Economics of Public Sector II

Masahiro Hori
Spring semester, 2023
April 17 (2/13)
Course contents
• Tentative plan of the lectures are as follows:
• April 10 Review of Economics of the Public Sector I
• April 17 Budget Analysis
• April 24 Cost-Benefit Analysis
• May 8 Political Economy (1)
• May 15 Political economy (2)
• May 22 Economics of Local Government (1)
• May 29 Economics of Local Government (2)
• June 12 Midterm Exam. & Review
• June 19 Education
• June 26 National Defense
• Juｌｙ 3 Social Insurance
• July 10 Welfare Policy
• July 17 Final Exam.
There will be no lecture on June 5, Monday, due to the APPP Oral
Defense for M2s being set for that week.
Budget Analysis
• Today, we study the complexity of budgetary
issues that arise as governments consider their
revenue and expenditure policies.

• Questions to keep in mind are as follows:

 What is the right way to measure the budget

deficit?

 What is the effect of higher budget deficits on the

economy?
Government Budgeting
Government debt is the amount that government owes to
others who have loaned it money. Debt is a stock or an
amount that is owed at any point in time.

Government’s deficit is the amount by which its spending has

exceeded its revenues in any given year. The deficit is a flow
or the amount each year by which expenditures exceeds
revenues.

Each year’s deficit flow is added to the previous year’s debt

stock to produce a new stock of debt owed.

Debt(t) = Debt(t-1)+Deficit(t)
Government Budgeting (cont.)
The debt-to-GDP ratio is a commonly accepted method
for assessing the significance of a nation's debt.

For example, one of the criteria of admission to the

European Union's euro currency is that an applicant
country's debt should not exceed 60% of that country's
GDP.

Generally speaking, the debt-to-GDP ratios are higher

among developed countries. Above all, that of Japan
exceeds 200%, which is by far the highest in the world.
Government Budgeting (cont.)

Hong Kong Hong Kong

Brunei Brunei
Russia Russia
Kazakhstan Kazakhstan
Cambodia Cambodia
Saudi Arabia Saudi Arabia
Taiwan Taiwan
Uzbekistan Uzbekistan
Indonesia Indonesia
Deficit to GDP ratio (% GDP), 2019/2020

Burma - Myanmar Burma - Myanmar

Turkey Turkey
South Korea South Korea
New Zealand New Zealand
Tajikistan Tajikistan
Debt to GDP ratio (% GDP)

Vietnam Vietnam
Australia Australia
Iran Iran
Thailand Thailand
Philippines Philippines
China China
Israel Israel
Mexico Mexico
Malaysia Malaysia
Kyrgyzstan Kyrgyzstan
Laos Laos
Germany Germany
South Africa South Africa
Mongolia Mongolia
Iraq Iraq
Sri Lanka Sri Lanka
Pakistan Pakistan
India India
Brazil Brazil
Argentina Argentina
United Kingdom United Kingdom
France France
Spain Spain
Bhutan Bhutan
United States United States
Singapore Singapore
Italy Italy
Greece Greece
Japan Japan

50%
250%
200%
150%
100%

0%

-5%
5%
0%

-10%
-15%
-20%
Government Budgeting (cont.)
General government gross debt (percent of GDP, 2018)
Government Budgeting (cont.)
A budget deficit is when spending exceeds income. The term
applies to governments, although individuals, companies, and
other organizations can run deficits.

As the figure on the next page shows, many countries have

been in budget deficits in recent years, especially after 2008.

Governments around the world often set a goal to restore

fiscal balance, but that seems to be difficult.

Conservatives often blame the deficit by the government,

while liberals counter that an insufficiently progressive tax
system fails to raise revenues needed for valuable
government programs.
Government Budgeting (cont.)
General government deficit, Total, % of GDP, 2000 – 2019
Measuring the Budgetary Position of the Government
• There are a number of alternative ways of representing
the budgetary position of the government.

• Real vs. Nominal

The first alternative way to represent the deficit is to take
into account the beneficial effects of inflation for the
government as a debt holder.

We need to pay attention to the difference between real

prices and nominal prices.
Nominal prices are those stated in today’s dollars.
Real prices are those stated in some constant year’s
dollars.
Measuring the Budgetary Position of the Government
• Real vs. Nominal (cont.)

Government debts and deficit are both typically stated in

nominal values (in today’s dollars).

However, this practice can be misleading, because

inflation lessens the burden of the national debt, as long
as that debt is a nominal obligation to borrowers.

