Public Finance Lecture 4 PDF

Dr. Mona Mahmoud Lecture 4 Budget Surpluses and Deficits Budget deficit is the amount by which government spending exceeds government revenue in a given time period. Budget deficit = government spending – Tax revenues ˃ 0 Deficit spending is the use of borrowed funds to finance governm...

Dr. Mona Mahmoud Lecture 4 Budget Surpluses and Deficits Budget deficit is the amount by which government spending exceeds government revenue in a given time period. Budget deficit = government spending – Tax revenues ˃ 0 Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues. - If the government spends less than its tax revenues, a budget surplus is created. Budget Surplus is an excess of government revenues over government expenditures in given time period. Types of Budget Deficit Cyclical deficits. Short term deficits Structural deficits. Long term deficits Cyclical Deficits It is important to distinguish between “cyclical” and “structural” deficits. Cyclical deficits are caused by a weak economy. Recessions drive down government revenue because many workers and businesses are no longer earning as much taxable income. At the same time, government spending rises because more people need assistance through programs such as Medicaid, unemployment benefits. Structural Deficits If government spending exceeds tax revenue even when the economy is strong, however, then the deficit is structural. Unlike cyclical deficits, structural deficits reflect a chronic problem that must be addressed through significant changes in tax and spending policies. With structural deficits, one-time spending cuts or temporary tax increases may help to relieve the pressure but cannot solve the long- term problem. Which is more problematic? Cyclical or structural deficit. Cyclical and Structural Deficits The real problem has always been over the long term. A temporary spike in deficits to combat a short- term national emergency is reasonable, but a national debt that consistently grows faster than even a healthy economy is not sustainable. As the economy recovers from the recession, policymakers may use the fiscal tools (create a debt). Cyclical and Structural Deficits Debt burden is not fit with the strong economy, even assuming a strong economy with no cyclical deficit, current policies will mean structural deficits and a steadily rising debt-to-GDP ratio. Eventually, the debt burden would become too great to bear. The deficit is broken down into cyclical and structural components. Total budget deficit = Cyclical deficit + Structural deficit. Debt Creation The national debt is the accumulated debt of the government. When the treasury borrows funds it issues treasury bonds. Treasury bonds are promissory notes issued by the government. The national debt is a stock of bonds created by annual deficit flows. National debt is divided into: Ownership of Debt Internal debt is the government debt (Treasury bonds) held by households and institutions. The external debt is government debt (Treasury bonds) held by foreign household’s institutions, and states. Refinancing The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due. Refinancing is the issuance of new debt in payment of debt issued earlier. With refinancing, debt and debt services will get worse. Debt Service Debt service is the interest required to be paid each year on outstanding debt. Interest payments restrict the government’s ability to balance the budget or fund other public sector activities. How do we limit or reduce debt? Deficit and Debt Ceilings Deficit ceilings are an explicit, legislated limitation on size of the budget deficit. A debt ceiling is another mechanism for curbing the national debt. A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt. Why do we try to limit debt? (Side effects of debt) Consequences of a Growing Public/National Debt The main consequences are: Lower national savings and income. Higher interest payments, leading to large tax hikes and spending cuts. Decreased ability to respond to problems. Greater risk of a fiscal crisis. Crowding Out If the government borrows funds to finance deficits, the availability of funds for private sector spending may be reduced. Crowding-out is the reduction in private sector borrowing (and spending) caused by increased government borrowing. Chances of crowding-out rise when the economy gets closer to full employment. Crowding In A reduction in debt takes pressure off market interest rates. Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing. As interest rates drop, consumers are willing and able to purchase more big-ticket items like cars, appliances, and houses. But actually crowding in depends on the state of the economy. In a recession, a decline in interest rates is not likely to stimulate much spending of consumer and investor confidence is low. Crowding In There are four potential uses for a budget surplus: Cut taxes. Increase income transfers. Spend it on goods and services. Pay off old debt. Discretionary VS Automatic Spending Discretionary Fiscal Policy: The central government exercises discretionary fiscal policy when it identifies an unemployment or inflation problem, so it establishes a policy objective concerning that problem, and then adjusts taxes and/or spending accordingly. Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment, as opposed to a policy set by predetermined rules. In practice, most policy changes are discretionary in nature. Discretionary VS Automatic Spending Automatic Fiscal Policy: When changing economic conditions cause government expenditures and taxes to change automatically, which in its turn, helps to combat unemployment or demand-pull inflation. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond. The key difference between automatic and discretionary is timing of implementation. Discretionary VS Automatic Policy Fiscal restraint – tax hikes or spending cuts intended to reduce (shift) aggregate demand. Use fiscal restraint to control inflation. Fiscal stimulus – tax cuts or spending hikes intended to increase (shift) aggregate demand. Use fiscal stimulus to eliminate unemployment. Economic Cycle An economic cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the expansion and contraction in economic activity that an economy experiences over time. Stages of the Economic Cycle In the diagram above, the red straight line in the middle is the steady growth line. The economic cycle moves about the line. Below is a more detailed description of each stage in the economic cycle: 1. Expansion: The first stage in the economic cycle is expansion. In this stage, there is an increase in positive economic indicators such as employment, income, output, wages, profits, demand, and supply of goods and services. Debtors are generally paying their debts on time, the velocity of the money supply is high, and investment is high. This process continues as long as economic conditions are favorable for expansion. Stages of the Economic Cycle 2. Peak: The economy then reaches a saturation point, or peak, which is the second stage of the business cycle. The maximum limit of growth is attained. The economic indicators do not grow further and are at their highest. Prices are at their peak. This stage marks the reversal point in the trend of economic growth. Consumers tend to restructure their budgets at this point. Stages of the Economic Cycle 3. Recession: The recession is the stage that follows the peak phase. The demand for goods and services starts declining rapidly and steadily in this phase. Producers do not notice the decrease in demand instantly and go on producing, which creates a situation of excess supply in the market. Prices tend to fall. All positive economic indicators such as income, output, wages, etc., consequently start to fall. Stages of the Economic Cycle 4. Depression: There is a commensurate rise in unemployment. The growth in the economy continues to decline, and as this falls below the steady growth line. 5. Trough: In the depression stage, the economy’s growth rate becomes negative. There is further decline until the prices of factors, as well as the demand and supply of goods and services, contract to reach their lowest point. The economy eventually reaches the trough. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure. Stages of the Economic Cycle 6. Recovery: After the trough, the economy moves to the stage of recovery. In this phase, there is a turnaround in the economy, and it begins to recover from the negative growth rate. Demand starts to pick up due to low prices and, consequently, supply begins to increase. The population develops a positive attitude towards investment and employment and production starts increasing. Employment begins to rise and, due to accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced, leading to new investments in the production process. Recovery continues until the economy returns to steady growth levels. This completes one full economic cycle of boom and contraction. The extreme points are the peak and trough. Automatic Stabilizers Remember that automatic stabilizers are ongoing government policies that automatically adjust tax rates and transfer payments in a manner that is intended to stabilize incomes, consumption, and business spending over the economic cycle. These adjustments in government expenditures and taxes occur without any deliberate legislative action, and stimulate aggregate spending in a recession and reduce aggregate spending during economic expansion. In budget parlance, these adjustments are known as “automatic stabilizers.” Automatic Transfers Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, and unemployment benefits.