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Lecture 5:Instruments of budgetary policy in times of economic weakening (Vladimír Vaňo)

Lecturer: UPMS | Thursday, 20. 10. 2011

Why are governments trying to combat the recession?

  • Regularly recurring business cycles are due to processes in the private business sector (be it the shortest inventory cycle or long macroeconomic cycle associated with technological innovations).
  • Business sector (mostly private) is not only the dominant employer in the economy, but the only economically productive sector of the economy: the government only redistributes tax revenues through public services.
  • Nevertheless, in regularly recurring periods of recession increased government initiative appears to seek financial and other instruments of "solution" to economic weakness.
  • Regularly recurring business cycles are accompanied in the time of recession by cyclical increases of unemployment. Therefore, governments and politicians seek to engage mainly during the economic weakness in order to mitigate the effects of recession on households and voters.
  • However, is budgetary policy for the economy in time of recession a miracle cure, or on the contrary part of the problems that accompany a period of economic weakening?

Cyclical deficit deepening as a result of the recession

  • Public finances are an instrument of redistribution of tax revenues through the provision of public services.
  • A period of economic weakening is associated with a cyclical weakening of the base from which the amount of tax revenue derives: declining volume of sales and retail(consumption tax, VAT), decreasing the profitability of firms (corporate income tax), and decreasing employment (income tax of natural persons).
  • On the other hand, the volume of services provided from the budget expenses even grows in some cases (especially in the field of social affairs when due to rising unemployment more people are dependent on the social safety net).
  • In addition, politicians in times of recession effort to alleviate its negative impact with additional "fiscal stimulus" by increasing expenses in some areas. Such efforts, however, have vastly different effects depending on how the economy structure looks like, especially what is the relationship between domestic and foreign demand, which decides on the strength of economic activity.
  • The result this mismatch between the cyclical weakening of budget incomes and increased budget spending is cyclical deepening of budget deficits. Almost none of the EU countries avoided it during the last recession, where the average deficit in 2009 rose to more than 6% of GDP.
  • The extent of the deepening deficit depends not only on that condition in which the particular public finances were caught by recession (such as how governments had managed before the recession), but also the structure of the domestic economy (which affects not only the impact of the recession on tax revenues decline, but also the rise in unemployment).

Theory of automatic stabilizers

  • Common sense says that if during the economic downturn and reduction in revenues costs must be cut (and company’s staff), public finances should respond with the same adequate change on a similar decline in tax revenues.
  • Theory of automatic stabilizers, however, assumes that while in time of recession weakening of the volume of companies’ investments (I), and due to rising unemployment and household final consumption (C) acts negatively on economic activity, the development of governments final consumption (G) supported by increased deficit should help alleviate the economic weakening. This theory, however, presumes an economy model where external demand does not play such an important role.
  • According to this theory a temporary increase in government deficit is a contribution to reducing the depth of economic weakness, or its impact on households. Whether with additional expenses stimuli, or a slower reduction of budget expenditure than the drop in budget incomes.
  • In addition to relatively low openness of domestic economy, this theory assumes a relatively low level of public debt, which increases temporary deficit deepening.

Cycle in the economy versus cycle in public finances

  • The theory of automatic stabilizers can be effectively applied mainly in the less open economies (where domestic demand by households (C), companies (I) and government (G) has a dominant weight compared to external demand, which affects the balance of foreign trade and especially the volume of industrial sales and employment).
  • Besides that, the theory assumes implicitly that for the state to be able to allow the management of growth of deficit during worse times, it must create space for it in good times, in times of expansion, during which the state should decrease the amount of public debt by balanced or surplus budget maintenance.
  • The theory of temporary surpluses in a cyclically recurring recession is therefore subject to cyclical recurrence of public finances management along with the sinusoid of the business cycle: with balanced or surplus at the time of expansion, thus in times of recession there is room for temporary deficits.
  • Denial of this logic in the case of many European economies that even in good times did not reduce their public debt led to the deepening of cyclical deficit, otherwise also a natural part of the business cycle, leading to deterioration in public finances to unsustainable levels.

Save or spend in the bad times?

