L7: Government Debt and Sustainable Fiscal Policy Anna Seim, Stockholm University September 27, 2016

Contents • Ricardian Equivalence. • Why are budget decits potentially a problem? • Government debt dynamics. • Fiscal Sustainability. • The Swedish Fiscal Policy Framework.

Literature: The Swedish Fiscal Policy Council (2010), Chapters 2 and 4; EEAG(2016); Barro (1974).

Ricardian Equivalence

• Normally we expect lower taxes today to increase the real

disposable income of households and therefore increase private consumption.

• Under Ricardian Equivalence, households recognise that a tax

cut today implies higher taxes in the future, leaving lifetime income unchanged.

• Under Ricardian Equivalence, private consumption is

unaected by a change in the tax rate.

Assumptions Behind Ricardian Equivalence

1. Forward-looking households. 2. Households understand the intertemporal government budget constraint. 3. Lower taxes today do not imply lower future government consumption. 4. Households are not credit constrained. 5. The current generation cares for future generations.

Ricardian Equivalence in a Two-period Model

Notation Gt : government consumption in period t , t = 1, 2. Tt : tax revenue in period t . D : the government budget decit. r : the interest rate.

Ricardian Equivalence cont'd.

Period 1: Period 2:

D = G1 − T1 .

(1)

T2 = (1 + r )D + G2 .

(2)

Ricardian Equivalence cont'd. Substituting D from (1) in (2) we obtain: T2 = (1 + r )(G1 − T1 ) + G2 .

(3)

Re-arranging, the intertemporal government budget constraint can be written: T1 +

G2 T2 = G1 + . 1+r 1+r

Equation (4) suggests that the present value of tax revenue and expenditures must be equal.

(4)

The Eects of a Tax Cut For a given stream of government consumption, (4) implies ∆T1 = −∆T2 /(1 + r ) ⇔ ∆T2 = −(1 + r )∆T1 .

(5)

A period-1 tax cut ∆T1 must be met by a period-2 tax increase of magnitude (1 + r )∆T1 . Present value of the future tax increase: PV =

(1 + r )∆T1 = ∆T1 (1 + r )

(6)

The tax cut has no eect on the lifetime income of households and therefore no eect on their consumption.

The Household's Perspective Notation Yt : household income in period t , t = 1, 2. Ct : consumption in period t .

The household's intertemporal budget constraint: C1 +

C2 Y2 = Y1 + 1+r 1+r

(7)

Equation (7) suggest that period-2 consumption prior to the tax cut must satisfy: C2 = Y2 + (1 + r )(Y1 − C1 )

(8)

The Household's Perspective cont'd. Disposible income after the tax cut: Period 1: Y1 + ∆T1 Period 2: Y2 − (1 + r )∆T1 Using (8), period-2 consumption after the tax cut is: C2 = Y2 − (1 + r )∆T1 + (1 + r )(Y1 + ∆T1 − C1 ) = Y2 + (1 + r )(Y1 − C1 ),

which corresponds to the consumption level prior to the tax cut.

A Temporary Increase in Government Expenditure Consider a temporary increase in government expenditure,

∆G1 > 0.

Households anticipate a temporary future tax increase to pay for the higher G . The future tax increase lowers lifetime income, causing households to consume less, but because of consumption smoothing, the decrease in consumption in any given period is small. Since ∆G1 > 0 and ∆C1 < 0, but the former dominates the latter, a temporary increase in government expenditure will increase aggregate demand in the current period.

A Permanent Increase in Government Expenditure Next, consider a permanent increase in government expenditure. Households now anticipate a permanent future tax increase to pay for the higher G . The permanent future tax increase lowers lifetime income by more than under a temporary increase in G , causing private consumption to decrease more. Since |∆C1 | is much larger in this case, it will oset ∆G1 > 0, so that a permanent increase in G will increase aggregate demand very little (if at all).

Two Types of Fiscal Policy

Automatic stabilisers: automatic changes in tax revenue and government expenditure occurring over the business cycle. Discretionary scal policy: active decisions. Consensus view in normal times: avoid discretionary measures, rely on automatic stabilisers.

Why are Fiscal Decits Potentially a Problem? 1. Higher future taxes imply large distortionary costs. • Distortionary costs rise more than proportionally to the

marginal tax rate.

• Tax smoothing optimal.

2. Intergenerational redistribution. • Interest payments are a transfer from future generations to the

current generation.

• Crowding out investments.

3. Risk of government default. • Credit losses may trigger nancial crises. • Defaulting country will be unable to borrow on nancial

markets.

Decit Bias Inherent tendency to accumulate government debt. Why? 1. Myopia. 2. More popular to lower taxes and increase government spending in recessions than raising taxes and reducing spending in booms. 3. Incumbent governments seek to favour their constituents. Running decits ties the hands of future governments. 4. Common-pool problems: interest groups try to elicit favours without consideration for the costs of others. 5. Governments may seek to signal competency by combining high spending and low taxes if voters are uninformed.