When price levels rise, the consumption that the nation

has to forgo to pay the national debt falls.
Measuring the Budgetary Position of the Government
• Real vs. Nominal (cont.)

The interest payments that government makes are in nominal

dollars, which are worth less at the higher price level, so when
prices rise, the real deficit falls.

This outcome is called an inflation tax on the holders of federal

debt (though it is not really a tax).

Inflation tax can be sizable, even in the low-inflation environment.

e.g. In 2017, the U.S. national debt was $20.2 trillion and the inflation rate
was 1.8%. Therefore, inflation tax in that year was 20.2×0.018=$364 billion.

Taking account of the effects of inflation on eroding the value of the

national debt reduces the conventionally measured deficit in 2017 from
$665 billion to $301 billion.
Measuring the Budgetary Position (cont.)
• Economic Conditions
The second alternative way to represent the deficit is to
recognize the distinction between short-run factors that
affect government deficit/surplus and longer-run trends in
the government’s fiscal position.

In particular, the government can account for the fiscal role of

automatic stabilizers, i.e., automatic reductions in revenues
and increases in outlays when GDP is falling relative to
potential GDP.

These factors tend to increase the deficit in the short-run,

while they should be balanced by the rise in receipts and the
decline in spending that occurs during periods of economic
growth.
Measuring the Budgetary Position (cont.)
• Economic Conditions (cont.)
To account for the factors, we can calculate a cyclically
adjusted budget deficit, a measure of the government’s
fiscal position if the economy were operating at full
potential GDP.

In the periods of economic expansion, the cyclically

adjusted deficit is higher than the reported deficit.

On the other hand, when the economy is

underperforming, the cyclically adjusted deficit is
significantly lower than the reported deficit.
Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting
To assess the budgetary position, governments usually use
cash accounting, a method of measuring the government’s
fiscal position as the difference between current spending
and current revenues.

However, there is a general concerns with the government’s

use of cash accounting.

Suppose that the government borrows $2 million and spends

it on two activities.
 One is a big party to celebrate the King’s birthday, which
costs $1 million.
 The other is a new office building for government
executives, which also costs $1 million.
Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)
When the government produces its budget at the
end of the year, both of the two expenditures will be
reported identically, and the deficit will be $2 million
bigger if there is no corresponding rise in taxes.

Yet these expenditures are clearly not the same.

 In the former case, the expenditure financed a fleeting
pleasure.
 In the latter case, it financed a lasting capital asset, an
investment with value not just for today but for the future.
Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)

Some argues that the appropriate means of assessing the

government’s budgetary position is to use capital
accounting, which takes into account the change in the value
of the government’s net asset holdings.

Under capital accounting, the government would set up a

capital account that tracks investment expenditures (funds
spent on long-term assets such as buildings and highways)
separately from current consumption expenditures.
Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)

Within the capital account, the government would

subtract investment expenditures and add the value of
the asset purchased with this investment.

For example, if the building built with the second $1

million had a market value of $1 million, this expenditure
would not change the government’s capital account
because the government would have simply shifted its
assets from $1 million in cash to $1 million in building.
 Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)

The absence of capital accounting gives a misleading picture of the

government’s financial position.

For example, in 1997, the Clinton administration trumpeted its

victory in proposing a balanced budget for the first time in 28 years.

However, little recognized in this fanfare was that $36 billion of the
revenues that would be raised to balance the budget came from
one-time sales of a government asset, broadcast spectrum licenses.

The government was gaining the revenue from the sale, but at the
same time, it was selling off a valuable asset---the spectrum licenses.
So the fiscal budget was balanced, but at the expense of lowering
the value of the government’s asset holdings.
 Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)

While adding a capital budget seems like a very good

idea, there are practical difficulties with implementing
such a budget since it is hard to distinguish government
consumption from investment.

For example, is the purchase of a missile a capital

investment or current consumption? Does its classification
depend on how soon the missile is used?

Are investments in education capital expenditures

because they build up the abilities of a future generation
of workers?
 Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)

And if examples above are capital expenditures,

how can we value them?

For example, without selling the spectrum licenses

in 1997, how could the government appropriately
assess the value of the intangible asset?

These difficulties might make it easier for politicians

to misstate the government’s budgetary position
with a capital budget than without one.
 Measuring the Budgetary Position (cont.)
• Cash vs. Capital Accounting (cont.)

