How Fiscal debt can be controlled
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This document discusses fiscal deficit and ways to control it. It begins by defining fiscal deficit as when a government's total expenditures exceed its total revenues, forcing it to borrow money to make up the difference. It then discusses the impacts of fiscal deficit, including debates around whether deficits help or hurt economic growth. Three main ways to control fiscal deficit discussed are implementing fiscal policy rules to promote discipline, increasing transparency in fiscal management, and reducing spending while increasing taxation. The document argues that public debt does matter and future taxpayers will be obligated to pay off the debt and accumulated interest.
How Fiscal debt can be controlled
- 1. FACULTY OF SOCIAL SCIENCES DEPARTMENT OF POLITICAL AND ADMINISTRATIVE STUDIES MPA – 609 PUBLIC BUDGETING & FINANCE STUDENT NAME: SOLOMON SAMUEL ADETOKUNBO STUDENT NUMBER: 201502535 LECTURE: PROFESSOR NORBERT MUSEKIWA MID-TERM PAPER TITLE: HOW CAN FISCAL DEFICIT BE CONTROLLED? IS IT TRUE THAT “DEBT DOES NOT MATTER BECAUSE WE ONLY OWE IT TO OURSELVES”? 1
- 2. INTRODUCTION One of the macroeconomic problems that constantly keep government on it toes is controlling and managing the nation’s fiscal deficit. The concept of fiscal deficit has been analyzed from numerous perspectives and become a major socio-political issue across the globe. Policy advisors are constantly faced with the problem of how best to go about addressing fiscal imbalance in the economy. Reason was that fiscal balance is a core objective of economic development; when a country experiences budget deficit, it resorts to lending which could either be domestic or foreign; if the latter is chosen, it declines the self respect of the country as well as its citizens. Therefore, there is a need for government to ensure that the expenditure does not overshoot its revenue, rather ensure that the expenditure and the revenue are of the same ratio or the revenue is greater than the expenditure. This is imperative in order to protect the goals of economic development in the country. Steady upward shifts of fiscal deficit have been witnessed by many developing countries over the last few years. High fiscal deficit poses a major challenge on the economy as this increases public debt incurred, amongst other economic decay. The rise in public debt has created factions among researchers and policy makers with some subscribing to Paul Krugman philosophy of “public debt does not matter because we owe it to ourselves”. This paper examines the question how fiscal deficit can be controlled bringing into context examples from different countries. The first section outlined the concept of fiscal deficit, closely followed by the impact fiscal deficit has on the economy and nation as a whole. The third section discussed the ways by which fiscal deficit can be controlled through effective use of fiscal rule, transparency in fiscal management, spending cuts and increased taxation. The argument of this paper is that debt does matter and the burden lies on the shoulder of future tax payers who are obligated or voluntarily coerced to make payment for the debt and accumulated interests. 2
- 3. 1.0 CONCEPT OF FISCAL DEFICIT To fully understand the concept of budget deficit, the term “fiscal deficit” has become very common. Before the concept of fiscal deficit was conceived, common terms used include capital deficit, budget deficit, revenue deficit etc. (Gupta, 2001, p.1). Gupta (2001, p.3), defined fiscal deficit as a gap in the government budget that arises in any financial year when the governments total expenditure exceeds its total income and is forced to borrow money to bridge the gap. Investopedia in a similar manner defined it as when government’s total expenditure within a given financial year exceeds the revenue that it generates excluding money from borrowings. Often time people use fiscal deficit and budget deficit interchangeably, though they are similar, a very thin line exists between the two terms. Budget deficit also referred to as national debt is when there is an excess in government’s expenditure over its revenue for a financial year or budget, while fiscal deficit refers to the accrual of annual deficits of past previous years (Teresa 2004, p.2). Budget deficits can usually be fixed by raising taxes, reducing spending or adopting a combination of both. Unfortunately, the same cannot be said of fiscal deficit. Foremost economist John Keynes argued that deficits help climb out of economic recession. Fiscal conservatives share a totally different view on this matter, they are of the opinion that government should boycott deficit and stick to a balanced budget policy. There are a number of factors that can trigger fiscal deficit, they include: increase in government expenditure, poor performance of public sector, tax evasion, increase in subsidies, low revenue, inflation etc. Kundu (2012) stressed that fiscal deficit can be influenced by international market dynamics, stating India as an example. “India is a large importer of crude oil; rise in oil prices in international market raises the domestic price level and the government takes action to check the domestic prices by increasing the subsidy expenditure on oil and thus incurs a higher fiscal deficit”. (Kundu, 2012) 3
