appreciation by expanding money
supply, thereby reinforcing initial
fiscal stimulus
Otherwise, exchange rate could not
remain fixed




Need for financing tends to lift
interest rates, so capital flows in and
currency appreciates
Appreciation reduces net exports,
aggregate demand, and interest rates
Process continues until interest rates
fall to their initial level
So, fiscal stimulus is ineffective with
perfect capital mobility

In times of large deficits and growing
public debt, public spending can
have weak or even negative effects
 By
creating expectations of a fiscal crisis,
and hence of higher future taxes
 Increased saving may lead to a sharp fall
in consumption
 Hence, fiscal stimulus can fail, and may
even prove counterproductive
 Conversely, fiscal contraction may prove
expansionary


Fiscal policy is frequently key to
addressing balance of payments
problems
Simple mechanism
M
= R + D means
R = M – D = M – DG – DP
 Hence, given M and DP, key to raising
R is reducing DG
 IMF: It’s Mostly Fiscal!
Or look at it this way:

Y = C + I + G + X – Z means
X–Z=Y–C–T–I–G+T=S–I+T-G
 Hence, current account balance (X – Z)
equals sum of private sector surplus of
saving over investment (S – I) and
government surplus of taxes over public
expenditure (T – G)
 Equivalently, Z – X = I – S + G – T means that
external deficit equals sum of private sector
deficit and government budget deficit

Unsustainable fiscal policy can trigger a
crisis if public loses confidence in
government’s macroeconomic policy

Sudden capital outflow can result, weakening
balance of payments and leading to a sharp
devaluation
 Financing the budget externally builds up
external debt, increasing risk of crisis
 Fiscal sustainability thus matters not only for
debt, but also for balance of payments



Fiscal contraction (spending cuts, tax
increases) can slow down inflation,
reduce current account deficit
Fiscal expansion (tax cuts, spending
increases) can shrink unemployment,
increase aggregate demand and help
restore output to full capacity, i.e.,
bring actual GDP up to potential GDP,
especially if monetary policy is
impotent
Automatic, or built-in, stabilizers are
revenue or expenditure provisions that
have counter-cyclical impact without
need for policy intervention

Protect against shocks
 Dampen business cycles

Examples

Progressive taxes on income, profits
 Price stabilization funds
 Unemployment insurance

0
-5
-10
-15
-20
-25
2003
1999
1995
1991
1987
1983
1979
1975
1971
1967
1963
1959
1955
1951
1947
1943
1939
1935
1931
1927
1923
1919
1915
1911
1907
1903
1899
1895
1891
1887
1883
1879
1875
1871
Change in US per capita GDP from year to year 1871-2003 (%)
20
15
10
5
0
-10
-20
1821
1826
1831
1836
1841
1846
1851
1856
1861
1866
1871
1876
1881
1886
1891
1896
1901
1906
1911
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
Change in French per capita GDP from year to year 1821-2003 (%)
50
40
30
20
10
0
-10
-20
-30
-40
-50
1851
1855
1859
1863
1867
1871
1875
1879
1883
1887
1891
1895
1899
1903
1907
1911
1915
1919
1923
1927
1931
1935
1939
1943
1947
1951
1955
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
Change in German per capita GDP from year to year 1851-2003 (%)
20
10
0
1821
1826
1831
1836
1841
1846
1851
1856
1861
1866
1871
1876
1881
1886
1891
1896
1901
1906
1911
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
Change in Swedish per capita GDP from year to year 1821-2003 (%)
10
5
-5
-10
-15
Source: Maddison (2003).
Objections to fiscal activism

Borrowing to finance increased government
expenditures raises interest rates, thereby
crowding out investment and reducing multiplier
 At full employment, increased public spending,
however financed, leads to inflation without
stimulating output except temporarily
 Increasing spending or cutting taxes to combat
unemployment may impart inflation bias to
economic system




Rules vs. discretion
Long lags, including approval and implementation
Fiscal activism may tend to expand public sector
Government has vital role to play in
modern mixed economies (allocation role)

Education
 Health care, cf. current debate in US
 Infrastructure (roads, bridges, etc.)

