Understanding Government Financing, Debt, and Fiscal Policy
Government Financing: Taxes and Debt
Government financing is typically achieved through taxation and public debt. While taxes are a primary source of revenue, raising taxes can be unpopular. Another option is deficit spending financed by issuing government bonds. However, public debt also has limitations.
Public Deficit and Debt: A Closer Look
Deficit and surplus are flow variables, while public debt is a stock variable, representing the total amount owed by the state at a specific time. Public debt is the total value of government-issued bonds held by the public. Higher debt leads to higher interest payments for the state.
Public Budget and the Business Cycle
A budget deficit occurs when public revenues are lower than expenditures. The extent to which this should happen is debated.
Classical vs. Keynesian Perspectives
- Classical Economists and Monetarists: Advocate for limited public spending and a balanced budget annually, believing in self-correcting economic mechanisms.
- Keynesians: Argue that the public sector should intervene during recessions by manipulating taxes and expenditures to address inadequate aggregate demand. They accept temporary deficits during recessions, compensated by surpluses during upswings. The budget should be balanced over the cycle, not annually.
Cyclical Fluctuations and Public Deficits
During economic recessions, tax collection decreases due to reduced activity, while public spending increases due to higher unemployment benefits. This leads to public deficits. The opposite occurs during expansions. It’s useful to divide the deficit into two components:
Cyclical vs. Structural Deficit
- Cyclical Deficit: Attributable to the current economic cycle.
- Structural Deficit: Caused by a mismatch between the structure of public income and expenditure, not cyclical fluctuations.
The relationship is twofold, as cyclical fluctuations also affect the budget.
Discretionary Policy and Automatic Stabilizers
Discretionary fiscal policies are still used. However, their effectiveness as stabilizing policies is limited by slow institutional, political, and bureaucratic procedures.
Automatic Stabilizers
When taxes are proportional to income, tax revenue automatically adjusts as national product varies. Therefore, proportional taxes function as automatic stabilizers for the economy.
Fiscal Policy and the Displacement Effect
Increased public spending can create a displacement effect, potentially crowding out private investment. This can occur in two ways:
- Direct displacement of private investment.
- Increased interest rates due to public debt growth, reducing private investment.
A displacement or expulsion effect occurs when reactions in the money market decrease the effectiveness of fiscal policy.