- 4. Other factors promoting inflation identified by Kundu (2012) are: volatility in the currency market and depreciation of the domestic currency leading to increase in import bills. Fiscal deficit doesn’t occur only when generating less revenue and having high expenditure. it can also be ushered in by recession or slow economic activities. 2.0 IMPACT OF FISCAL DEFICIT Economist have been unable to reach an agreement based on analytical grounds and empirical result as to whether funding government expenditure by accruing a fiscal debt is good, bad or neutral in terms of its real effects, particularly on investment and growth. (Feldstein, 2004). Nobel laureate and American economist Paul Krugman, stated that the government inability to invest much capital and the slow recovery from the recession that hit America in 2008 was due to the reluctance on the part of the congress to improve aggregate demand. Contrary to Krugman’s position, Ross (2015) argued that fiscal and budget deficits crowd out private borrowing, manipulate capital structures and interest rates, decrease net exports, and leads to either higher taxes, higher inflation or both. Tempelman (2005) highlights three theories that sheds more light on the effects of fiscal deficits and public debt: Keynesian, Neoclassical and Rikardian Paradigm. The common feature of the three school is that they generally discuss deficit from the angle that it occurs when there is a reduction in tax not looking at it from the angle of an increase in government expenditure. Differences in views on deficit and public debt often result from different choices of assumptions fundamental to the models of the various paradigms. The neo-classical perspective of deficit regards fiscal deficits unfavorable to investment and growth in a nation, while in the Keynesian school, it constitutes an essential policy prescription. Theorists who subscribe to the Ricardian school of thought stress that fiscal deficits do not really matter except for smoothening the adjustment to expenditure or revenue 4
- 5. shocks. While the neo-classical and Ricardian paradigm focus on the long run, the Keynesian view emphasizes the short run effects. (Feldstein, 2004). Debate arises often times whenever there is discussion centered around the long term macro- economic impact fiscal deficit has on the economy, but less debated when the short term effect of the deficit is discussed. The impact a fiscal deficit has on a country depends on the nature of the deficit. For instance, if the deficit arises as a consequence of extra spending’s on projects (infrastructure investment, small and medium enterprise grants/loans) then the sector responsible for the project is given an operational boost to maximize profitability. If deficit is as a result of fall in government revenue either through tax cut or recession, then no stimulus takes place. We cannot dispute the fact that when a fiscal deficit occurs certain sectors leverage and benefit from it in the short run. Rangarajan (2004) in his address to the Reserve Bank of India, the apex bank in the country drew importance to the fact that the impact of fiscal deficit on investment arises both from its effect on private investment and government investment. He stated that: “the adverse effects on private investment occur if fiscal deficits put pressure on interest rates, and if private investment is sensitive to the interest rate. The effect on government capital expenditure is through committed interest payments, which rise if the debt-GDP ratio rises and/or interest rate rises". Other consequences of high fiscal deficit include: debt trap, cut in capital expenditure, high fiscal deficit tends to discourage foreign investment in the country etc. 3.0 HOW TO CONTROL FISCAL DEFICIT In these 21st century, deficit control and reduction are among the few central focus of public debate on economic policy across the globe. It is a popular opinion that high fiscal deficit can be controlled or reversed. For instance, if the state experiences a continuous increase in expenditure, it can increase the taxation rate to compensate for the increase in expenditure. When this is done the general public will have no other option than to cut down on their own personal expenditure to offset the taxes. 5
- 6. A huge fiscal deficit is a sign for the government to know that the economy is not in good shape and this necessitates a cause for alarm. When this occurs the first thing most government wants to do is reduce the fiscal deficit rather than controlling it, as they try to cut down the fiscal deficit they are faced with the challenge of where to cut spending. The following measures of controlling fiscal deficit shall be considered, they are: fiscal policy rule, transparency in fiscal management and spending & taxation. 3.1 FISCAL POLICY RULE In order to control fiscal deficits, fiscal policy rules and target borrowing must be adopted and implemented by the government to ease economic tension and promote fiscal discipline in the country. The Government at the national level should make provision for exogenous limits on borrowing through fiscal legislation or other institutional measures. A notable example is the Australian Loan Council and the Maastricht Treaty for member countries of the European Economic Community (EEC) as highlighted by Feldstein (2004). The Maastricht Treaty on Economic and Monetary Union requires two unifying conditions for the members of the European Monetary Union to borrow. The first states that the country’s overall budget deficit for each fiscal year must be equal to or below three percent of the GDP and the country’s stock of public debt must be equal to or less than 60 percent of the GDP (Feldstein,2004). The three percent boundary should not be exceeded on any occasion except when there is an unusual economic downturn. The United Kingdom in similar manner has operated a golden rule since 1997, which stipulates that borrowing can only be carried out to fund capital spending only, also the Canadian government just like the UK have fiscal rules with balanced budgets obliging them to take on debt only for the purpose of funding investment projects. In the United States, all states have laws that provide for for balanced budgets, this restricts the states from incurring 6
