Transcript Unit 8

Antony Davies, Ph.D.
Duquesne University
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This unit is divided into several sections. Start with the micro-lecture.
Then proceed onto each section. You can click on a link below to
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Micro-Lecture
Section 1: Introduction
Section 2: Taxation
Section 3: Borrowing
Section 4: Monetization & Defaults
Unit Summary & Assignment
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INTRODUCTION
Governments impose taxes as a means of raising money. When, in a
given year, a government raises more money in taxes than it spends, we
say that the government has earned a budget surplus for that year.
When, in a given year, a government spends more money than it raises
in taxes, we say that the government has incurred a budget deficit for
that year.
Each annual surplus or deficit is accumulated to form what is known as
the national savings (if the past surpluses are larger than the past
deficits) or the national debt (if the past deficits are larger than the past
surpluses).
For example, suppose a government has no debt and no savings in 2001.
In 2002, the government collects $1.1 billion in tax revenue and spends
$1.0 billion. In 2003, the government collects $1.5 billion in tax revenue
and spends $1.8 billion. In 2004, the government collects $1.4 billion in
tax revenue and spends $1.6 billion. The government’s budget numbers
look like this:
TAX REVENUE
SPENDING
SURPLUS
(DEFICIT)
SAVINGS
(DEBT)
2002
$1.1 billion
$1.0 billion
$0.1 billion
$0.1 billion
2003
$1.5 billion
$1.8 billion
($0.3 billion)
($0.2 billion)
2004
$1.4 billion
$1.6 billion
($0.2 billion)
($0.4 billion)
Governments spend money on many things including infrastructure
(roads, bridges, power grids), the military, and social programs
(education, aid for the poor, health care). There are four ways a
government can acquire money to pay for its spending:
1.
2.
3.
4.
Taxation
Borrowing
Monetization
Default
Taxation and borrowing are ways in which the government raises
money. Monetization and default are ways in which the government
eliminates debt.
TAXATION
Governments typically impose taxes on many things.
Taxes on money that people receive are called income taxes.
Taxes on labor are called wage taxes.
Taxes on products that are sold are called sales taxes or excise taxes.
Taxes on products that are produced are called value added taxes or
VAT.
Taxes on things that people own are called property taxes.
Taxes on imported or exported goods are called tariffs.
The progressivity or regressivity of a tax refers to how the tax changes as
people’s incomes change.
Progressive tax rates are greater for people with higher incomes.
Regressive tax rates are greater for people with lower incomes.
Flat tax rates are the same for all people, regardless of income.
Progressive tax rates are greater for people with higher incomes.
Regressive tax rates are greater for people with lower incomes. Flat tax
rates are the same for all people, regardless of income.
For example, if the government taxes poor people 10% of their incomes,
but taxes rich people 50% of their incomes, we say that the government’s
tax rates are progressive.
If the government taxes poor people 10% of their incomes but taxes rich
people 5% of their incomes, we say that the government’s tax rates are
regressive.
If the government taxes all people 10% of their incomes, we say that the
government’s tax rate is flat.
As you saw in the previous units, governments specify the statutory
burden of taxes, but cannot control who ultimately pays the tax (the
economic burden). You also saw that, when it taxes, the government
slows economic activity.
This suggests that there is an optimal level of taxation. If taxes are too
high, the economy cannot grow and so people suffer from an inability to
produce and consume. If taxes are too low, the government cannot raise
enough money to pay for services it provides and so, again, people
suffer.
Economist measure the total tax burden imposed by a government as the
amount of tax revenue the government collects expressed as a
percentage of total economic activity (GDP).
Sweden
Zimbabwe
France
Lesotho
Swaziland
United Kingdom
Brazil
Russia
Botswana
Guyana
Australia
Namibia
United States
South Africa
Morocco
Ghana
Senegal
Gambia
Kenya
India
Zambia
Egypt
Côte d'Ivoire
Tunisia
Rwanda
Mozambique
Liberia
Uganda
Tanzania
Ethiopia
Guinea-Bissau
Niger
Madagascar
Gabon
Mexico
Guinea
Algeria
Central African Republic
Sudan
Nigeria
Angola
Chad
Libya
Equatorial Guinea
Kuwait
Government Spending as % of GDP
50%
45%
40%
35%
30%
Among all countries, Sweden’s government taxes its economy
the most and Kuwait’s government taxes its economy the least.
The more of the economy the government taxes, the more
services the government can provide. But, the more of the
economy the government taxes, the less economic activity
occurs.
25%
20%
15%
10%
5%
0%
Source: 2009 Index of Economic Freedom, Heritage Foundation.
Among all countries, Sweden’s government taxes its
economy the most and Kuwait’s government taxes its
economy the least.
The more of the economy the government taxes, the more
services the government can provide. But, the more of the
economy the government taxes, the less economic activity
occurs.