As a result of these difficulties, while some states

use capital budgets, they have not been
implemented at the federal level in the U.S.

New Zealand is the first country to fully implement

capital budgeting in 1989, and it still continues to
use the method.

Other countries (such as Denmark, Finland and the

Netherlands) have used this method in the past as
well but have stopped doing so because of the
problematic issues discussed.
Measuring the Budgetary Position (cont.)
• Static vs. Dynamic Scoring

Another important source of debate over measurement is the

debate between static and dynamic scoring.

Budget modelers usually use static scoring, which assumes

that the size of the economic pie is fixed and that
government policy serves only to change the relative size of
the slices of the pie.

Some believes that government policy affects not only the

distribution of resources within the economy but the size of
the economy itself.

They advocate dynamic scoring, an approach to budget

modeling that includes not only a policy’s effects on resource
distribution, but also its effects on the size of the economy.
Measuring the Budgetary Position (cont.)
• Static vs. Dynamic Scoring (cont.)

For example, lowering taxes on economic activity

may increase the amount of that activity, increasing
the production of society.

This larger economic pie produces more tax

revenues for a given tax rate, offsetting the revenue
losses from the tax reduction.

Ignoring the reaction can lead the government to

overstate the revenue loss from cutting taxes.
Measuring the Budgetary Position (cont.)
• Static vs. Dynamic Scoring (cont.)

Budget estimators have resisted the dynamic approach

largely because the impact of government policy on the
economy is not well understood.

However, it is not clear why policy makers and budget

estimators should assume there are zero effects.

Alternatively, we can use multiple models to evaluate the

impacts of the administration’s budget on the economy.
Do Current Debts and Deficits Mean Anything?
Governments often make some implicit obligations
to the future.

Whenever Congress passes a law that entitles

individuals to receipts in the future, it creates an
implicit obligation that is not recognized in the
annual budgetary process.

To understand implicit obligations, it is important to

review the concept of present discounted value.
Do Current Debts and Deficits Mean Anything? (cont.)
• Present Discounted Value

If you take $1 this year and put it in the bank, you will
earn interest on it and have more than $1 next year.

This means that $1 next year is worth less than the $1

this year.

To compare the value of money in different periods, one

must compare the present discounted value (PDV): the
value of each period’s payment in today’s term.
Do Current Debts and Deficits Mean Anything? (con.)
• Present Discounted Value (cont.)

To compute the present value of any stream of payments, we

discount payments in a future period by the interest rate that
could be earned between the present and that future period.

Mathematically, if the interest rate is r, and the payments in

each future period are F1, F2,..., and so on, then the PDV is
computed as:

If payments are a constant amount (of F) for a very long time

into future, then the PDV=F/r.
Do Current Debts and Deficits Mean Anything? (con.)
• Current Labels May be Meaningless

Policy debates have traditionally focused on the extent to

which this year’s governmental spending exceeds this year’s
governmental revenues.

The existence of implicit obligations, however, suggests that

these debates may be misplaced.

This concept is nicely illustrated by the following example.

Imagine that the government offers to pay you $1 less in

Social Security benefits, in return for which the government
will reduce your payroll tax today by only half of the present
value of that $1.
Do Current Debts and Deficits Mean Anything? (con.)
• Current Labels May be Meaningless (cont.)

Such a deal would clearly be a net winner for the

government: in PDV terms, the government is reducing
current taxes by less than it is reducing future
expenditures.

Yet, from today’s perspective, it is still cutting current

taxes and not reducing current expenditures, so the
deficit and the debt are rising.

Such a problem can lead to biased government policy

making that favors policies that look good in terms of
current budget, even if they have bad long-term
consequences for the fiscal position of the government.
Do Current Debts and Deficits Mean Anything? (con.)
• Measuring Long-Run Government Budgets

Researchers have begun to consider alternative measures of

government budgets that include implicit obligations.

The basic idea is to correctly measure the government’s

intertemporal budget constraint, an equation relating the
present discounted value of the government’s obligations to
the present discounted value of its revenues.
Do Current Debts and Deficits Mean Anything? (con.)
• Measuring Long-Run Government Budgets (cont.)

To measure the government’s intertemporal budget constraint,

researchers computed what the government will spend, and what it
will collect in taxes, in each year into future.

They then took the present discounted value of these expenditures

and taxes, and subtracted expenditures from taxes to get a PDV of
the government’s fiscal imbalance.