Some would also stress government’s
distribution role …

… claiming that the government should try to
secure reasonable equality in the distribution of
income and wealth, including poverty alleviation
 Normative or positive economics?


Partly positive: Equality is good for growth
views
 Inequality sharpens
incentives and thus
helps growth
 Inequality
endangers social
cohesion and hurts
growth
 117 countries,
1960-2000
Per capita growth adjusted for intial income (%)
 Two
r = -0.27
6
4
2
0
-2
-4
-6
-8
10
20
30
40
50
60
Gini index of inequality
70
is good for
growth
 No visible sign here
that equality stands
in the way of
economic growth
 An increase in Gini
index by 16 points
goes along with a
decrease in per
capita growth by
one percentage
point per year
Per capita growth adjusted for intial income (%)
 Equality
r = -0.27
6
4
2
0
-2
-4
-6
-8
10
20
30
40
50
60
Gini index of inequality
70
Why not raise government expenditure
on public services or whatever and
reduce taxes? – to buy votes


Supposing all objections could be swept aside
Because this would create a deficit and
deficits can lead to inflation, and inflation is
undesirable for many reasons – it reduces
efficiency and growth, for one thing
 Even so, a modest deficit can be sustained in
a growing economy
 So how modest is modest?

 Debt
accumulation is, by its nature,
a dynamic phenomenon
A
large stock of debt involves high
interest payments which, in turn, add
to the deficit, which calls for further
borrowing, and so on
o
Debt accumulation can develop into a
vicious circle
 How
do we know whether a given debt
strategy will spin out of control or not?
o
To answer this, we need a little arithmetic
Revenues
Expenditures
Budget Deficit
Financing
Increase in debt
Higher interest payments
 Recall
operational budget deficit:
G – T = B + DG + DF = D = GN + rD - T
where D is total government credit outstanding
 Further,
assume for simplicity
T = GN
 Then,
we have
D = rD
ΔD
r
 This gives
D
So, now we have:
ΔD
r
D
Now subtract growth rate of output from
both sides:
ΔD ΔY

 r-g
D
Y
Y
g
Y
But what is
ΔD ΔY

D
Y
?
This is proportional change in debt ratio:
 D
Δ 
ΔD ΔY
Y



D
D
Y
Y
This is an application of a
simple rule of arithmetic:
%(x/y) = %x - %y
z = x/y
log(z) = log(x) – log(y)
log(z) = log(x) - log(y)
But what is log(z) ?
dlog(z) dz 1 Δz
Δlog(z) 
  
dt
dt z
z
So, we obtain
Δz Δx Δy


z
x
y
Q.E.D.
We have shown that
Δd
rg
d
where
D
d
Y
Debt
ratio
rg
r=g
rg
Time
We have shown that
Δd
rg
d
where
D
d
Y
Debt
ratio
rg
r=g
rg
Time
We have shown that
Δd
rg
d
where
D
d
Y
Debt
ratio
rg
r=g
rg
Time
Primary deficit = GN – T = G – T – iDG
Primary balance: PB = T – G + iDG


Take another look
Intertemporal budget constraint:
Dt  1  it Dt-1  PBt

Dividing by nominal GDP (= PY), we get
1  it 

Dt
Dt 1 PBt


PY
1  p t 1  gt  Pt 1Yt 1 PYt t
t t
dt
 1  rt 
d t-1  pbt
d t  
 1  gt 
dt 1
pbt
1  it
1  rt 
1 pt

We have seen that
 1  rt 
d t-1  pbt
d t  
 1  gt 

To find where debt ratio is headed,
i.e., the long-run equilibrium value of
d, we set dt = dt-1; this gives
(1  gt ) pbt
dt  
gt  rt
> 0 if pb < 0 and g > r