This is not to imply that Sweden experiences less economic activity than
Kuwait. There are many other factors that influence economic activity in
addition to taxation (e.g., workers’ educations and training, availability
of resources).
What is true is that, whatever a country’s level of economic activity,
increasing taxation slows that activity in exchange for an increased
ability for the government to provide services.
BORROWING
When a government borrows, it does so by selling government bonds. A
bond is a legal contract that states that the government promises to pay a
specific sum of money to the person who owns the bond at a specific
date in the future. A simple bond is a contract that looks like this:
The government of the United States
of America promises to pay the bearer
of this bond $1,000 on January 1, 2015.
The government of the United States
of America promises to pay the bearer
of this bond $1,000 on January 1, 2015.
Notice that there is no interest rate specified on the bond. The
government will attempt to sell this bond for as much money as it can
get. Suppose the government succeeds in selling the bond for $850. The
$850 is called the price of the bond.
The government gets $850 today (suppose today is January 1, 2010) in
exchange for paying back $1,000 on January 1, 2015.
The government of the United States
of America promises to pay the bearer
of this bond $1,000 on January 1, 2015.
We can calculate the interest rate on the bond as follows:
 Face value 
 Price 


1
Life
1
The government of the United States
of America promises to pay the bearer
of this bond $1,000 on January 1, 2015.
In this example, the face value is $1,000, the price is $850, and the life is 5
years, so the interest rate on the bond is:
1
5
 1000 
 850   1  3.3%


The government of the United States
of America promises to pay the bearer
of this bond $1,000 on January 1, 2015.
A mathematically easier (though less exact) formula for the
interest rate is:
Face value  Price
Life Face value 
1000  850
 3%
5 1000 
The government of the United States
of America promises to pay the bearer
of this bond $1,000 on January 1, 2015.
Notice that, the price of the bond and the interest rate move in opposite
directions. If the government finds that no one wants to buy the bond at
$850, the government will have to ask a lower price. But, the lower price
means that the interest rate on the bond has risen. For example, if the
government sells the bond for $700 instead of $850, then the interest rate
becomes 7.4% instead of 3.3%.
1
5
 1000 
 700   1  7.4%


The price of the bond and the interest rate move in opposite directions.
This result has important implications for government borrowing. The
more debt a government incurs, the greater becomes the chance that the
government will default on the debt. The greater the chance that the
government will default on the debt, the less incentive people will have
to purchase government bonds. The less incentive people have to
purchase government bonds, the lower will be the price at which the
government will be able to sell its bonds. The lower the price at which
the government will be able to sell its bonds, the higher the interest rate
the government pays on the borrowed money. The higher the interest
rate the government pays on the debt, the greater becomes the chance
that the government will default on the debt.
The price of the bond and the interest rate move in opposite directions.
This result also has important implications for private borrowing.
Because the amount of loanable money is finite, the more a government
borrows, the less money is available for people and companies to
borrow. This phenomenon is called crowding out.
350%
As with tax revenue, countries’ debts are measured in relation
to the sizes of the countries’ economies. Among all countries,
Zimbabwe’s national debt is the greatest (at more than three
times the size of its economy), and Equatorial Guinea’s is the
lowest (at 1% of the size of its economy).
300%
200%
150%
100%
50%
Source: CIA World Factbook.
Equatorial Guinea
Libya
Algeria
Namibia
Angola
Nigeria
Botswana
China
Uganda
Tanzania
Mozambique
Zambia
Ethiopia
Gabon
South Africa
Mexico
Tunisia
United States
Morocco
Kenya
India
Cote d'Ivoire
Ghana
United Kingdom
Germany
Egypt
Sudan
Greece
Japan
0%
Zimbabwe
National Debt as % of GDP
250%
As with tax revenue, countries’ debts are measured in
relation to the sizes of the countries’ economies. Among all
countries, Zimbabwe’s national debt is the greatest (at more
than three times the size of its economy), and Equatorial
Guinea’s is the lowest (at 1% of the size of its economy).
Zimbabwe’s debt is large relative to its GDP, in part, because its GDP is
so low. The government’s land reform program has badly damaged the
farming sector causing Zimbabwe to go from a country that produced
enough food to feed itself plus to export to other countries to a country
that must rely on food aid from other governments to feed its people.
The land reform program, which eliminated land property rights for
many, debt monetization, which created hyperinflation, and price
controls, which created chronic shortages of products acted together to
reduce Zimbabwe’s economy to $0.3 billion with 95% unemployment.
Equatorial Guinea’s economy, at $23 billion, is 70 times the size of
Zimbabwe’s economy. The small size of Zimbabwe’s economy
contributes to the high debt-to-GDP ratio.
MONETIZATION & DEFAULT
Monetization is the printing of money to pay government debt.
A classic error that people make is to equate money with wealth. Wealth
is assets that a person owns. An asset is something that is valuable and,
according to accounting rules, money is an asset.
