MBA 34 Managerial Excellence 1 Term Fiscal policy

MBA 34 Managerial Excellence – 1° Term Fiscal policy Class 18 The firm and its environment - Francesco Giavazzi Copyright SDA Bocconi 2004 1

Motivating questions The Government budget constraint Why does the Maastricht Treaty condition the entry of new countries into the Monetary Union on the fulfillment of public budget and debt limits? Why has Berlusconi not swiftly enacted his promised tax cuts? The effects of fiscal policy Why has GW Bush cut taxes right after the eruption of the sub-prime crisis? Copyright SDA Bocconi 2004 2

To answer, one needs to: § Learn some vocabulary (and be aware of main fiscal facts) § Understand the effects of fiscal policy on GDP during the business cycle § Understand the long-run effects of fiscal policy Copyright SDA Bocconi 2004 3

Vocabulary: Govt spending and revenues Budget deficit (DEF) = Spending – Revenues Total spending = public goods + transfers Total spending = G + Ig + Tr + i. D-1 § G = Govt purchases of goods and services (for education, justics, defense) § Ig = public investment (for roads, highways) § Tr = transfers (pensions, assistance to the poor). Tr G or Ig: doesn’t have to do with provision of goods and services § i. D-1 = interest payments on outstanding debt (another type of transfers) Revenues = T § T = indirect taxes (e. g. VAT) + direct taxes (personal & corporate taxes) + social security contributions Copyright SDA Bocconi 2004 4

Vocabulary: budget deficit and debt • Budget deficit (DEF) = G + Ig + Tr + i. D-1– T • DEF goes up in recessions and down in booms § Why? In recession: Tr and T (why? ) § Hence: in recession, DEF. The opposite during booms § Structural DEF computed as if GDP were at its potential • Balanced budget: DEF=0, G + + Ig Tr + i. D-1 = T • Primary deficit = (G + Ig + Tr – T) • Deficit is not debt: debt = sum of current and past deficits Copyright SDA Bocconi 2004 5

Vocabulary: the Maastricht criteria to enter the EMU • Low inflation (not above 1. 5 p. p. from three most virtuous countries in the Union) • Low long-term interest rates (not above 2 p. p. from three most virtuous countries in the Union) • Exchange rate stability in 2 years before joining the European Monetary Union • Attainment of fiscal stability • DEF/GDP<3% (structural DEF, after recent reform) • Public Debt/GDP<60% (or “showing progress towards this goal”) Copyright SDA Bocconi 2004 6

Vocabulary: Pact for Fiscal Stability and Growth After giving up monetary policy autonomy, why do Europeans constrain national fiscal policy as well? There is a cost of ‘excessive deficits’ at the national level for Europe as a whole – Suppose a (large) country runs DEF>3% – Under single currency, interest rate on govt bonds for ALL EU countries may go up – This would be a “beggar-your-neighbor” policy. To be ruled out in a Union Hence: Stability Pact (same rules for all, in principle). Union countries “deviating” from Maastricht criteria would be fined up to 0. 5% of their GDP In practice: sanctions never implemented (and perhaps never implementable). But countries did correct their imbalances Copyright SDA Bocconi 2004 7

Facts on fiscal policy Facts on • Government size • Government deficit • Government debt Copyright SDA Bocconi 2004 8

Best measure of Govt size is total Govt outlays (GDP shares, %, 2008 p) Much lower Govt size in the US and Japan than anywhere in Europe Copyright SDA Bocconi 2004 9

Govt budgets / GDP (%, 2008 p; “-”=deficit, “+”=surplus) Fiscal adjustment lags behind almost everywhere in the world. Den & Fin show that “Big Govt” is not the same as “fiscally Copyright SDA Bocconi 2004 irresponsible” Govt 10

The deficit stance of countries may and does change over time US fiscal stance: from positive to sharply negative with GW Bush France, Germany, Italy: same fiscal deterioration from 2000 to 2004. Substantial fiscal adjustment in Ger since then Finland: always positive budget, by substantial extent Copyright SDA Bocconi 2004 11

Govt public debt / GDP (%, 2008 p) Italy and Belgium stand out. Belgium showed much faster progress than Italy Copyright SDA Bocconi 2004 12

