Deficit, Debt and Political Theory of Government Debt - Essay Example

? Deficit, Debt and Political Theory of Government Debt Deficit, Debt and Political Theory of Government Debt Introduction Budget Deficit being highly dangerous vs. Ricardian Equivalence The theory of Ricardian equivalence is a theory of Economics by Robert Barro. The theory states that when a government proposes a tax cut to increase consumer spending, this leads to a higher budget deficit financed by more treasury bonds, which does not lead to much economic growth. Those who support this theory base it on the following two assumptions: 1. A budget constraint for the government does not mean that the government will have a deficit forever. A tax reduction or increase in expenditure that leads to spending being higher than revenues means that the deficit will have to be financed through a future tax increase or decrease. 2. The second assumption assumes that consumers are rational and will not increase consumption due to a debt financed tax cut. Their being rational means that they will reduce their consumption, because they understand the government’s fiscal policies that the increase in government spending finance through debt, will lead to higher taxes in future. The above assumptions imply that lower taxes and higher government expenditure through increased debt will not affect the economy as a whole (Alesina & Guido, 1990). There are those economists who are against the Ricardian equivalence and argue that a budget deficit can be extremely dangerous for an economy. According to Ricardians, lower taxes today means higher taxes tomorrow. The opponents see the timing of the expected future tax increase to trickle up to a future generation. Barro counters this argument by saying that people care for their kids and would not want to burden with future tax increases. Others against the Ricardian Equivalence argue that there will be budget constraints on the government. According to Ricardians, a tax cut now leads to an increase in consumer expenditure and GDP. It is assumed that the government’s position of a higher debt will not get worse due to the consumer’s increase in expenditure due to lower taxes. The questions will always arise as to whether consumers are aware of the government’s fiscal position. More debt for the government leads to a higher budget deficit (Barro, 1974). Budget Deficit and Public Debt Public debt or government debt is the amount a government owes. A government needs money to finance its expenses. It finances through borrowing from the public by issuing treasury bills or bonds and borrowing from corporations, individuals and foreign governments. The public debt is the outstanding amount borrowed in the past but has not yet been repaid. The size of the public debt is determined by the cumulative amount of borrowing that the government has done. Budget deficit is the excess spending the government has incurred over its income. When the total expenses are subtracted from all income and there is a shortfall, this is known as a budget deficit. The government has spent more money than they can earn. When the income is more than the expenditure this is known as a surplus. The link between budget deficit and public debt is that when a government has a budget deficit it has to get money to finance the deficit and it does this by borrowing which leads to accumulation of more debt. The magnitude of the debt is measured by the debt to GDP ratio (Barro, 1979). Foreign investors will be interested in the debt to GDP ratio, as this clearly indicates the financial position of the economy. A foreign investor will invest in a country that can pay its debt and where the economy is growing. Factors determining an Explosive dynamic Debt to GDP Ratio Public debt increases due to excessive borrowing by the government from issuing treasury bills or bonds and borrowing from foreign governments, individuals and state corporations. GDP is the Gross Domestic Product of an economy and it is the total income from individuals, corporations and the government. Debts are judged by calculating the ratio of debt to GDP. The ideal situation is that debt should grow at the same rate as GDP in order to keep this ratio constant. Debt is required to finance the government and the economy. A constant debt to GDP ratio will ensure that the economy is growing. The ratio indicates the ability of the government to pay back its debts. A high debt ratio is not bad in a situation where the economy is growing as this means that the government can pay its debt in the future. The higher the debt ratio the less likely the government will be able to pay the debt. A high debt can cause huge problems for an economy and cause panic in the domestic and international markets. A ratio below 50% is healthy whereas a ratio above 90% may indicate that the economy is in danger. These are just guidelines and it is important to note that countries that have a growing economy are able to support much higher debt ratios (Barro, 1981). The composition of the debt can indicate whether the high debt to GDP ratio is a risk for the economy. A high debt comprising of domestic investors and repeat buyers is less at risk than the reverse. If an economy has a foreign country as one of its main buyers then they would have a high debt to finance the trade between the two countries and keep a balance of trade. Increased trade between the two countries ensures that the debt can be paid in future. A high debt to GDP ratio is acceptable if an economy is growing rapidly. It means the economy is guaranteed some earnings in the future which will pay off the debt. A poor economy will not be able to sustain the high debts. An unexpected slow down in an economy is a factor that can lead to an explosive high debt to GDP ratio. An economy may have been growing tremendously and therefore took on huge debts as it was able to sustain the debt, however an unexpected slow down in the economy due to unforeseen circumstances may lead to a very high debt to GDP ratio. The demographics of the population are also a factor that determines the high debt to GDP ratio. A population that has a high ageing population means that the government has to spend more on the aging populations through increase in social security. The government will need to borrow to meet the social security obligation (Cukierman & Meltzer, 1989). Increased government spending with no corresponding increase in income will also lead to a high debt to GDP ratio. The type of government whether socialist or capitalist will have a huge impact on the type of government spending. A socialist government will have higher expenditure which leads to high inflation and leads to a higher debt to GDP ratio. High interest rates means the government has to increase taxes that impacts on the economic growth of the economy. Low economic growth means lower revenue and a higher debt to finance its expenses and