Lecture10 - Public Expenditure and Public Debt-2

CHAPTER TEN
10 BEC 310: Public

Finance
Public Expenditure and Public

Debt
In this chapter……
 Introduction
 Public Expenditure Size and Growth
 Theories of Public Expenditure Growth
 Public Expenditure Policy in Zambia
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 Introduction
 Domestic and External Debt
 Sources, Causes, Management and Financing
 Overview of Debt in Zambia
 Fiscal Sustainability and Debt Sustainability
 Methods of Debt Redemption
 The Role of Public Borrowing in a Developing
Economy
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 Difficulties of Public Borrowing in

Underdeveloped Countries
 The Effects or Burden of the Public Debt
 Ricardian Equivalence
 Departure from Ricardian Equivalence
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Introduction
 So far , we have looked at why governments

should play a role in a market-oriented economy
and therefore, mobilise and spend resources.
 We look at theories of expenditure growth and
the relationship between government
expenditure and economic growth.
 Public expenditure is the value of goods and
services bought by the Government and its
articulations.
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Introduction
 Public expenditure is simply the cost of carrying

out government activities and policies.
 Public expenditure can be classified according to
the official body and organization from
which budget it is paid.
 It can be reported at different tiers of
government:
 Central government and its ministries,
 Local government.
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Introduction
 Public expenditure plays four main roles:

1. It contributes to current effective demand;
2. It expresses a coordinated impulse on the economy,
which can be used for stabilization, business cycle
inversion, and growth purposes;
3. It increases the public endowment of goods for
everybody;
4. It gives rise to positive externalities to economy and
society as a whole (or in specific sectors and geographical
areas), the more so through its capital component.
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Introduction
 In democracy, public expenditure is an

expression of people's will, managed through
political parties and institutions.
 At the same time, public expenditure is
characterised by a high degree of inertia and law-
dependency, which tempers the will of the
current majority.
 Public expenditure can be financed through
taxes, public debt, money emission and
international aid.
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Introduction
 Public expenditure can be classified in terms of

the kind of goods and services bought such as:
1. capital goods;
2. consumption goods;
3. personnel expenditure.
 Does public expenditure in national accounts
include the following:
 Transfers among social groups such as pension schemes?
 Payments of interest on public debt?
 Sate owned firms’?
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Introduction
 In modern states, the expenditure of the different

bodies is interlinked, with national programmes
co-financing both international and decentralised
projects.
 The co-financing with the private sector is
sometimes actively looked for.
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Introduction
 Public expenditure can be classified according to

the macro-function at which it is directed:
1. justice and public order;
2. infrastructure (roads, railways,...);
3. military system;
4. education system;
5. environmental protection;
6. health care;
7. support for the poor, the old, the disadvantaged;
8. support for firms, export and production in general;
9. regional policies for rural and urban areas;
10. special policy expenditure (foreign aid, integrated fight against
drugs,...).
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Introduction
 In different places and over time, those macro-

functions have largely changed their level of
priority and even the social acceptance of the
idea that it is the Government that must take
care of them.
 In particular, as a very sketched framework, one
may distinguish at least three general models of
state to which public expenditure corresponds:
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Introduction
 1. The minimal state, where only justice, public

order, foreign policy and some other basic
functions should be carried out by the
government, relying on private initiative for the
others;
 2. The welfare state, where the Government
cares about the people's well-being directly
through expenditure on schooling, health,
support for the poor, the old and the
disadvantaged;
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Introduction
 3. The developmental state, where the

Government takes the responsibility of fostering
economic development, through expenditure on
infrastructure, support for firms, innovation,
export and production in general.
 Both the welfare and developmental state include
the items of the minimal state.
 Military expenditure and special policies are
common traits of the three models, maybe in
different proportions.
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Introduction
 Comparing macro-function shares in public

expenditure, one can get insights in the kind of
state under analysis.
 Needless to say, the Government does not exert
its influence on economy and society through
public expenditure only but also through laws.
 By integrating laws, public expenditure and the
tax system (as well as other components) one put
together comprehensive policies.
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Introduction
 Transparency and public monitoring of prices of