Theory: the two goals of fiscal policy Increase potential GDP • G and T to raise permanent GDP by K accumulation or efficiency improvements – – – Tax breaks for investment or R&D outlays Subsidies for education Public investment in infrastructures Stabilize GDP around its permanent level • G and T set so as to make GDP very close to its potential level most of the times • Also said: ‘fine tuning’ of GDP Copyright SDA Bocconi 2004 13

Goal #1 of fiscal policy: raise potential GDP Supply-side economics, at the roots of Reaganomics and Bushnomics (? ) § taxes entail welfare loss § tax rates on K and L incomes enhanced incentives to invest and work Implication: growth of permanent GDP= supply side phenomenon tax rates to be lowered to favor growth Yet most people think that tax elasticity of investment and work effort is rather low. If this correct, then fiscal policy left with goal #2 Copyright SDA Bocconi 2004 14

Goal #2: GDP stabilization If supply-side effects are not there or small, then goal of fiscal policy is: stabilize GDP • when economy overheated, fiscal policy should simply cool it down (by G and T) • when in recession, fiscal policy should sustain GDP by either T or G In both cases, fiscal policy meant to affect aggregate demand (by shifting AD curve) – By how much? It depends on the multiplier Big issue: does fiscal policy really stabilize GDP? Copyright SDA Bocconi 2004 15

Does fiscal policy really stabilize GDP? Three possible reasons for why this may not be the case • Political delays • Ricardian equivalence • Crowding out Copyright SDA Bocconi 2004 16

Political delays ‘Right’ fiscal policy stance hardly delivered when needed. Approval takes time When tax cuts to sustain GDP obtain Parliament approval, it may be too late If approved and implemented late, risk of GDP de-stabilization Copyright SDA Bocconi 2004 17

Ricardian equivalence Robert Barro (Harvard economist) If T temporary, effects on AD very small Why? If tax cut is “temporary”, then people would save additional income from tax cut, rather than consume it – If G has not been cut in parallel, I expect taxes up tomorrow & save to meet future tax obligations Hence AD stays where it is If Barro is right, changing tax rates does not stabilize GDP Copyright SDA Bocconi 2004 18

Crowding out Suppose G to counteract recession; expect large effect on AD (shift of AD)? No, if other AD items ‘crowded out’ • How is G financed? Suppose G financed by DEF – – DEF price of T-bonds and interest rates I (private investment) overall effect on AD dampened By how much, it depends on how responsive investment and savings are to interest rates With today’s high K mobility, only if large economy (e. g USA, Euroland or OECD) runs a large DEF will it have an impact on world interest rates; unlikely to work for small economies in isolation if G financed by T: T C, effect on AD dampened either If crowding out important, stabilizing role of fiscal policy may not be there • Copyright SDA Bocconi 2004 19

Crowding out Interest Rate Private Savings + Government Savings Private Savings Deficit 6% 5% Investment I 1 Copyright SDA Bocconi 2004 I 0 S 1 Output 20

There may also be crowding in Conventional view: fiscal deficits boost output while fiscal contractions lower output However there are examples of contractions expansionary fiscal • For instance, Italy has high level of debt and pays relatively high interest rates - markets worried about risk of debt default • By announcing credible cuts in G or Tr, primary DEF falls and so do concerns about future debt which lowers interest rates • When Govts heavily indebted, this may lead to big cuts in DEF and - via lower interest rates - higher investment and consumption Copyright SDA Bocconi 2004 21

Optimal fiscal policy: rules or discretion? To best stabilize GDP, should policy-makers follow fiscal policy rules or act under discretion (i. e. deviate from rules)? Fiscal policy rules state which and how fiscal policy instrument should react under what circumstance • Automatic rules are well understood by people and do not suffer from implementation delays • Counterargument: If recession very serious, they may not stabilize enough Copyright SDA Bocconi 2004 22

An example of simple rules already in place: automatic stabilizers Taxes and G do depend on actual GDP • As GDP , so does T for given tax rate t • As GDP , Tr (e. g. unemployment subsidies) Under current institutional setting, GDP stabilization automatically achieved to some extent I. e. initial GDP (due to AD fall) is partly offset by C due to T As a result: GDP fluctuations of smaller entity with automatic stabilizers in place • This is in the data: length and depth of businesscycle downswings, in parallel with Govt size Copyright SDA Bocconi 2004 23