  • Why then, despite the theory of contribution of temporary deepening of the deficit during a recession it is called for public spending cut and deficit reduction?
  • First of all, especially since the temporary deficits increased by recession encounter "credit limit" of the country available on the bond market.
  • In particular, in case of combination of high debt and increased government deficit, bond markets penalize by increasing the country’s risk rates, price for submission of the increased credit risk.
  • In an extreme case especially countries with high debt are facing difficulties in accessing the new loans (through regular auctions of bonds). Without it for refinancing of the public debt they may be forced to apply a bridging loan from transnational lenders (for example, emergency IMF loan to Hungary in October 2008).
  • It is possible to discuss hypothetically the effectiveness of temporary deepening of the deficit of public finance in case of the U.S., whose economy has two important particularities:
    • It depends mainly on domestic demand.
    • It uses the most important reserve currency of the world, which gives access to foreign exchange reserves of central banks and can seamlessly refinance even the deficit management deepened by recession  with new government issued bonds.

The deficit and credibility of public finances

  • In particular, the state of public finances (the amount of the deficit and public debt) is the most important part of the evaluation rating of the country (the most important sign is the full text of "long-term debt rating of the government").
  • Excessive deterioration in public finances may thus lead to rating downgrades.
  • Worse rating is penalized in the bond market by higher risk surcharge for undergoing a credit risk against the government (with the purchase of government bonds).
  • Worse rating and a higher risk surcharge is an increase in interest costs each year, the public finances have to pay for old debts. Conversely, a better rating means lower interest costs, lower operating costs for the old debt. Lower interest costs can be used to reduce the government deficit, or in the priority headings.
  • Therefore is a healthy management of public finances in the long run - beneficial for the country: higher credibility helps to make debt service cheaper and also convince potential investors about a more stable business environment in the country with a higher rating.

Safety net and support for the engine of growth: The importance of direct taxes

  • Deepening of the government deficit is a part of cyclical economic developments. Among other things, for example, it relates to an increase in the number of people dependent on social safety net system. To reduce these costs it is crucial boost job creation. The dominant employer is the private sector.
  • The engine of economic life is the private business sector. This is the engine for the recovery of economic growth and creation of new jobs after the recession.
  • Part of the "relationship" between public finance and private sector are direct taxes, especially corporation tax.
  • Direct taxes are on the one hand, part of the state budget revenues, on the other hand, have an incentive (or disincentive effect) to the behaviour of private business.
  • A sustainable response to the deterioration in the labour market, but also in public finances, is the earliest possible recovery of economic growth, which stands and falls on the business activity of the private sector.
  • Thus, even in the periods when countries seek to reduce public deficits, at the same time extend the measures to reduce direct taxes, as a motivational element to encourage the earliest possible return to growth and creation of new jobs (midterm, together with boosting growth the revenue strengthens as well).

From where does the state get income: Why increase in indirect taxes

  • Reduction of the government deficit after having it deepened by cyclical recession, can be achieved in the short term only in three ways:
    1. Increasing tax income.
    2. Cuts in public expenses.
    3. The combination of income and expenses measures.
  • Looking at the income side, it is essential to look at the weight of the most important items:
    • Three-quarters of tax income are indirect taxes:
      • Half is VAT (value added tax).
      • A quarter is excise taxes.
      • Less than a fifth of tax revenues is represented by tax on corporate income tax (tax on profit).
      • In the case of Slovakia it is also worth remembering, that, in addition to local tax incomes a significant income item is the income from the EU budget, the so-called EU funds. These constitute nearly a quarter of the income.
      • Tax on profit has besides its income function of public finance also a motivational role for the private sector, on the activity of which the recovery of growth and also creation of new jobs depend.
      • A high proportion of indirect taxes in total tax income (three quarters), therefore consideration of revenue measures to reduce the deficit does not permit to pay no attention to these biggest items (VAT and excise taxes). In times of a recession many countries in the region had to reach for the increase (Romania increased last year tax by 5 percent, the United Kingdom by 2.5 percent, etc.).
      • Since the indirect taxes burden the consumption, which is beyond the minimum living needs, it's upon the discretion of any household, they are also a fairer form of taxation (at comparable income more taxes pay those households, which spend more than those that save more).

