Fairness of Fiscal Sector | Daily News
Assessing Economic Development:

Fairness of Fiscal Sector

Fiscal sector is the state policy side of the economy implemented through taxes, spending, subsidies, regulations and enterprises. Therefore, all economists and public hold the government responsible for all ills of the economy, i.e., fiscal policy to be always pro-development and accommodative. In macroeconomics, budget deficit and debt are two of mostly analyzed macroeconomic indicators used to reflect the performance and interactions of the fiscal sector in the economy.

However, budget deficit and debt are not independent decisions made by governments. They are the immediate, accumulated and joint results of all government policies on its finance. For an objective assessment, economic and social benefits of the underlying government policies must be assessed. For example, various tax concessions, extensions services, low cost credit and free irrigation provided by the government to agriculture sector have profound results on the economic growth, employment and prices in the economy, despite financial cost. However, analysists do not have tools to detect and analyze socio-economic results of all government policies on respective sectors of the economy. Therefore, macroeconomic analyses on budget deficit and debt should be made and interpreted cautiously.

Economics of Fiscal Policy

Fiscal policy is one of the two macroeconomic policies implemented to influence the aggregate demand or total spending, i.e., consumption and investments, for promoting growth, employment, resource utilization, etc., and setting the socio-economic policy. The other policy is the monetary policy assigned to the central bank to regulate the monetary conditions of the economy such as interest rates, exchange rates, credit and monetary liquidity for same economic objectives, generally independent from the government, but with close coordination to avoid macroeconomic policy conflicts with the fiscal policy.

From the beginning of economics, it is presented that the unemployment and low income prevail as the demand for production is inadequate to employ all resources (full employment) for production and, therefore, it is necessary to increase the demand. For this purpose, either the government can increase its spending (fiscal policy) or the CB can print more money (monetary policy) to enable the public to spend more through new money or both can be pursued parallelly. For example, during the past decade since 2007, the developed world has been following both policies to recover from the economic recession (rising unemployment, falling growth and falling prices/inflation) caused by the global financial crisis 2007/09.

Fiscal policy also can be implemented to have specific impact on identified sectors of the economy such as agriculture, SMEs, international trade and income distribution. All policy instruments such as taxes, subsidies, regulations and enterprises have direct and indirect impact on government finance or budget and debt.

Budget Deficit

Budget deficit is the excess of the government spending over its revenue or tax income.

In fiscal policy, governments first decide volumes of spending based on current needs of the economy and then consider sources of financing such as new taxes and borrowing. Only few countries run surplus budgets.

Although macroeconomics does not separate spending by purpose, analysts separate it between consumption (recurrent) and investment (capital) with further break-up of sectors to understand the distributional impact of government spending/budget. Capital spending is considered more favourable as it enhances production capacity in the economy.

* Unfavourable Effects

However, economists often criticize high budget deficits due to various reasons. First, such a fiscal policy suppresses markets and private sector. Second, it crowds out private investments as private saving is attracted to government debt being the safest investment to finance the budget deficit. Third, aggressive government borrowing raises interest rates and cost of funds that discourage private investments in the economy. Fourth, high spending raises inflation and reduces trade competitiveness of the economy. Therefore, almost economists and central banks propose to reduce the budget deficit as high or rising budget deficit is considered as unhealthy macroeconomic indicator/factor. However, they do not analyze distributional effects of budget deficits.

* Deficit Numbers

Budget deficit is conventionally presented as a percent of the country income (Gross Domestic Product-GDP) for economic analysis due to its connection to overall performance and income of the economy. For example, government spending is expected to generate more income in the economy and more tax revenue. In contrast, finance in business firms and households is analyzed in proportion to their income as the barometer of private business and financial management is the own income stream. However, as economists propose governments to live within means, it is useful to compare government finance with its income in addition to GDP. However, budget is not business-base finance, but the fiscal policy for the business of the public in the economy.

Government or Public Debt

Debt arises due to deficits financed through borrowing. Continuous budget deficits result accumulated debt. The higher the deficits, the higher is the debt accumulation. If the debt stock rises while current debt is repaid by issuance of new debt, public insolvency or debt crises/debt default can occur at any time in the event of adverse external economic shocks.

Debt is an essential economic resource as business growth is mostly financed by debt raised from others’ savings. Monetary economies essentially perform on savings and debt, two of economic functions of money. In business, what matters is the debt sustainability which depends on the economic utilization of debt, i.e., generation of income to repay debt and grow capital/surplus. This is applicable to governments as well. As debt is used to finance both recurrent and capital spending due to lack of present tax revenue, the macroeconomic role of public debt to keep the economy going and growing is essential.