the whole process starts to be a viscous cycle (Frederick, 2004). Possible solutions to stabilize growing debt ratio The best solution is to either cut spending in order to reduce the debt or to encourage economic growth to increase GDP. These two solutions can lead to the stabilization of the debt to GDP ratio. The ideal situation is to keep the ratio constant and to ensure the debt grows at the same rate as the GDP. Governments need to come up with ways to cut spending. Emerging economies that have had high debts have had to cut their spending through initiatives such as cutting down on the size of their government with huge salaries and allowances. Corporations need to be innovative and increase their sales which in turn reduce their expenditure and these increases the GDP. Governments need to encourage growth by reducing interest rates, this increases commercial lending, increases capital, investments and in turn the GDP. An increase in GDP leads to an overall reduction in the debt to GDP ratio. Government can also increase taxes as long as this does not affect the GDP growth. Taxes can be increased in luxury items or income tax on the higher income levels. In the 80’s and 90’s most emerging economies had huge debt to GDP ratios. The concerned governments had to come up with ways to reduce the debt through drastic reduction of government spending otherwise their economies would have collapsed. Currently debt ratios of emerging economies are very low in 2012; Hong Kong’s ratio was 4% and China at 16.3%. In the same year, the debt to GDP ratio was over 100% and Japan had a debt to GDP ratio of 233%. When governments take on debt it is important for them to make a plan of action detailing how the debt is going to be repaid. These plans of action can act as leverage for them when unexpected events happen that make it difficult for them to pay their debts. Political Theory of Government Debt In a neo- Ricardian world there are two types of individuals; those that are constrained and those that are not constrained. Those that are constrained will advocate for tax cuts and the issue of bonds that will be paid by future generations. This will mean increased spending and high taxes in future to pay off the debt. The unconstrained are also not indifferent to the government’s budget. Current conditions are conducive for higher debt and deficits because the current generations have the right to determine the current taxes, social security benefits and the national debt by a simple majority rule (Van Riet, 2010). With the evolution of debt; debt began at the point a government could not meet its expenses which meant that it had to borrow from individuals, corporations and foreign governments. In the process as the economy started to grow there was need for more money to fund the economy which meant more debt. An economy’s political stability influences the level of debt for an economy. A stable economy can sustain high debts which mean high economic growth whereas unstable economies due to wars mean increase in government spending on the war and reduced GDP. Higher taxes are justified when it means that this is a way to distribute the taxes equally over time over several generations (Van Riet, 2010). The theory of public debt is an attempt to minimize the excess burden of taxation over time. Lower taxes now mean higher debt and higher taxes for future generations. The main function of a government incurring debt is to redistribute the burden of taxation over time. The politics of any economy will influence the public debt of that economy. In democratic economies, the population has rights over decisions made by the government that will affect them. Consumers will favor tax cuts that will increase their spending. Under majority rule, a larger debt will lead to a larger deficit. A large debt means that there are large inequalities in the distribution of wealth between those that depend on labor income and those that do not. There is a larger rate of technical progress in that economy meaning more investment and higher economic growth. A high debt is less responsive to wages and more responsive to return to capital and to a change in the capital – labor ratios (Van Riet, 2010). A political theory of government debt is based on the redistribution across current and future generations in the presence of different individual abilities and different amounts of wealth. The implication of the political theory is that the existence of a large public debt is directly related to the number of individuals who desire to no money or property when they die and are prohibited from doing so. By voting for low taxes that increase the budget deficit, this increases their consumption and crowds out capital needed for investment. Even when the present value of future taxes is equal to the value of debt as suggested, a high debt will always have a macro effect on interest rates, wages and capital. This all have an effect on the GDP of any economy. In time of war, a government will spend more while most of the workforce is not generating any income, meaning higher expenditure and lower revenues. The budget of any economy is greatly influenced by the political leadership of that economy. Different policy makers may alternate due to the electoral process of that economy; this means that there will always be differences in the fiscal policies of that economy regarding public debt and budget deficit. The government debt will always be used as a strategic variable for any policy maker running office in influencing the choices of his successors. The different policies will mean different desired composition of the government debt. Differences in the level of government debt will increase when there are huge differences in alternating governments. A socialist government’s attitude towards government spending may be very different from a government that is capitalist. Political stability and distributional stability will influence the stabilization of public debt to GDP ratios. Budget deficits and government debt is a necessary tool to distribute income over time and across generations (Van Riet, 2010). References Alesina, A., & Guido, T., 1990. A Positive theory of fiscal deficits and government debt. Review of Economic Studies, 57 (3), pp. 403-414. Barro, R.J., 1974. Are Government Bonds Net Wealth? Journal of Political Economy, 82, pp. 1095-1117. Barro, R., 1979. On the Determination of the Public Debt. Journal of Political Economy, 87, pp. 940-71. Barro, R., 1981. On the Predictability of Tax Rate Changes. NBER Working Paper, No. 636. Cukierman, A., and Meltzer, A., 1989. A Political Theory of Government Debt and Deficits in a Neo-Ricardian Framework. American Economic Review, 79 (4), pp. 713-32.  Frederick, V., 2004. Macroeconomics of Fiscal Policy and Government Debt. ECB Monthly Bulletin.  Van Riet, A., 2010. Euro area fiscal policies and the crisis. Occasional Paper Series, No 109. Read More