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Lecture 22: Public Debt I. L11200 Introduction to Macroeconomics 2009/10. Reading: Barro Ch.14 22 March 2010. Introduction. Last time: effect of different forms of taxation on real activity Labour income and asset income taxes both proved ‘distortionary’
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Lecture 22: Public Debt I L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.14 22 March 2010
Introduction • Last time: effect of different forms of taxation on real activity • Labour income and asset income taxes both proved ‘distortionary’ • Cost to society was lower output and income • Today: the ‘public budget’ • Governments’ budgets and debt
Public Debt • So far, considered how government raise income (tax) and spend revenue • Governments can also amass assets / incur debts • Call the government’s budget position the ‘public budget’ • U.K./U.S. governments currently have large public deficits (expenditure > income) and also large public debts.
Government Bonds • Government can borrow by issuing ‘bonds’ • An i.o.u. from the government, bought by households • So households can either buy private bonds, or government bonds • In aggregate, Bt=0, so aggregate household bond holdings are equal to
Government Budget Constraint • Previous government budget constraint • With borrowing/saving this becomes government spending + government transfers = tax revenue + real revenue from money creation spending + transfers + interest payments = tax revenue + real debt issue +real revenue from money creation
Government Budget Constraint • If Mt and Pt do not change over time, simplifies to: • If , government is saving, and vice-versa • So real government saving given by:
‘National Saving’ • So saving of an economy is given by: • Total private saving (household lending to other households cancels out) • Total private capital investment • Government saving • So government saving and private saving cancel out (just a flow of money between the two)
Public Debt and Household Budget • Household multiyear budget constraint: • Now add household government bond holding present value of consumption = value of initial assets + present value of wage incomes + present value of transfers net taxes present value of consumption = value of initial assets + present value of wage incomes + present value of transfers net taxes
Government Borrowing and Taxation • Now assume government has zero debt, and no transfers but decides to lower taxes without lowering spending • With no debt or transfers, government has no initial interest payments, so
Government Borrowing and Taxation • In period 2, government repays all of its debts • For simplicity, assume borrowing was 1 unit • So, interest due is r multiplied by ‘1’, bond to be repaid is ‘1’: • Hence:
Impact on households • How does this impact on households? • T1 falls by 1, T2 rises by 1+r • Present value Decrease in year 1’s real taxes + present value of increase in year 2’s taxes
Debt Neutrality • So effect of cutting taxes, then increasing taxes again is 0 • Household pay lower tax in the first period • But then have to pay higher taxes in the second period • No change to present value (cost of debt interest offset by present value deduction)
Ricardian Equivalence • This famous result is known as ‘Ricardian Equivalence’ • Households view a cut in real taxes as equivalent to an increase in the real budget deficit, and hence higher future taxation • So the real budget deficit is equivalent to the present value of real future tax rises
Crucial Result for Public Policy • Ricardian Equivalence implies • Cutting taxes now to finance government spending has no impact on the economy – households ‘internalise the debt’ save more now • Borrowing more now to finance government spending has no impact on the economy – households anticipate tax rises and save more now
‘Fiscal Stimulus’ • No role for a fiscal stimulus • Idea: government should borrow and spend more now to ‘keep up demand’ during a recession • Problem: government borrowing means future tax rises for households • Households anticipate this, and save more now • Net effect (we have shown) is zero
Summary • Government has an asset/debt position, just like households • Debts eventually have to be paid-off by lower spending or more taxation • Households know this, and offset govt activity • Next time: intertemporal effects • Taxes distorted output decision • Intertemporal tax/spend policy distorts household activity as well