Where are the deficits from: How to cut

  • For a topic this complex, such as the state budget expenses, and where to find room for cuts in expenses, it is important to recall the relationship between economic growth before the recession, and budget expenses.
  • Even in the last years before the recession, the volume of tax revenues has grown with more than a solid pace (chart)along with the particularly strong economic growth.
  • Strong growth in tax income before the recession was not used to balance the state budget: expenses of the state budget have grown along with higher revenues, the state also operated with deficits in the years of record growth before the recession.
  • Because the annual deficits were lower than the rate of economic growth, the level of debt in relation to GDP was reduced down to less than 28% of GDP at the end of 2008.
  • When discussing budget cuts, however, it should be noted that this is not about cutting from some long-time unchanging status quo, but only a return to the level of spending from a period not so long ago (taxpayers looking at an increase in spending in recent years might as well ask whether the increased volume and quality of public services was adequate, for example, compared to 2005).

Why cut despite the fragile growth

  • The best answer as to what is for small and open economy response for the "dilemma", whether in the times of economic weakness in the name of maintaining sound public finances to seek to reduce the deficit as soon as possible, or to conversely "support" a temporary economic downturn by running deficits is a look at structure of Slovak GDP expenditure components.
  • Government consumption expenses represents only 18% of Slovak GDP.
  • The fact that Slovakia is an extremely open economy as illustrated by the fact that the total turnover of foreign trade (total imports and exports) is more than 1.6 times the annual Slovak GDP.
  • This means that abnormal increase of state budget expenditures (which brings credibility worsening of public finances, rating, etc.), for a country like Slovakia has no chance to compensate the slight decline in external demand (exports). In case of weakening of the external demand are attempts to boost the economy with higher public expenditure in countries like Slovakia, like a fight with windmills.
  • On the contrary, sound public finances and, consequently, a good rating contributes to greater regional competitiveness of the Slovak economy.

Public finance: part of the problem or the solution?

  • Especially for small and extremely open economies, such as the Slovak one, it is therefore unrealistic to even pretend an automatic stabilizer of the government deficit would significantly affect, or reverse the course of the recession.
  • On the other hand, unsustainable deepening of the government deficits may not only damage the credibility of the public finance, increase the interest rate required by investors in the bond market due for refinancing debt, but with later need to increase the tax burden, it may reduce the rate of economic renewal.
  • For small and open economies is therefore the contribution of disciplined public finances (with the lowest deficit) to a stable economic environment and better competitiveness much more important than the contribution of fiscal stimulus to boost domestic demand.
  • Therefore, for small and open economies two most important priorities must be present in a fiscal policy during a time of economic weakness:
    1. Maintaining and strengthening of the competitiveness of the business and investment environment. This is the most important prerequisite for the earliest possible restoration of the growth led by the private business sector. Only that is a sustainable midterm solution to the recession weakened labour market situation, as well as weakening government income.
    2. 2. Maintaining the credibility of public finances. The responsible development of the government deficit is crucial not only to maintain the rating and the associated interest costs on debt refinancing. Maintaining the ratings and perceptions is related to the stability of the country in the eyes of foreign direct investors (and related jobs). Conversely, increasing the rate of loan interest to state as the least risky borrower in the market, negatively affects the development of the interest for the private sector as well.

The conclusion

  • For small and open economies might be the deficient public finances much more than the solution (through the bad times) rather a part of the problem (threat to credibility, interest costs for state and private sector, foreign investors' uncertainty, weakening of domestic private sector motivation to strive for the earliest possible return to growth, ultimately the creation of new jobs).


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Tomáš Janík

Studenti UPMS, najdite si chvilku cas a napiste svoj clanok do Amaterskych novin (http://www.amaterskenoviny.comule.com). Ti, ktori maju diplomovku pred sebou, by mali cim skor zacat so sebarealizaciou a tym, ktorych len zaujima makroekonomia, pomoze vymena informacii a napadov. Napiste hocico.

Ja som sa napriklad rozhodol analyzovat, ako a ci vobec zavisi stastie ludi od stupna uzavretosti ekonomiky. Specialne pri Slovensku som pritom narazil na zaujimave fakty. Moj novy clanok ma nazov:
82% z toho, co vyprodukuje cele Slovensko putuje do zahranicia (http://www.amaterskenoviny.comule.com/82percent.html) Potreboval by som tiez pomoct pri rieseni dvoch prikladov, ktore som pridal k clanku.

23.10.2011 | 16:09:51