* Unfavourable Effects

First, as government debt is the safest financial investment in the country, private investments are crowed out by government debt. Second, if current tax revenue does not increase, the government has to increase tax on public to repay debt. Third, as the government has to borrow for repayment of existing debt (roll-over of debt), debt bubbles will develop and may burst causing debt crises as reported from several countries. Fourth, long-term borrowing to finance short-term consumption spending is unfair as debt is passed to future generation for repayment.

 

* Debt Numbers

Government debt stock also is assessed as a percent of GDP as it is the country’s income/GDP that has to be used for repayment. In private finance, debt sustainability is measured on own income and total assets, or leverage (ratio of assets to debt). In corporate finance, debt ratio is the accounting ratio of debt to assets. High and rising leverage/debt finance above certain thresholds such as 10 is an alert on future vulnerabilities to solvency. The liquidity or the ability to repay financial commitments out of current cash flows also is assessed parallelly to protect the short-term solvency. In respect of capital financing, net present value, internal rate of return, pay-back periods, etc. are calculated to compare and monitor cost and returns on borrowing/investments. However, such techniques are not used in government financial management due to lack of information although government bankruptcies also are reported in the world.

Story of Fiscal Numbers

In general, periods of low economic growth are expected to raise budget deficits (or negative relationship) to drive economic growth and employment through fiscal stimulus. In turn, periods of high budget deficits are expected to associate with rising inflation. In Sri Lanka, annual data do not sufficiently support such of macroeconomic expectations. This may be partly due to defects in measurement in economic growth (GDP calculation) and inflation (highly policy-controlled/suppressed cost of living). The behaviour of deficit and debt stock largely varies due to contemporary economic and political factors in different periods. For example, period immediately after economic liberalization (early 1980s) accompanied record levels of deficits and debt along with high growth and high inflation.

* Fiscal Ratios: The main issue is whether the fiscal front is excessive when compared to financial capacity of the government and the economy. Government income-based ratios are seen more adverse than GDP ratios. Deficit-income ratio has increased even to 50% to 80%. Meanwhile, debt-income ratio has risen steadily from the two times the income to more than five times. Therefore, fiscal ratios seem to speak for excesses beyond the financial capacity. Non-availability of total asset value is a lapse to assess the leverage (debt ratio) and debt sustainability.

* Real Terms: In economics, inflation and inflation expectations influence current spending and borrowing, the link between the present and future. When inflation is expected to rise, it is rational to borrow and spend now and pay later with low-valued money. Therefore, spending and debt in real terms are important. Although fiscal variables in nominal/current value rose excessively, the increase in real terms, i.e., after removing the increase in consumer prices or inflation, has been low. For example, between 1960 and 2017 budget deficit and debt in real terms have increased by 7 times and 96 times, respectively, as compared to respective increases in nominal/current value by 733 times and 10,311 times. Therefore, fiscal front in real terms appears to be of better hygiene, given its socio-economic impact. See tables and graphics

Policy challenges

Healthy management of fiscal front requires addressing several challenges. First, debt bubbles/crises are real world events that has caused catastrophes to nations. Therefore, management of budget and debt in line with principles of finance and economics is necessary to avoid such debt bubbles.

Second, budget and debt are results of broad fiscal policy on country’s macroeconomic management. Therefore, a detailed set of information on macroeconomic and social impact of fiscal policy on economic and social sectors is necessary. Application of aggregate GDP ratios and accounting ratios is only a part of the story.

Third, financial management requires close monitoring and management of cash flows and performance targets of public services. Most criticism is about the poor quality of public services. It is not a problem of fiscal policy, but the problem of the bureaucracy which does not manage public services in business and economic context. Therefore, Treasury managers have to have a list of public services with targets of deliverables and cash flows to monitor and manage fiscal discipline at least quarterly. This is necessary because, unlike in corporate world, it is difficult to identify members of political governments and bureaucracy who are responsible for inefficient use of budgetary funds or public funds.

Fourth, fiscal discipline is necessary to avoid fiscal deficits being financed by creation of money/credit beyond stable levels of real macroeconomic needs. High inflation, economic collapses and debt crises of many countries have been due to excessive budget deficits. Therefore, analysts and authorities who talk about fiscal slippages must present a reasonable set of information rather than standard GDP ratios in ad-hoc manner to justify their views. Otherwise, it is unfair for the fiscal policy.

Therefore, it will be good economic democracy if those who seek public votes to govern the country propose a framework to address above challenges of fiscal front for the macroeconomy and living standards of the public.

(The writer is a recently retired public servant as a Deputy Governor of the CB and a chairman and a member of 6 Public Boards. In his nearly 35 years’ service in the CB, he also served as Director of Bank Supervision, Secretary to the Monetary Board and Senior Deputy Governor and authored 5 economics and financial/banking books published by the CB and more than 50 published articles.)


 

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