To improve primary balance
 Raise
o
o
Raise taxes and fees
Reform revenue collection by levying
efficient taxes and fees
o
o
and reform revenue
E.g., pollution fees rather than income taxes
Improve tax administration
 Reduce
o
o
and reform expenditure
Emphasize efficiency
Avoid waste
Adequacy


Taxes must be consistent with budgetary needs
and with revenue generating capacity
Simplicity


Tax rules must be easy to understand and
entail low administrative and compliance costs
Fairness


Tax system must ensure that equals pay the
same and rich pay more than poor
Efficiency


Tax policy must minimize distortions and
disincentives
Broad base improves efficiency


Simple rates ease administration




Use single or few preferably ad valorem rates
Excessively high rates are ineffective


Limit holidays, exemptions, deductions, etc.
Use moderate internationally comparable rates
Pay attention to economic tax incidence
Consider long-term consequences

Revenue from broad-based sales tax
 Specifically,
value added tax (VAT)

Little reliance on trade taxes

Simple personal income tax

Corporate tax at single, low rate

An elastic tax system
VAT

Single rate of 10-20%
 Few exemptions

Trade taxes


Low uniform tax on imports


For protection, not revenue
Avoid taxes on exports
Income taxes

No more than three brackets,
 Top marginal rate of no more than 40%
 Limited exemptions

Corporate tax

Single proportional rate of 30-40%
 Equalize top marginal rate of personal and
corporate income taxes



Prevents tax avoidance through choice of
corporate or non-corporate form
Few exemptions
Elastic tax system


Ensures that tax revenues will increase as
economy grows
Early 1990's
Early 2000's
13
16
Sub-Saharan Africa
2
9
Central Europe and the BRO
1
14
Africa and the Middle East
3
5
Asia and the Pacific
4
11
Small Islands
0
2
23
57
Americas
Total number of developing
countries with a VAT
Source: Keen and Simone, 2004.
55
1990-91
2000-01
Americas
4.9
2.2
Sub-Saharan Africa
9.0
8.1
Central Europe and BRO
4.7
1.5
North Africa and Middle East
5.9
5.7
Asia and Pacific
6.3
2.7
10.1
8.4
Developing countries
6.5
4.2
High-income countries
3.1
1.2
Small Islands
Source: Keen and Simone, 2004.
56
45.0
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Low-income
countries
Lower-middleincome countries
1990-91
Upper-middleincome countries
1998-99
Source: Keen and Simone, 2004.
12.0
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
10.0
8.0
6.0
4.0
2.0
0.0
Americas
SubCentral North Asia and Small
Saharan Europe Africa and Pacific Islands
Africa and BRO Middle
East
Corporate Tax Revenue (LHS)
Avg.Tax Base (LHS)
Avg. Statutory Rate (RHS)
Source: Keen and Simone, 2004.
Essentials of Tax Administration Reform
 Explicit
 Team
and sustained political commitment
of capable officials
 Well-defined
 Relevant
training for staff
 Adequate
 Changes
and appropriate strategy
resources for tax administration
in incentives for taxpayers and tax
administrators
 United
States
 Replace
current income tax code by
uniform flat tax or by national sales tax
 Europe
 Lower
domestic tax rates to stimulate
moribund economies
 Latin
America and Asia
 Lower
tariffs to improve competitiveness
at home

Compensate for market failure
 Externalities
(education, health care)
 Public goods (national defense, air)
 Collective goods (fish)
 Social insurance

Support private sector development
 Education
 Health
care
 Infrastructure
Affordability


Level of public expenditure must be consistent
with revenue and financing constraints
Efficiency


Appropriate mix of goods and services at lowest
possible cost
Priorities


Expenditure priorities must be defined in
accordance with economic goals

Are expenditures productive?
Equity


In line with distributional objectives and poverty
alleviation goals






Public wages and employment
Provide adequate operations and
maintenance spending
Eliminate subsidies and target
transfers
Minimize military expenditure
Encourage capital expenditures
Eliminate unproductive spending
Average
central
government
wage to per
capita GDP
Ratio of
public to
private
sector
wages
General
government
employment as
percent of total
nonagricultural
employment
Asia
3.0
0.8
56.7
Eastern Europe and
Central Asia
1.3
0.7
54.6
Latin America and
Caribbean
2.5
0.9
20.9
Middle East and North
Africa
3.4
1.3
53.7
Sub-Saharan Africa
5.7
1.0
37.8
OECD 1/
1.6
0.9
23.0
Sources: World Bank, ILO, and OECD.
Data refer to 1996 - 2000 average.
64
Identify white elephants
Look for proximate indicators of
misallocation


