Public Sector Finances

Distinction Between Discretionary Fiscal Policy and Automatic Stabilisers

The government can influence the level of aggregate demand (AD) through discretionary (or active) fiscal policy. If the economy is heading towards a recession, the government can adopt an expansionary fiscal policy, which means increasing public expenditure and/or reducing taxes. If this results in government spending exceeding tax revenues (G>T) it will boost the level of AD and also result in a budget deficit (ie government borrowing in the current year). If government spending is already greater than tax revenue, the size of the deficit will increase. It also follows that the national debt will increase, meaning that future taxpayers have more debt to repay and more interest on the debt.

If the economy is overheating the government may choose to raise taxes and/or reduce government spending, possibly running a budget surplus (T>G). This is called contractionary fiscal policy. This would help to bring down inflation and correct a current account deficit. Some of the National Debt could also be repaid.

The business cycle can also be partially controlled through automatic fiscal stabilisers. In developed economies, public expenditure and taxation typically take up between 30 to 50 percent of GDP. In a recession, public finances will move towards a deficit, as tax revenues shrink (because of lower incomes and spending), whilst government spending increases (because of higher benefits to people out of work). The resulting budget deficit helps to contain the recession by boosting AD.

When the economy is in a boom, the opposite happens; tax revenues rise and government spending on benefits falls. This moves the public finances towards a budget surplus, thereby reducing AD.

The automatic increase or decrease in government spending will also be subject to a multiplier effect.

Factors Influencing the Size of Fiscal Deficits

The business cycle – As discussed above, an economy in a deep recession is likely to have a budget deficit. The worse the recession, the bigger the deficit.

Government policy _– Sometimes a government may deliberately cut taxes or increase spending in order to boost growth (expansionary fiscal policy). This may lead to a bigger deficit if the growth does not generate sufficient extra tax revenue. Other governments (such as the UK government from 2010 to 2018 may regard high levels of borrowing and debt as a long term threat to the economy and seek to reduce the deficit through spending cuts (and/or tax increases). This has been called ‘austerity_’.

Tax evasion

Demographic change – See above. Many countries are struggling with an ageing population and a smaller working population to pay for pensions. This can only be resolved by making a painful choice between higher taxes, lower pensions or a later retirement age. Governments are reluctant to make these hard choices so that in the meantime borrowing increases.

Interest rates – An increase in interest rates will increase the cost of government borrowing. This may result in additional borrowing in future years to pay the interest on the national debt.

Factors Influencing the Size of National Debts

The factors above will also affect the size of the national debt, since any change in borrowing affects the total of outstanding debt. Only when there is a budget surplus can the national debt start to fall in terms of the actual amount. But note that although the actual amount may increase it is possible that as a percentage of GDP it could fall. For instance, if the actual national debt rose by 1%, but the economy grew by 10%, the national debt would have fallen relative to the size of the economy.

It is also possible for the national debt to shrink in real terms even if it increases in nominal terms. This is because inflation reduces the real value of debt. It is believed by some economists that some governments deliberately create inflation as a way of reducing the real value of the national debt, as this avoids harder choices like tax increases or spending cuts.

The Significance of the Size of Fiscal Deficits and National Debts

An increase in government borrowing (and a corresponding rise in the national debt) has the following possible consequences for the economy:

Higher interest rates – Other things being equal, higher borrowing may drive up interest rates as the government is the largest borrower in the economy. This may lead to ‘crowding out’ and may also increase the costs for households in mortgage repayments and consumer credit.

_Higher inflation _– If the economy is close to full capacity, it is likely that higher government borrowing may create excess demand leading to ‘demand pull’ inflation.

Higher debt servicing costs – The more the government borrows, the greater the national debt, and consequently the cost of interest payments on the debt. In extreme cases this can be unsustainable and lead to the debt spiraling out of control. This is because higher interest payments may lead to yet more borrowing, particularly if the economy is not growing. This is part of the problem faced by Greece after the financial crisis; a stagnant economy and high borrowing lead to an ever increasing national debt.

The problem is made worse by the fact that a country with a high national debt and big budget deficit is considered a risk, which may lead to higher interest rates for the government. It could even lead to a default and the government would then find it impossible to borrow more money. This would then require very big cuts in public spending and tax increases, almost certainly plunging the economy into a very severe recession.

__Note: __It is not the actual size of a budget deficit or the national debt that matters, but its size in relation to the economy (GDP). A country with a large economy can service a bigger debt, just as can an individual.

The European Union has a rule for eurozone countries that budget deficits should be no greater than 3% of GDP and national debts should be no greater than 60% of GDP. These are considered sustainable levels of borrowing and debt. Member countries that exceed these figures are required to cut spending and/or raise taxes to rectify the situation.

Explain why some countries have larger budget deficits and national debts (as a % of GDP) than others.

Your answer should include: structural budget deficit / business cycle / cyclical budget deficit / government policy / demographic change / tax evasion / debt servicing costs

Structural and Cyclical Deficits

A cyclical budget deficit is one that is caused by a contraction of GDP, especially a recession, as discussed above. It should automatically self-correct as the economy recovers and government finances move to a budget surplus. Over the course of the whole business cycle, a cyclical deficit and surplus may cancel each other out, so that the national debt does not change significantly.

A structural budget deficit is one that results from taxes being too low to pay for public expenditure. This can mean that there is a budget deficit even when the economy is growing healthily and close to full employment. It has to be remedied either by raising taxes and/or reducing spending commitments. A number of European countries have structural deficits. Causes include widespread tax evasion (a major problem in southern European countries) and unaffordable state pensions together with an ageing population.

__Note: __the actual budget deficit = cyclical deficit + structural deficit

Fiscal Deficits / Surpluses and the National Debt

A fiscal deficit is the same thing as a budget deficit; it is simply the amount that a government borrows in any particular year. It can be measured as an actual amount, or as a % of GDP (eg in 2017/8 the UK budget deficit was £41 billion or 2% of GDP. A fiscal surplus is the same thing as a budget surplus; it is the excess of tax revenue over government spending in any particular year.

The national debt is the sum total of all government borrowing that has not yet been repaid. If there is a budget deficit in the current year, the national debt will increase by that amount. If there is a surplus, it will go down.

The national debt can also be expressed as an actual amount or a % of GDP. In 2017/8 the national debt in the UK was £1.8 trillion,equivalent to 85% of GDP.

Note that the national debt is NOT the same as a country’s foreign debt. Much, if not all of the national debt may be owed to UK citizens and UK financial institutions. Some of it may, however be owed to foreign investors. For instance the US government has borrowed substantially from Chinese and Middle Eastern banks and sovereign wealth funds.