MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

1. MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Fiscal Policy and the Role of Government

2. Key Concepts • Debt and deficits • Fiscal Finance • Debt versus taxes • Intergenerational equity • Debt sustainability and the primary surplus

3. Government Spending • Types • Consumption of goods and services • Investment • Transfer payments • Considerable variation in spending

4. Fiscal Policy Components • Financing • Taxes • Borrowing • Others? • Composition of Spending (G) • Current goods and services • Public investment • Government Expenditures • Spending + transfer payments + payment on debt

5. Government Spending% of GDP, 2002 Source: OECD online database

6. Looming Issues

7. Value of government spending • Rationale for Government Role • Market Failure & Public Goods • Markets are not allocating all goods efficiently • Pareto Efficiency: unable to make anyone better off by reallocating resources without making someone worse off • Public goods will not be provided by private sector…lack of incentive • Redistribution • Paternalistic view • People will not always act in own best interest • Subsidize education, force savings (retirement) • Social Welfare • Stabilization Policy (later)

8. Public Goods • Goods produced in the market have two characteristics: rivalry & excludability • rivalry: one’s use of good makes it unavailable for others (e.g. if I eat the snickers candy bar, you can’t) • excludability: those unwilling to pay do not have access to benefits of product (e.g. if you don’t pay for the snickers candy bar, you can’t have it) • Public goods have characteristic of nonrivalry and nonexcludability • Examples: national defense, lighthouse, highways • Degrees of nonrivalry & nonexludability (“quasi-public goods” like police and fire protection) • Nonexludability characteristic creates a free-rider problem: no incentive to contribute to cost • makes private production unprofitable

9. Level of Spending • What proportion of GDP should be allocated to public spending? • Merit of spending • Sources of spending • Taxation creates distortions • Creates a wedge between value of labor and availability of labor • May alter a firm’s decision to invest • Deficit financing can have adverse economic effects • Crowd out private investment • Intergenerational transfers • Unsustainable debt levels => financial crisis • Do benefits exceed costs (distortions)?

10. Laffer Curve • Taxes collected = Tax rate x Wage x N • Two competing effects • Tax rate x Wage is rising • N is falling • Eventually, tax collections will fall Tax Revenue 0% 100% Tax Rate

11. Government Borrowing • Deficit: debt issued in a particular fiscal year • Debt: accumulation of past deficits and surpluses • Developed country trend: increasing budget deficits during post-WWII era with increased government spending • Historically, deficits during wartime only • Revenues have not kept up with expenditures • Figure 10.13, 10.15, page 240 • Debt payments increasing portion of budget • Table 10.3, page 242 • Primary balance: difference between revenue and spending not including interest on debt

12. Deficit Debt Debt

13. Debt Debt Surplus

14. Debt as a percentage of GDP, 2002 Source: OECD Economic Outlook

15. Cost of Government Borrowing • Intergenerational Redistribution • Government effectively reallocates resources between age groups • Running a deficit • Unfunded pension programs with rising old-age dependency • Developed countries: younger generation will receive fewer benefits for taxes paid • Figure 10.18, page 246 • Deficit financing uses up national saving • Less saving for private investment • Poorly managed public debt can create financial crisis • Unsustainable debt accumulation

16. Generational Accounts Present value of net tax payments (until death) by different generations indexed by age in 1995 (Thousands $).

17. Recall Saving-Investment Model Private Savings Interest Rate 5% Investment I0 Output

18. Deficit = Negative Savings Private Savings + Government Savings Private Savings Deficit Interest Rate 6% 5% Investment I1 S1 I0 Output

19. Dynamic ResponseSuppose savings increases with the deficit Private Savings + Government Savings Private Savings Interest Rate 6% 5% Investment I1 I0 = S1 I0 = I1 S1 Output

20. Sustainability of Debt • Debt sustainability: debt does not rise relative to GDP • Stable debt/GDP ratio • Can continue to run budget deficits if… • GDP grows faster than or equal to growth in debt • Increase in debt/GDP ratio arises from • (1) ↑interest on debt changes • (2) ↓GDP growth • (3) ↑primary deficit • Budget balance = primary balance + interest payments

21. Sustainability of Debt r = real interest rate g = real growth rate of GDP • If r > g, must have primary surplus • If r < g, can run deficit indefinitely

22. Intertemporal Budget Constraint Year 2005: D(2005) = G(2005) - T(2005) Suppose debt is paid off in Year 2006 Year 2006: T(2006) = G(2006) + D(2005)x(1+R) Hence, taxes are higher in 2006 T(2006) - G(2006) = D(2005)x(1+R) Year 2005: G(2005) = T(2005) +[T(2006)-G(2006)]/(1+R)

23. Spending in year 2005 must be supported by current and future taxes. =

24. Implications • Countries with high debt must • Default • Run tighter fiscal policy in future • Debt levels should vary across countries • Purpose of spending (consumption versus public investment) • Role of expected future liabilities (pensions) • Intergenerational equity

25. Optimal Budget Deficits • For what purpose is spending being used? • Consumption • Investment • Cyclical considerations • Recessions mean low tax collections, high payouts • Should taxes increase during recessions? • Distortionary effects of taxation • Tax smoothing

26. Summary • Government spending is a significant fraction of economic activity • Role of government spending • Financing • Taxes, and their distortionary effects • Deficits • Effect of deficit spending • Debt sustainability