Literacy rates
 Mortality rates

Identify sectoral expenditure imbalances


E.g., high teacher/pupil ratio with
inadequate teaching supplies
Identify allocative inefficiency


E.g., generalized subsidies

Avoid across-the-board cuts
 Be
selective
 Target needed cuts



Consider capacity for efficient
project realization
Focus on medium-term rather than
one-shot measures
Emphasize sound incentives,
targeting, and transparency



Address budget rigidity
Address fiscal federalism
Use fiscal policy to promote
economic growth
 Long-run
growth is endogenous, and
responds to fiscal and monetary policy
Monetary policy?
 Yes, because low inflation is good for
economic growth

Many countries face budgetary problems
from mandatory expenditures


Creating automatic outlays, without needing
formal approval by the government
Examples

Loan guarantees
 Public pensions, health insurance, jobless
benefits
 Deposit insurance programs
 Tax expenditures


Automatic reductions in tax liability for those with
qualifying expenses
Challenge is to reduce pre-committed
spending
Some options are



Limit tax expenditures


Reform public pension programs



Put ceilings or require minima on amount of expenses
qualifying for deductibility from taxable income
Consider shifting to basic minimum benefit plus
mandatory saving (defined contribution plan)
U. K. (minimum benefit), Chile (more extensive reforms)
Limit loan guarantees and deposit insurance

Insurance should not provide 100% coverage
Many countries allocate expenditure
responsibilities to multiple levels of
government


Advantages



Disadvantage


May be more responsive to local needs
Possibly better management
 Subsidiarity principle
May be harder to control fiscal performance as a
whole
Challenge is to ensure adequate funding
for services at all levels while achieving
overall fiscal objectives

Different countries have different
ways of maintaining discipline
 Balanced
budget rules (common in US)
 Restrictions on borrowing by state and
local governments (common in Brazil,
India)

Look for enforceability of
restrictions and ability of subfederal units to evade limits
Tax policy


Consistent with investment-friendly business
climate and adequate funding for government
Expenditure policy

Supply productive “public goods”
 Address externalities efficiently
 Restrict monopolies, promote competition
 Foster good governance, rule of law
 Provide financial regulation and safety nets
 Support private sector activity while focusing on
those things that government can do better than
private sector
 Avoid inflation, inefficiency, excessive inequality

Creating an investment-friendly tax
climate

Moderate overall tax burden that allows
financing efficient levels of government activity
 Focus taxes on consumption rather than income,
to reduce double taxation of savings






Modest income tax
Limiting payroll tax burden
Keeping corporate profit taxes modest
Address double taxation of dividends
Keep tax burden competitive with neighboring
and comparable jurisdictions; may require
moderating corporate profit tax rate
Be serious about stabilization, allocation,
and distribution








Keep spending consistent with revenue levels, to
avoid heavy debt and debt service levels
Build and maintain productive infrastructure
Maintain effective education system
Maintain cost-effective health care system
Maintain impartial and effective courts
Maintain appropriate regulatory environment,
especially for financial sector and other sectors
with important economy-wide externalities
Also, encourage private sector
 Sound
fiscal policy is critical for good
macroeconomic management, and can
help manage capital flows
 Fiscal stimulus is usually expansionary, but
not invariably
 Fiscal policy crucially affects BOP, and
interacts with monetary policy
 Fiscal policy, as before, is crucial to
responding to financial crises

Especially when monetary policy lands in
liquidity trap and loses traction
 Fiscal
policy can help foster rapid growth