In economics, however, money itself is neither an asset nor is it valuable.
Money represents the opportunity to obtain assets (or products) and is
only as valuable as the assets (or products) it can obtain.
*Economists use the term product to refer to something that was produced in the current year, and the
term asset to refer to a product that was produced in a previous year.
For example, suppose you are in a city and you have a suitcase filled
with $1 million in money. The money has tremendous value to you
because you can walk into any store and exchange the money for
products – food, clothes, a car, an apartment.
Now, suppose you are on a raft in the middle of the ocean. All you have
with you is a suitcase filled with $1 million in money. You only have two
valuable assets: the raft and the suitcase. The money has no value
because, being stranded and alone in the middle of the ocean, there is no
opportunity for you to use the money to obtain products.
Money, unto itself, is not valuable. Any value it has comes solely from
the fact that others will give you assets or products in exchange for the
money.
This raises the question: Why would people give you assets in exchange
for money if money, unto itself, has no value?
The answer is: Because those people believe that other people will give
them assets or products in exchange for the money.
Notice this rather dangerous line of reasoning:
1. Money has value only if people can exchange the money for
assets or products.
2. People will exchange assets or products for money only if they
believe that the money has value.
Given this circular reasoning, you can see that it is extremely important
that a country’s people believe that the country’s money has value.
The average price of products in a country reflects the ratio of the
amount of money in the economy to the amount of products in the
economy.
For example, suppose that there are a total of $100 billion in money in an
economy and that, each year, producers and consumers buy and sell 50
billion items.
$100 billion was used to buy 50 billion items, so the average price per
item was $100 billion / 50 billion items = $2.00 per item.
*The average price level is somewhat more complicated than this, because one must adjust for the
number of times each dollar changed hands, but this analogy is adequate for our discussion.
$100 billion was used to buy 50 billion items, so the average price per item was
$100 billion / 50 billion items = $2.00 per item.
If the government prints an additional $20 billion, then there is now $120
billion being used to buy 50 billion items, and so the average price per
item rises to $120 billion / 50 billion = $2.40 per item.
Printing an additional $20 billion in money caused the average price
level to rise by 20% from $2.00 to $2.40. We call this rise in the average
price level inflation.
Remember that money has value only if people can exchange the money
for assets or products. When the average price level rises from $2.00 to
$2.40, each dollar buys 20% fewer products than before.
Inflation has made the money less valuable.
Inflation makes money less valuable.
When the government prints money to pay its debts, all money in the
economy becomes less valuable. Suppose a person has saved $1,000 and
the government prints money thereby creating 20% inflation. The money
the person saved will now buy 20% fewer products than before.
By printing money, the government has done the same thing as if it had
taxed the person 20% of his savings and used that money to pay its
debts.
Monetizing debt achieves the same result as if the government taxed
people who saved money and used the money to pay its debts.
Monetizing debt achieves the same result as if the government taxed people who
saved money and used the money to pay its debts.
If the government monetizes a large amount of debt thereby creating
very high inflation, called hyperinflation, there is a danger that people
will lose faith in the money.
If this happens, people will no longer accept money in exchange for
assets and products and so all the country’s money will become
valueless. In turn, this will impose tremendous costs on people because
people would have to resort to barter – exchanging goods directly for
other goods.
A government defaults on its debt when it announces that it will not
repay debt. Typically, government default on portions of their debt. For
example, a government may announce that it will only pay 10 cents for
every $1 dollar it owes. Default and monetization are similar. The
difference lies in who ends up losing.
When the government monetizes debt, everyone who is holding money
loses because the money they are holding becomes less valuable. When
the government defaults on debt, those who are holding government
bonds lose because the bonds become less valuable.
Defaulting on debt can create significant economic problems for a
country in the future. From time to time, governments naturally need to
borrow money. If a government defaults on its debt, it will find it
extremely difficult to borrow money in the future.
In this unit, you learned that the government can pay for spending via
four mechanisms: taxation, borrowing, monetization, and default. You
learned that responsible governments use taxation and borrowing
judiciously, that too much taxation or too much borrowing slows the
economy, and that monetization and default hurt those who have
savings or those who have loaned to the government.
Pick a country (preferably your own) to research. Referring to the
amount of government spending, the major tax rate(s), deficit, and the
national debt, write an 3- to 5--page paper describing the major services
the government provides, how much those services costs, and what
mechanism the government uses to pay for those services.
Explain the way in which the issues you wrote about in your paper
impact your ministry.
Post this to the JPIC 220 Google Groups discussion page.
HOW TO POST ONTO GOOGLE GROUPS
1. Click on the Google Groups discussion link above.
2. Sign in into Google Groups so that you are able to post via the “Sign In” link on
the top right of the page.
3. Click “Reply” to add your response.
Keeping in mind what you have learned about the impact of taxes,
borrowing, and debt, meet in groups and discuss the pros and cons of
your governments’ spending, taxation, and borrowing.