- 7. huge debts. (Feldstein,2004). In addition to fiscal rule, debt ceiling can also serve as a useful complement control fiscal deficit. It is imperative to note that fiscal rules do not operate in isolation. it requires institutions and reforms that will give it the needed support to deliver the expected result. Fundamental reforms to make fiscal rules effective. Amo-Yartey (2014) shared similar views and argued that reforms such as good budget preparation, apportioning and implementation, an autonomous fiscal policy council to deliver independent appraisal of macroeconomic and income projections; and legislative resolutions to make the fiscal rule obligatory are imperative to make fiscal rules applicable and work efficiently 3.2 TRANSPARENCY IN FISCAL MANAGEMENT Fiscal transparency is an essential component of fiscal management and accountability (IMF, 2012). The need for fiscal transparency is imperative in order to control fiscal deficit in a country, it provides the government with adequate accurate information about their fiscal position, opportunities and risk that might arise in the wake of policy changes as well a future projection. The United Kingdom, New Zealand and United States, India etc. are among countries that have enacted legislations for transparency. This measure helps countries control fiscal deficit by providing an effective and accountable use of expenditures. Transparency in fiscal management operates best when there exists a clear legal provision which helps to improve “guiding principles of fiscal policy, clear statement of objectives of changes in fiscal policies and requirements for providing fiscal information to the public” (Feldstein,2004). Taking a look at India, The Indian Fiscal Responsibility and Budget Management Act enacted in 2003 has been serving as a legal check on the level of government borrowing at the central level, also similar legislations have been put in place in all states in the subsequent years. Kundu (2012) indicated that the post-IFRBM Act era has witnessed ardent efforts by 7
- 8. the governments (state & central) to cut down their deficits “The Act and the Rules, as these presently stand, have provided for the elimination of the revenue deficit by 2008-09, with 0.5 percentage point of GDP as the minimum annual reduction target, and fiscal deficit to be brought to the level of 3 percent of GDP, with 0.3 percentage point of GDP, as the minimum annual reduction target” (Kundu, 2012). The IFRBMA has some element of internal flexibility used in achieving fiscal deficit reduction and control, this include a provision that specifies that debt limit may only be surpassed on ground or grounds of national security, national disaster or any other special grounds that follows the discretion of the central government. In addition to helping control fiscal deficit, fiscal transparency in management gives room for a better and well informed debate by researchers, policymakers and the general public about fiscal agendas. 3.3 SPENDING & TAXATION A smart mix of spending cuts and an increase in tax can help control high fiscal deficit in a country even though the latter might not go down well with the general public. In the 90’s, Canada experienced almost a double-digit budget deficit. According to Smith (2013) the government had to institute a minimum 20% budget cut, within four years of implementing the budget cut, Canada’s budget deficit reduced to zero in the fifth years its fiscal deficit had been reduced by one-third. Spending cut can also be complimented with tax raise to further have a firm control on the deficit. For example, Smith (2013) noted the case of Sweden, the country was experiencing a devastating recession in 1994 but by late 90’s it was able to control its fiscal deficit through a combination of spending cuts and tax increases. Politicians enjoy and flourish on public votes. This makes the prospect of reducing or cutting spending a difficult task which may end up being a disaster for them in the next election. This makes spending cuts and hence controlling fiscal expenditure unlikely. 8
- 9. Failure to cut down expenditure while increasing tax often times amount to nothing, they work better together in controlling fiscal deficit. 4.0 WHY DEBT MATTERS “Debt does not matter because we only owe it to ourselves?”