Why the actual budget deficit is not a good indicator of the fiscal stance and suggest any other better alternatives - Essay Example

? MACROECONOMICS by of the of Location of the Macroeconomics Explain why the actual budget deficit is not a good indicator of the fiscal stance and suggest any other better alternatives. Introduction Budget deficit has been has been an issue in both developing and industrialized countries. Originally, the issue was blamed in large for the assortment of ills that beset developing countries at that time such as indebtedness, poor investment, high inflation, and poor growth performance. During the 1990s, budget deficits also took center stage in the reform programs that were initiated in many countries across all continents (Easterly and Schmidt-Hebbel 2004). The problem associated with a budget deficit raises many issues. Not the least of these is how to define and measure the budget deficit. Which is the best and most meaningful measure of budget deficits? How should one assess public sector solvency, fiscal stance, and sustainability of deficits? The budget deficit must therefore be subjected to an intense analysis and scrutiny. Unless it is cautiously interpreted, the budget as is conventionally defined deficit can give rise to misleading conclusions regarding fiscal policy stance. Such conclusions may result in erroneous policy prescriptions that cause more harm than good to the economy (Abedian and Biggs 1998). For many years policy makers placed a lot of emphasis on limiting government’s role in the economy and lowering the budget deficit (Easterly and Schmidt-Hebbel 2004). The two were regarded as policy goals necessary to achieve equity, growth and redistribution of resources. The big question as to whether the conventional budget balance is the correct indicator of the fiscal stance however remains. It should be noted that there are several other fiscal indicators were proposed as alternatives to the conventional budget balance. These indicators are already in use successfully by international organizations such as the OECD and the IMF (Abedian and Biggs 1998). This study will aim to explore the possibility of using alternative fiscal indicators in monitoring and evaluating the sustainability of fiscal policies. A critical analysis of the actual budget balance indicates that it is not the ideal measurement instrument with regard to ascertaining the fiscal stance of a country. The term budget deficit also referred to as budget balance appears regularly in news articles, policy documents by the government that usually warn of it being very undesirable (Eisner 1999). The budget deficit is usually blamed for several economic ills, such as high levels of inflation and discouragement of private investment (Eisner 1999). There is rarely any concrete proof produced for all these guilty assumptions. To add on to this, concerned parties pay very little attention to the objective measurement and interpretation of the budget deficit. The method of measurement of the budget balances also raises several conceptual and practical issues, which are compounded by the absence of uniformity in usage among many countries. For instance, one way of measuring the conventional budget balance is by cash basis. Another person may use the accrual/ payment order basis (Agenor and Montiel 1999). In the first instance, the balance will be the difference between fiscal revenue and total cash flow expenditure. For the second case, the balance will reflect accrued income and spending flows, regardless of whether they involve cash payments or not. The accumulation of arrears on revenue or payments is reflected by a higher balance when measured using the accrual basis as compared to the cash-based approach (Agenor and Montiel 1999). Definitions By definition, actual budget deficit is the difference between government revenues and government expenditure. Structural budget deficit is an estimation of what the government’s budget would be at full level of employment in the economy (Abedian and Biggs 1998). The cyclical budget deficit is defined as the component of the government’s budget deficit that fluctuates with the state of the economy. It is the difference between the actual budget deficit and the structural budget deficit. The fiscal stance is defined as the tendency of taxation and expenditure policies adopted by the government's budget to contract or expand the economy. It involves comparisons made with regard to the normal budgetary position (Abedian and Biggs 1998). It is argued that the fiscal stance of a government cannot be inferred purely from its tax revenues and actual spending. One of the reasons for this is that the changes in the deficit depend on two factors. These are the discretionary changes as a result of expenditure programs or taxes and changes in the state of economy, that is, whether the national income equilibrium level is increasing or decreasing (Eisner 1999). The deficit is particularly sensitive to the state of the economy due to the fact that both the transfer payments and taxes will vary with the national income level. The structural budget deficit which is a component of the actual budget deficit also contributes to the inaccuracy of the actual budget deficit as a measure of the fiscal stance. One of the reasons is that the structural deficit is usually an estimate and not an actual number therefore compromising the computed results. Also, the natural rate of unemployment component is a moving target making it difficult to value. The empirical analysis of the fiscal stance is complicated by the fact that there lacks a precise definition of fiscal sustainability. An example is the debt-to-GDP ratio (Eisner 1999). This ratio may grow in a selected sample; nevertheless it does not mean that it will continue to grow in the future. The ratio may also be stable but other factors such as say the effects of the population that is aging may pose a different challenge in the future. Considering the size and complexity that is associated with most government budgets, it is important to create broad indicators that will convey a sense of the impact of fiscal policy on financial resources and domestic demand. In the ideal sense, a comprehensive coverage the activities of government should be reflected by such indicators. These should also be easy to derive from budget documents and other statistical sources that are available. In reality, this is not often the case. A lot of effort is required to piece together accurate and appropriate indicators of the impacts of fiscal policy. This requires an analysis of effected policies both within and outside the budget. One of the indicators commonly used to assess the stance of fiscal policy is the overall balance. The balance may be a deficit or surplus. A deficit would mean that an expansionary fiscal stance is required to deal with the negative impact of taxes (Agenor and Montiel 1999). Although the overall balance is important as an indicator for assessing fiscal policy, this measure should be cautiously judged. This is because though it offers an insight into the aggregate demand effects of a fiscal policy, it is deficient as an indicator how fiscal actions impact on other policy variables of concern such as sustainability, monetary stance and growth. Furthermore, being a simple indicator, it does not clearly look into the many factors that are involved in the operation of government such as how financing of the deficit is undertook any country (Easterly and Schmidt-Hebbel 2004). With this in mind it should be noted that there exists alternative method that can be used in order to arrive at the fiscal stance of a country. There are other different definitions of the deficit that can be used to get a clearer picture on the fiscal stance of a country. The factor that determines this is whether the fiscal policy is sustainable in the long term. When the different definitions of the budget deficit are compared it is noted that they do not vary much in magnitude. The variations are within a range of a surplus of 2% of GDP and a deficit of 5% of GDP (Eisner 1999). When the differentiating variables are excluded it is noted that all approaches rely greatly on the interest rates, size and level of economic growth and inflation. When conducting fiscal analysis it is the norm to use the operational deficit when one wants to measure fiscal sustainability. This is a good choice since the other definitions only have marginal variations with regard to their relationships to GDP (Easterly and Schmidt-Hebbel 2004). Conclusion If alternative methods of determining budget balances are developed or good fiscal indicators are used, it is possible to develop fiscal analysis and policies that are more compared to when using actual balance deficit. How one chooses the alternative to use depends on the purpose for which it is to be used for. It is important to view the long term implications of fiscal expansion against the background of the impact of the conventional deficit on fiscal sustainability. Alternative methods outlined in this study should be used for proper fiscal analysis. An example is the cyclical adjusted indicator that can be used in cased where economies are in a transition phase. References Abedian, I. & Biggs, M. (ed.) 1998. Economic Globalization and Fiscal Policy. Cape Town: Oxford University Press. Easterly, W.R., Rodriguez, C. A. & Schmidt-Hebbel, K. (ed.) 2004. Public Sector Deficits and Macroeconomic Performance. Washington, D.C. Oxford University Press. Eisner, R. 1999. Budget Deficits: Rhetoric and Reality. Journal of Economic Perspectives 3: 73-93. Agenor, P.R. & Montiel, P.J. 1999. Development Macroeconomics. (2nd edition) Princeton, New Jersey: Princeton University Press. Read More