PVD of the fiscal imbalance for the US suggests that the entire
long-run fiscal imbalances of the US federal government arises
solely from the major entitlement programs for the elderly, i.e.,
Social Security and Medicare.
Do Current Debts and Deficits Mean Anything? (con.)
• Measuring Long-Run Government Budgets (cont.)

Moreover, it suggests that the implicit debt of the US

government is three or four times as large as its existing
outstanding debt.

Therefore, in the case of the US federal government, to

achieve intertemporal budget balance would require
doubling the existing payroll tax that finances the
government’s social insurance program.
Do Current Debts and Deficits Mean Anything? (con.)
• Problems with Long-Run Measures

The results above are typically and unfortunately

taken with a grain of salt by policy makers.

This reflects the short-run focus of policy makers most

interested in winning the next election and fairly
tenuous nature of all these computations, which
depend critically on a wide variety of assumptions.

There is no reason, however, to think that these

estimates are biased one way or another, either
always too low or always too high.
 Do Current Debts and Deficits Mean Anything? (con.)
• What Are the US Government Doing?

While not adopting the measure of the government’s

intertemporal budget constraint, the U.S. government has
moved to consider somewhat longer-run measures of
policy impacts.

Until the mid-1990s, the budgetary impacts were

considered over a one- or five-year window.

This approach has the important limitation of promoting

policies that had their greatest costs outside of that window.

A policy that cut taxes starting in six years was viewed as

having no budgetary cost, but the implicit obligation
implied by this policy change could be quite large.
 Do Current Debts and Deficits Mean Anything? (con.)
• What Are the US Government Doing? (cont.)

In 1996, the U.S. government moved to evaluating

most policy options over a ten-year window to try to
avoid the problems.

In principle, this should help promote policies that are

more fiscally balanced over the long run.

In practice, however, moving to a ten-year window

added a new problem: it worsened the forecast error
inherent in projecting the implications of government
program.

Therefore, the new approach leaves policy makers

dealing with very uncertain numbers when assessing
the ten-year impact of a tax or spending policy.
 Do Current Debts and Deficits Mean Anything? (con.)
• What Are the US Government Doing? (cont.)
The problems that forecast errors can cause become apparent in
real U.S. history.

By the time President George W. Bush was inaugurated in

January 2001, the CBO projected a surplus that would amount to
almost $6 trillion over the next ten years.

These projections led Mr. Bush to propose major tax cuts, with
an estimated ten-year cost of $1.35 trillion.

The problem, as we now know, is that the $6 trillion surplus

never appeared. The combination of the 2001 tax cuts, a
recession, and the economic shocks of the September 11, 2001
had a sharply negative effect on the budget picture, resulting in
the deficit by 2002.
 Why We Care About the Government’s Fiscal Position?
• Short-Run Effects on Macroeconomy

First reason to care about budget deficits has to do

with short-run stabilization issues.

Short-run stabilization is accomplished on two fronts.

 Automatic stabilization that occurs through policies

that automatically cut taxes or increase spending
when the economy is in a downturn.

 Discretionary stabilization occurs through policy

actions undertaken by the government to offset
business cycle fluctuations.
Why We Care About the Government’s Fiscal Position? (cont.)

• Short-Run Effects on Macroeconomy (cont.)

Stabilization role of the government have not been the focus

of the field of public finance for more than two decades,
probably due to the conclusion in the 1970s that the tax and
spending tools are not well equipped to fight recessions.

The Great Recession (in and after 2008) inspired a

resurgence of interest in this area.

A number of studies over the past decade have shown

convincingly that fiscal policies such as spending and tax
cuts can play an important role in stabilizing the
macroeconomy.
Why We Care About the Government’s Fiscal Position? (cont.)

• Savings and Economic Growth

Public finance studies are often more concerned

with the longer-run impacts of government budget
deficits on economic growth.

Economic growth models emphasized a central

role for savings as an engine of economic growth.

Higher saving and a larger capital stock means

more total output for any level of labor supply.
Thus, the savings and the size of capital stock is a
primary driver of growth.
Why We Care About the Government’s Fiscal Position? (cont.)

• Government Deficit and Economic Growth

Suppose that there is a government deficit, and the

government must borrow to finance the deficit.

The government’s borrowing might compete with the

borrowing of private firms. In other words, the
government’s borrowing may crowd out the
borrowing of the private sector and lead to a lower
level of capital accumulation.