. Debt does matter in every form and no; we do not owe it to ourselves. The “we owe it to ourselves” philosophy was popularized by functional finance proponent and renowned economist Abba P. Lerner, and was recently advocated by Princeton economics professor and Keynesian champion Paul Krugman, through his New York Times editorial published on February 9, 2015. The doctrine, “debt does not matter because we only owe it to ourselves” is clearly illogical. The fundamental question to ask should be, who is the “we” and who are the “ourselves” that the statement refers to. I rightly concur with Rothbard (2004) viewpoint on this subject matter “Analysis of the world must be individualistic and not holistic. Certain people owe money to certain people, and it is precisely this fact that makes the borrowing as well as the taxing process important. For we might just as well say that taxes are unimportant for the same reason”. Whenever the government has an overlapping expenditure it resorts to borrowing and this on the other hand increases the size of its debt. The burden of the debt lies on the shoulder of future tax payers who are compelled to make payment for accumulated interest on public debt. In essence debt isn’t owed to ourselves, it is owed to the lenders, creditors or bondholders who are authorized to reclaim their interest payment at the appropriate time. Other than the bondholders, Tucker (2012) described government employees as another set of stakeholders who have a claim on pension rights payable in the future; when the day for the pension payment comes, will it be possible for the government to ignore them or say they don’t need to be reimbursed because debt is only owed to ourselves? Taking a look at the US and presumably other countries of the World, in 1978 one could have easily said debt didn’t matter because it owed it to themselves but that is not the case 9
- 10. anymore. Currently about 35% of the $6.13 trillion US debt is owed to foreigners, with China having the biggest chunk amounting to $1.3 trillion. Same goes for Greece that is on the verge of collapse, owing a whooping sum of $323 billion as at 2015, the European Union (EU) and the International Monetary Fund (IMF) is the Greece’s highest lender, accounting for 75% of the country’s debt (Egan, 2015) Greece probably wont collapse as a result of inability to pay their huge debt, it will eventually meet its demise because it would get to a stage when the country can’t continue to borrow to maintain its standard of living as a result of investors or lenders declining the country’s borrowing request. Debt does strongly matter because we just don’t owe it to ourselves. There are real costs to every governments borrowing, but not until when the bills are due for payment and the citizens have to pay for it through taxation before they start asking rhetorically if borrowing and deficit spending was really a good idea. 5.0 CONCLUSION some scholars consider it is a myth to control fiscal deficit as a result of the global recession affecting various countries others most especially the Keynesian believers subscribe to the notion that, there is no need to control deficit since “we only owe debt to ourselves”. Controlling fiscal deficit is possible without a regressive taxation but difficult for the government to carry out as it revolves around spending cuts. It can be challenging to reduce fiscal deficit as a result of the problem of not knowing where to cut spending’s coupled with the fact that cutting spending may end up being a disaster for the politician in the next election. Methods of reducing fiscal deficit discussed in this paper are fiscal policy rule, transparency in fiscal management and spending cuts coupled with increased taxation. It is imperative to point out that the spending cuts and increased taxation work better when adopted 10
- 11. simultaneously. Increasing taxation without actually cutting down on the spending’s may be tantamount to futility. Debt does strongly matter because we just don’t owe it to ourselves. There are real costs to every governments borrowing, but not until when the bills are due for payment and the citizens have to pay for it through taxation before they start asking rhetorically if borrowing and deficit spending was really a good idea. REFERENCES Amo-Yartey, C. (2014).Improving Fiscal Management in Ghana: The Role of Fiscal Policy Rules Retrieved 24 February 2016, from http://ieagh.org/wp- content/uploads/2014/08/Improving-Fisical-Management-in-Ghana-final- inside.pdf Egan, M. (2015). China is dumping U.S. debt. CNN Money. Retrieved 24 February 2016, 11
- 12. from http://money.cnn.com/2015/09/10/investing/china-dumping-us-debt/ Feldstein, M. Srivastava, K. (2004). Fiscal Deficits and Government Debt in India: Implications for Growth and Stabilization, Retrieved 19 February 2016, from http://www.nipfp.org.in/media/medialibrary/2013/04/wp05_nipfp_035.pdf Gupta, J. R. (2001). Fiscal Deficit of States in India, New Delhi, Atlantic Publishers & Distributors, Rangarajan (2004). Fiscal deficits and government debt in India: Implication for growth and stabilization Retrieved 24 February 2016, from http://citeseerx.ist.psu.edu/viewdoc/download? doi=10.1.1.380.8230&rep=rep1&type=pdf Kundu, S. (2012). Fiscal Deficit. Retrieved 24 February 2016, from http://www.cbgaindia.org/files/featured_articles/Fiscal%20Deficit.pdf Krugman, P. (2015). Nobody Understands Debt. Nytimes.com. Retrieved 24 February 2016, from http://www.nytimes.com/2015/02/09/opinion/paul-krugman-nobody- understands-debt.html?_r=2 Rothbard, M. (2004) Man, Economy, and State with Power and Market, Scholar's Edition, Alabama, Ludwig von Mises Institute Tempelman, H. Buchanan, M. (2005) Public-Debt Finance, the Independent Review, Retrieved 19 February 2016, from http://www.independent.org/pdf/tir/ tir_11_03_06_templeman.pdf Teresa, S. (2004) Budget Deficit. Economic Issue of the day. Retrieved 18 February 2016, from http://dirp4.pids.gov.ph/ris/eid/pidseid0401.pdf Ross, S. (2015) What is the effect of a fiscal deficit on the economy. Investopedia. Retrieved 19 February 2016, from http://www.investopedia.com/ask/answers/021015/what- effect-fiscal-deficit-economy.asp 12