Government Debt Dynamics Notation Dt : government debt in period t . Yt : GDP. γt : the GDP growth rate. it : the nominal interest rate. Tt : tax revenue. Gt : government expenditure (excluding interest payments). St : the primary scal balance. Bt : the scal balance.

Government Debt Dynamics cont'd.

Debt dynamics: Dt = Dt−1 − Bt ,

(9)

Bt = Tt − Gt − it Dt−1 = St − it Dt−1 .

(10)

where

Using (10) in (9), we obtain: Dt = Dt−1 − (St − it Dt−1 ) = (1 + it )Dt−1 − St .

(11)

Government Debt Dynamics cont'd. Dividing (11) by Yt : Dt−1 St Dt−1 Yt−1 St Dt = (1 + it ) − = (1 + it ) − . Yt Yt Yt Yt−1 Yt Yt

(12)

Note that γt =

so that

Yt − Yt−1 Yt = − 1 ⇔ Yt = (1 + γt )Yt−1 , Yt−1 Yt−1 Yt−1 1 = . Yt 1 + γt

(13)

Government Debt Dynamics cont'd.

Using (13) in (12), we obtain: (1 + it ) Dt−1 St Dt = − , Yt (1 + γt ) Yt−1 Yt

or dt =

(1 + it ) dt−1 − st , (1 + γt )

(14)

where dt ≡ Dt /Yt is the debt-to-GDP ratio and st ≡ St /Yt .

Government Debt Dynamics cont'd. To obtain an expression for the debt-ratio growth rate, subtract dt−1 from both sides of (14): 1 + it − 1 dt−1 − st ⇔ dt − dt−1 = 1 + γt 





 it − γt ∆dt = d −s . 1 + γt t−1 t

If γt is small, we may write: ∆dt ≈ (it − γt )dt−1 − st .

(15)

Risk of Spiraling Government Debt • High debt ratios may lead to vicious circles (snowball eects). • Recall: ∆dt ≈ (it − γt )dt−1 − st . • Large dt−1 and st imply high debt-ratio growth. • Concerns that the country may default raise risk premia and

interest rates.

• Higher interest rates hamper GDP growth and increase the

costs of the existing debt.

• The debt ratio grows even faster.

The Fiscal Consolidation-Growth Trade-O

• Equation (15) implies that if it − γt > 0, debt can only be stabilised if there is a primary surplus, st > 0. • But a primary surplus requires scal consolidation (austerity). • Austerity implies lower growth, which raises the debt ratio. • Heated European debate in recent years on the eects of scal

austerity.

Extracted from: EEAG (2016).

Extracted from: EEAG (2016).

Fiscal Sustainability

• Fiscal sustainability: the debt ratio must settle down at some

constant value.

• In addition to large debts in the aftermath of the recent crisis,

ageing populations threaten scal sustainability in many countries.

Demographic Challenges: Sweden

Extracted from: "Fiscal Sustainability Report 2016", Occasional Paper No.47, The National Institute of Economic Research.

Demographic Challenges: the EU

Extracted from: "Fiscal Sustainability Report 2016", Occasional Paper No.47, The National Institute of Economic Research.

Long-Term Fiscal Sustainability Making assumptions about future growth, interest rates and employment, and assuming unchanged transfer systems and public expenditure per capita, one can calculate how much taxes must increase relative to GDP to fund the ageing population. The intertemporal government budget constraint: the net nancial worth of the government ≥ the discounted value of future primary decits. Government bonds hold value only because they are backed by the government's ability to service its debt.

Long-Term Sustainability: the S2-Indicator

The S2-indicator: the annual permanent budget improvement in per cent of GDP that would be needed to meet the intertemporal budget constraint. S 2 > 0: Non-sustainable scal policy S 2 ≤ 0: Sustainable scal policy

The S2-Indicator and its Components

Extracted from: "Fiscal Sustainability Report 2015", Institutional Paper 018, European Commission, January 2016. IBP=Initial Budgetary Position, CoA=Cost of Ageing, comprising Long-Term Care (LTC), Health Care (HC), Pensions and Other (education expenditure and unemployment benets).

The Swedish Fiscal Framework 1. Two-step decision process for the central government budget. 2. Surplus target (Överskottsmål): the scal balance (net lending) should currently be one per cent of GDP over the business cycle. • The surplus target will be lowered to 1/3 per cent of GDP over

the business cycle, eective as of January 1 2019.

• An anchor for gross government debt (at 35 percent of GDP)

will complement the new surplus target level.

3. Ceiling for central government expenditure (Utgiftstak) three years ahead. Comprises all expenditures including pensions, but excludes interest payments.

The Swedish Fiscal Framework cont'd.

4. Balanced budget requirement for local governments: municipalities (kommuner) and regions (landsting). 5. Fiscal policy is monitored by independent institutions, in particular the Swedish Fiscal Policy Council (Finanspolitiska rådet).