When the government competes with the private

sector for limited private savings, the private sector
ends up with fewer resources to finance the capital
investments that drive economic growth.
Why We Care About the Government’s Fiscal Position? (cont.)

• Government Deficit and Economic Growth

In reality, there are a number of complications.

 Under an integrated global capital market, the pool of

savings available to finance both private investment and
public borrowing was close to perfectly elastic, resulting
in little crowding out.

Literature that investigated the integration of

international capital markets concluded that while
integration is present, if is far from perfect.

So government deficit could crowd out private savings.

Why We Care About the Government’s Fiscal Position? (cont.)

• Government Deficit and Economic

Growth (cont.)

 Theory tells us that higher deficits lead to higher

interest rates and less capital investment, but it
does not tell us how much higher and how much
less.

The existing empirical literature is somewhat

inconclusive.

However, in recent years, large increases in public

indebtedness have not resulted in higher interest
rates. For example, Japan.
Why We Care About the Government’s Fiscal Position? (cont.)

• Government Deficit and Economic Growth

(cont.)

This situation has led to substantial support for a “new view”

of macroeconomic policy that suggests that we can absorb
quite large increases in debt without interest rates rising.

This may be because we have entered an era of “secular

stagnation,” where future growth is expected to be so low
that investors don’t have better alternatives to continuing to
hold government debt.

Or it could be because large countries like the U.S. and

Japan continues to be the safest place to invest money
internationally, so that the supply of capital is very flat.
Why We Care About the Government’s Fiscal Position? (cont.)

• Intergenerational Equity

The final reason that we might be concerned with

government debts and deficit is intergenerational
equity, or the treatment of future generations relative
to current generation.

The current government policy with a sizable deficit has

the feature of burdening future generations for the
benefit of current generations, making future
generations much worse off in the process.

It may be deemed socially worthwhile to equalize these

burdens.
Exercise Questions
Q. A government is considering paving a highway
with a newly developed “wear-proof” material.

Paving the highway would cost $3 billion today,

but it would save $400 million in maintenance
costs for each of the next 10 years.

Use the concept of present value to determine

whether the project is worth undertaking if the
government can borrow at an interest rate of 4%.

Is it worth it if the interest rate is 0%? 8%?

Exercise Questions (cont.)
A. As the following table shows, the project is
worth undertaking at 0% and 4% interest, but
it is not worth undertaking at 8%.
r =0.00 r =0.04 r =0.08
Initial Cost -3.000 -3.000 -3.000
Savings, year 1 0.400 0.385 0.370
Savings, year 2 0.400 0.370 0.343
Savings, year 3 0.400 0.356 0.318
Savings, year 4 0.400 0.342 0.294
Savings, year 5 0.400 0.329 0.272
Savings, year 6 0.400 0.316 0.252
Savings, year 7 0.400 0.304 0.233
Savings, year 8 0.400 0.292 0.216
Savings, year 9 0.400 0.281 0.200
Savings, year 10 0.400 0.270 0.185
Net benefits 1.000 0.244 -0.316
Exercise Questions (cont.)
Q. A politician says to you, “I don’t care what the interest rate is. The
project is clearly a good investment: it more than pays for itself in
only 8 years, and all the rest is money in the bank.” What’s wrong
with this argument, and why does the interest rate matter?

A. The politician’s argument is incorrect because it fails to take into

account the interest the government must pay on the money
borrowed to finance the project.

Q. A second politician says to you, “At an interest rate of 4%, the

project is a bad idea. Over 10 years, the project reduces
maintenance costs by a total of $4 billion. But borrowing $3 billion
for 10 years at a 4% interest rate means paying $1.44 billion in
interest. The total cost of the project over 10 years is therefore $4.44
billion!” What’s wrong with the second politician’s argument?

A. The politician is effectively counting the interest on the initial

expenditure but not the interest on the money saved by the project
in years 1–9.
Exercise Questions (cont.)
Q. The federal government is considering selling tracts of
federally owned land to private developers and using the
revenues to provide aid to victims of an earthquake in a
foreign country.

How would this policy affect the levels of federal revenues,

expenditures, and deficits under a cash accounting system?
What would be different under a capital accounting system?

A.Under a cash accounting system, there would be no effect on

the current level of the deficit. Revenue would increase by the
amount of the sale, but the revenue increase would be exactly
offset by the increased expenditures on foreign aid.

A capital accounting system would recognize that the

government has sold off a valuable asset. It would therefore
regard the policy as increasing the overall deficit.