Long-Term Objectives for Government Debt

1. Long-Term Objectives for Government Debt Alan J. Auerbach University of California, Berkeley January 29, 2008

2. Outline • What are the underlying objectives that motivate concern about the public debt? • Why simple deficit targets and budget rules are inadequate • Setting long-run targets for fiscal policy

3. I. Underlying Objectives • Intergenerational equity • Debt that is too large shifts too much of a burden onto future generations • But not clear what “too much” is when future generations will be better off • Not a question for economists alone to answer

4. I. Underlying Objectives • Economic performance • Debt accumulation may “crowd out” domestic capital formation or trade surpluses • The need to service the debt may force substantial increases in future marginal tax rates, leading to increased distortions of economic decisions

5. I. Underlying Objectives • Fiscal sustainability • If we rule out a “bubble” in which the government can forever service debt simply by issuing more debt, higher debt requires higher future taxes and/or lower future spending • But existing policy trajectory may be quite inconsistent with this requirement • If policy is not sustainable, sudden involuntary adjustments may follow, causing greater economic disruption than planned policy changes

6. Weighing the Objectives • Objectives point to similar, but not identical policy paths • For example, should tax rates be rising (equity) or constant (efficiency)? • Relative importance depends on empirical aspects of economic behavior • If bequest motives are strong, then intergenerational equity may be less important • If responses to tax rates are small, then keeping tax rates smooth and low may be less important

7. Key Point • It makes no sense to establish a target deficit path without first specifying underlying objectives

8. Targets or Restrictions? • Is it enough to determine targets, or are rules needed to enforce them? • Answer depends on the alignment of short-term government incentives with long-term objectives • If alignment strong, targets provide more flexibility for short-term action • If alignment weak, then simple and less flexible rules may work better

9. II. Inadequacy of Simple Targets • Several factors weaken and make more ambiguous the relationship between debt path and underlying objectives

10. Government Assets • Simple answer: subtract from government debt • But a lack of symmetry because assets may not provide a revenue stream, so don’t offset need for tax increases • Also, what is an asset? Many expenditures (e.g., health, education, etc.) provide future benefits

11. Implicit Liabilities • Isn’t the obligation to pay future health and retirement benefits similar to a debt obligation? • Intergenerational redistribution () • Need for future tax increases () • Strength of obligation (?) • May not present the same problem of sustainability if commitment weak, but otherwise like debt

12. Deferred Tax Assets • Tax systems that are otherwise equivalent differ in their timing of tax collections, and this can give rise to “deferred tax assets” • Example: to encourage saving, can exempt earnings on saving or defer initial tax on amount saved and tax ultimate withdrawal • the two approaches have same economic effects but differences in timing of tax payments • deferral approach appears to collect fewer taxes, but not if we take account of deferred tax assets

13. A Difficulty • Both implicit liabilities and deferred tax assets (or liabilities) must be measured relative to some benchmark tax and transfer system

14. Variations Along Desired Path • Targets may vary from year to year because of variations in the social value of deficits • short-term stabilization policy • other reasons why surges in deficits may be valuable • Wars are an obvious illustration, but also higher share of the population “in need” • Could justify higher spending on transfers as population ages, but only for temporary surges

15. Deficits versus Spending • Given deficit targets, should there also be spending targets? • Logic: • Spending exhaustive, tax cuts aren’t • Controlling spending limits government power • Big logical problem: what distinguishes direct expenditures from “tax expenditures”? • So, spending targets can make sense only to the extent that spending is well-defined

16. Deficits and Generational Distribution • Regardless of the adjustments that one makes, policies with the same deficit paths can be associated with differences in how burden is shared among generations • For example, accounting for implicit liabilities may provide a more accurate measure of burden on future generations, but won’t tell us to whom these liabilities are owed or how policy changes influence this

21. III. Setting Long-Run Targets • Start with simple assumptions and see how complications change prescription

22. A Path for Deficits and Spending • Suppose • revenue and spending well-defined • composition of revenue and spending fixed, so that only annual levels of each to be determined • Then each path for deficits and spending will correspond to a unique outcome, and we can choose from among fiscally stable policies the one that best balances equity and efficiency objectives

23. A Path for Deficits and Spending • This path would exhibit variation over time to reflect time variations in the value of resources • for example, we might see large deficits accumulate to provide benefits for large elderly cohorts, with surpluses both before and after to help spread the burden and tax distortions • this is one interpretation of current spending forecasts, but current tax policy would need to respond to generate large short-run surpluses

24. Notes • Uncertainty about the need for future spending generally points to higher surpluses now • High current surpluses, even if consistent with policy objectives, present additional problems • political: can the surplus be sustained? • economic: how should the surplus be invested? • Usefulness of spending targets may be limited to certain categories

25. Adjusting Deficit Targets • But composition of spending and revenues changes, so given path of spending and deficits can correspond to many patterns of burdens and distortions • Makes adjustments for government assets, implicit liabilities, and deferred tax assets useful • adjust taxes and spending to neutralize differences in the timing of burdens and tax distortions • this gives debt a more consistent meaning as the composition of revenues and spending changes • also, may make deficit targets look more “normal” when there are demographic fluctuations

26. Adjusting Deficit Targets • With adjustments comes subjectivity • when is a deferred liability more a commitment than a plan? • what is “current policy” for the future if that policy is not explicit? • Simple procedures for how to draw lines may be difficult to define ex ante

27. Further Measures • Even adjusted deficits, as explained before, do not provide all available information about distortions and distribution of burdens • Thus, augment using “generational accounts,” which allocate fiscal burdens across cohorts • more information and calculation required, so may not be feasible for very frequent calculations • but little argument against using in conjunction with other measures

28. Further Measures • In principle, only way to determine optimal policy path is within the context of a general equilibrium model of the economy, which traces through all interactions of policy and behavior of households and firms • This will not be feasible without considerable simplifying assumptions, but even with such simplifications can provide a useful check that chosen targets make sense given underlying objectives

29. Conclusions • Deficit targets are not an ultimate objective, but need to be derived from a weighing of underlying economic and social objectives • Rules may need to complement or supplant targets if short-run government incentives diverge from longer-run goals • Targets based on simple measures of debt are inadequate to deal with changing composition of spending and revenues

30. Conclusions • Adjusted debt measures make more sense but adjustments involve subjectivity that must be confronted • More detailed measures, notably generational accounts, provide additional information useful to evaluate policy • A full general-equilibrium evaluation to determine optimal policy path is not feasible without many simplifying assumptions, but is still useful