Explain and discuss why governments care about budget deficits and public debt?
Fiscal policy involves government expenditure on law and order, public sector, health and public goods and government revenue which is earned through taxation, public sector companies and privatization. When government expenditure is greater than government revenue, budget deficits occur which is considered to be expansionary fiscal policy. Budget deficits can be used to jump start the economy, increase aggregate demand and employment. However, for many countries including the USA budget deficits have become a major issue. As government spend more than they receive in revenue they borrow from the private sector or from international sources which results in high interest payments resulting in higher taxation for the public.
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The budget deficit is when government expenses are greater than government revenue and as government taxes make up the majority of revenue, the budget surplus/deficit function is B= t-g. The interest payment function is r-p ( interest rate minus inflation rate) as this is the real rate of interest.
Real national income
If the deficit is constant then the function will be a constant fraction of income, t-g = c Y c. The calculation of the change in the real value of debt will be cY+(r-p)Db; the budget deficit fraction of income plus the real interest rate into existing debt. Dividing it by debt; we find the growth of debt.
Budget deficits are not necessarily detrimental to the economy; persistent deficits increase debt and reduce growth. Government expenditure is one of the elements of aggregate demand ( AD = C+I+G+ (X-M)) and thus an increase in government expenditure would increase AD and thus national income. In times of recession and low GDP growth, budget deficits jumpstart the economy by increasing employment and income. Budget deficits are also beneficial when the government invests in infrastructure, electricity, law and order, health and education as they develop the economy and the economic environment thus helping the private sector. However, constant budget deficits that are not financed by revenue cause more harm than good.
Two major issues occur as a result of budget deficits; there is a crowding out of private investment and an increase in public debt. There are limited funds available for borrowing and investment in an economy. When there is a budget deficit it needs to be financed either through an increase in taxes or through borrowing. When the government enters the market as a potential borrower, this increases the demand for funds and thus increases interest rates. This hike in interest rates may force many private borrowers out of the market. As the government is a risk free borrower many investors would opt for government securities thus private investment is crowded out. When private investment is crowded out, new factories and ventures will not be set up thus decreasing the future production capacity of the economy. On the other hand, this borrowing due to the budget deficit leads to an increase in the public debt which the public are taxed for.
When a budget deficit occurs and the government opts for borrowing, it is not just increasing the debt burden it is increasing the tax burden on the public as well. $1 billion of borrowing is future taxation of $1billion with another $60 million of interest every year if interest rate is 6%. Increased borrowing by the government will lead to increased rates by lenders further harming the economy. Thus it decreases future income of the public and will have downward affects on GDP. If the budget deficits are short term they can be balanced of with surpluses, however most governments now face persistent budget deficits and thus a persistent increase in public deficits. As mentioned before, public borrowing leads to crowding out which leads to less growth and output in future years thus harming employment and GDP rather than proving beneficial.
Another cause for concern is that since the government is borrowing to a great extent the shortage of funds leads companies to look abroad for funds, which results in dividends and profits flowing outwards to foreign holders of stocks and bonds. This results in a fall of income for the public and an increase in what is owed to foreign nationals. Persistent budget deficits are also a cause of concern as they might lead to inflation. Excessive government spending may lead to the central bank increasing money supply in order to finance the deficit and prevent crowding out. This increase in money supply will lead to inflation.
Since many economists believe that public sector enterprise is inefficient due to bureaucracy and lack of profit maximization, excessive government expenditure is a waste of the countryâ€™s productive resources and has a harmful effect on economic growth. In an open economy, the borrowing from abroad will decrease GNP due to payments abroad and this will cause a burden on the future generations. Budget deficits and public debt may not impose a great expense on the current public but the increasing debt burden will result in greater tax burden on the future generation as well as a lower GDP due to lower investment in productive enterprises.
The greater tax burden is counterproductive as it leads people and capital to migrate to low tax economies or drives them underground which greatly harms the economy. Excess taxation will decrease disposable income and thus consumption, it will also decrease profits and thus investment furthermore the spike in interest rates will also decrease investment thus decreasing aggregate demand and employment. Short term benefits of increased government expenditure are offset by these factors with long term effect. If the multiplier effect is taken into account the increase in taxation, combined with decrease in consumption and investment would have a magnified impact on national income.
The graph shows the rising trend of debt to GDP ratio, governments are concerned with the cumulative effect of national debt, as deficits keep rising. The more the government borrows the greater increase in interest payments and debt burden on the future generations. It creates two costs on the country; a fixed cost in the form of interest payments and a wealth cost, meaning that it reduces future national income.
Governments are also concerned with the debt-GDP ratio and the proportion of interest and debt payment in the GDP. If these two factors keep rising then the country will keep on getting entrenched in debt which may call for a strict conservationist fiscal policy. Policies proposed to combat the situation include the policy of cyclically balanced budgets with deficits in slumps and surpluses in booms. In conclusion, the economy is affected adversely by persistent budget deficits and rising public debt thus it is vital for government to control their deficits and borrowing or future generations will bear the costs.