Macroeconomic management and fiscal policy

1. Macroeconomic management and fiscal policy Thorvaldur Gylfason Joint Vienna Institute/IMF Institute August 24–September 4, 2009

2. outline • Objectives and uses of fiscal policy • Stabilization • Allocation • Distribution • Risks associated with fiscal policy • Sustainability of public debt • Role of fiscal policy in crises • Exit strategies when things go wrong • Fiscal reforms

3. definition of fiscal policy • The term fiscal policy refers to the use of public finance instruments to influence the working of the economic system to maximize economic welfare • Effects of fiscal policy reflect not only the impact of the fiscal balance, but also various elements of taxation, spending, and budget financing • Assessing the stance of fiscal policy requires taking account of the activities of all levels of government Vito Tanzi

4. Objectives of fiscal policy 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 • Allocation • Fiscal policy also influences aggregate supply • Public infrastructure, education, health care • Distribution • Through taxes, transfers, and expenditures • Progressive, neutral, regressive

5. Objectives of fiscal policy • Fiscal policy can be used to several ends • To achieve internal balance • By adjusting aggregate demand to available supply • By achieving low inflation, potential output • To promote external balance • By ensuring sustainable current account balance • By reducing risk of external crisis • To promote economic growth • 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

6. Stabilization policy Demand management E.g., lower income taxes Aggregate supply in short run B Price level A Aggregate demand Output

7. Stabilization policy Demand management E.g., lower income taxes Supply management E.g., lower import tariffs Aggregate supply in short run Aggregate supply in short run B Price level Price level A A Aggregate demand Aggregate demand B Output Output

8. 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 Basic relationships • 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 • 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 Inflationary vs. noninflationary finance

9. Fiscal policy and inflation • Central bank financing involves money creation • Inflation tax: Most inflationary form of financing • Bond finance is less inflationary • Removes financial resources from circulation • Increases real interest rates • Crowds out investment • External financing can be inflationary • Especially if it leads to currency depreciation • Evidence 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

10. Fiscal position:Alternative concepts • 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 beat full employment • Independent of business cycles • A budget in deficit could be insurplus with full employment • Deficit can be consistent with a tight fiscal stance (see chart) Problem is not that deficit is too large but that income is too low Economic expansion would automatically turn deficit into surplus T, G T G YFE Y < YFE Y

11. Fiscal position: Alternative concepts • 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

12. Fiscal position: Alternative concepts r ≈ i - p • 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 • Conventional deficit: • G – T = GN + iDG – T = GN + (r + p)DG – T • Operational deficit: • G – T - pDG = GN – T + rDG • Hence, operational deficit includes only real part of interest payments, leaves out the inflation part GN = Noninterest expenditure GI = Interest expenditure r = Real interest rate DG = Government debt p = Inflation rate

13. Uses of fiscal policy • 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

14. Uses of fiscal policy • 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

15. uses of fiscal policy • 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

16. Uses of fiscal policy • 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

17. fiscal policy transmissions (-) RE (+) (-) Gov’t Budget Balance Consumption (+) (+) (-) (+) (+) (+) Tax revenue Expenditure Income Interest Rate (+) (-) Investment Fiscal Policy (-) (+) Capital (+) Labor

18. fiscal and monetary policy M = Money supply R = Reserves (NFA) D = Domestic credit (NDA) DG = Domestic credit to government DP = Domestic credit to private sector • Monetary survey • M = R + D • D = DG + DP • 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

19. fiscal and monetary policy • 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

20. Exit strategy • 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

21. Fiscal Stimulus with Fixed Exchange Rate Regime • 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 Fiscal stimulus works under fixed exchange rates

22. Fiscal Stimulus with Floating Exchange Rate Regime • 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 But concerted fiscal stimulus can work even under floating exchange rates

23. Fiscal Stimulus in crises of confidence • 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 Ricardian equivalence

24. Fiscal policy and balance of payments • Fiscal policy is frequently key to addressing balance of payments problems • Simple mechanism • M = R + D means DR = DM – DD = DM – DDG – DDP • Hence, given DM and DDP, key to raising DR is reducing DDG • IMF: It’s Mostly Fiscal!

25. Fiscal policy and balance of payments • 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

26. Fiscal policy and balance of payments • 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

27. Fiscal policy in action in the short run • 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

28. Automatic stabilizers • 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

29. Perhaps bank regulation during Great Depression also helped stabilize GDP Stabilization worked, or what? Change in US per capita GDP from year to year 1871-2003 (%)

30. Perhaps bank regulation during Great Depression also helped stabilize GDP Stabilization worked, or what? Change in French per capita GDP from year to year 1821-2003 (%)

31. Perhaps bank regulation during Great Depression also helped stabilize GDP Stabilization worked, or what? Change in German per capita GDP from year to year 1851-2003 (%)

32. Perhaps bank regulation during Great Depression also helped stabilize GDP Stabilization worked, or what? Change in Swedish per capita GDP from year to year 1821-2003 (%) Source: Maddison (2003).

33. limits of fiscal policy • 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

34. uses of fiscal policy • 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

35. inequality and growth • Two views • Inequality sharpens incentives and thus helps growth • Inequality endangers social cohesion and hurts growth • 117 countries,1960-2000 r = -0.27

36. inequality and growth • Equality 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 r = -0.27

37. Uses of fiscal policy • 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?

38. Public debt dynamics 2 • 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 • Debt accumulation can develop into a vicious circle • How do we know whether a given debt strategy will spin out of control or not? • To answer this, we need a little arithmetic

39. deficits and Debt Expenditures Revenues Budget Deficit Financing Increase in debt Higher interest payments

40. Public debt dynamics • 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 • This gives

41. Public debt dynamics So, now we have: Now subtract growth rate of output from both sides:

42. Public debt dynamics But what is ? This is proportional change in debt ratio: This is an application of a simple rule of arithmetic: %(x/y) = %x - %y

43. proof z = x/y log(z) = log(x) – log(y) log(z) = log(x) - log(y) But what is log(z) ? So, we obtain Q.E.D.

44. Debt, interest, and growth Deficits can be sustained as long as debt ratio does not spin out of control – i.e., at least as long as g > r We have shown that Debt ratio r  g where r = g r  g Time

45. Debt, interest, and growth We have shown that Need economic growth to keep debt ratio under control Debt ratio r  g where r = g r  g Time

46. Debt, interest, and growth Higher interest rates can turn a sustainable debt position into an unsustainable one We have shown that Debt ratio r  g where r = g r  g Time

47. Primary deficit = GN – T = G – T – iDG • Primary balance: PB = T – G + iDG Debt, interest, and growth • Take another look • Intertemporalbudget constraint: • Dividing by nominal GDP (= PY), we get • If r > g, d rises over time • If r = g, d remains unchanged • If r < g, d declines

48. Debt, interest, and growth • We have seen that • To find where debt ratio is headed, i.e., the long-run equilibrium value of d, we set dt = dt-1; this gives Reducing primary deficit is key to reducing debt ratio pb < 0 means that primary budget balance is in deficit > 0 if pb < 0 and g > r

49. Fiscal reform: Reducing deficits 3 • To improve primary balance • Raise and reform revenue • Raise taxes and fees • Reform revenue collection by levying efficient taxes and fees • E.g., pollution fees rather than income taxes • Improve tax administration • Reduce and reform expenditure • Emphasize efficiency • Avoid waste

50. Raising revenue: Pillars of tax policy design • 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