the goods purchased by public authorities can
substantially increase the efficiency and the
consensus around public expenditure.
 Public expenditure is determined by political
will of the leading forces in the government:
 their priorities,
 their desired state model, and
 their interpretation of current economic and
political phase.
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Introduction
 Past choices have relevant impact on public

expenditure because of inertia and
incrementalism.
 Bureaucracy may play an important decision role
for the actual expenditure.
 Sometimes considered as a completely
exogenous variable, the public expenditure
would thus be fully in the hand of political
decision makers without dependency from the
economic context.
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Introduction
 In a different political and institutional context,

public expenditure may, instead, positively
respond to state revenues.
 Higher revenues, and maybe even a public
surplus, may lead to higher public expenditure.
 Symmetrically, if there is an upper limit to public
deficit and because of a recession, tax revenue
falls, the government may be forced to cut public
expenditure.
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Introduction
 In this context, public expenditure would turn

out to be pro-cyclical.
 Lawmakers facing elections are sensitive to the
public opinion.
 Usually, low-income social groups are
in favour of expanding public expenditure on
social issues, as stimulus for jobs, and provision
of free or subsidised services.
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Introduction
 The rich tend to use less public services and to be

more worried by the amount of tax necessary to
fund public expenditure.
 The middle class is indecisive and will react
depending on the specific frame that will be
proposed by politicians.
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Public Expenditure and Public Debt
10.1 Public Expenditure Size and Growth

 However, in most developing countries, these
data are not so readily available.
 The most readily available is central government
expenditure.
 My thinking!
 It would be nice for you to get a rough picture of trends
in government expenditure as percentage of GDP and
compare it with other African countries.
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 The functional classification of government
expenditure refers to the amounts spent on
different goods and services provided by
government.
 Table 10.1 shows the components of functional
classification of government expenditure.
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Table 10.1: Functional Classification of Government Expenditure
.1. Administration
General administration
National defence
National assembly
Others
2. Economic services
Agriculture
Construction
Transport & communication
Others
3. Social services
Education
Health
Housing
Social welfare
Others
4. Transfers
Subsidies
Pensions
Unemployment benefits
5. Others
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 The relevance of this classification is that it will
show the orientation of government expenditure,
be it towards social services or national defence,
etc.
 This can be helpful in identifying developmental
and non-developmental expenditure.
 This will reveal the priorities given to each type
of function and will be instrumental in assessing
whether the priorities are well placed or not.
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 A GDP component as it is, public expenditure
has an immediate impact on GDP.
 An increase of public expenditure rises GDP by
the same amount, other things equal.
 Moreover, since income is an important
determinant of consumption, an increase in
income will be followed by a rise
in consumption.
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 A positive feedback loop has been triggered
between consumption and income, exactly as in
the case of shocks in export, investment or
autonomous consumption.
 The full extent of this mechanism will depend,
however, on the reactions of the other economic
agents.
 Firms have to decide whether to increase
production or prices in response to demand.
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 Moreover, if consumers interpret the increase in
public expenditure as a fall in their disposable
income (i.e. after-tax income), consumption may
fall accordingly.
 Public expenditure is also known to crowd-
out investment, possibly through an interest
rate increase.
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 This further leads, in a floating exchange
rate regime, to a currency appreciation.
 Exports would then be displaced as well.
 In more microeconomic terms, public
expenditure may be directed to consumer goods
and thus substitute families' expenditure, as with
the case of health drugs.
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 By contrast, in other cases, as with education,
public expenditure may trigger further
consumption on books and all the other goods
whose consumption depend on culture levels.
 Conversely, the part of public expenditure which
is burned in rent-seeking behaviours, corruption,
and purposeless purchases can alter the rules of
the game in markets, firms, and income
distribution.
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 In developed countries, it has always grown,
whatever the political orientation of the
government.
 Just the tempo can change, with a few exceptions,
only under extremely strong constraints has
public expenditure been cut in absolute terms.
 Therefore, the attempt of cutting public
expenditure can be judged as difficult.
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 Wars are episodes of extremely high public
expenditure, followed usually by a return to
normality.
 Public expenditure may turn out to be pro-
cyclical or anti-cyclical depending on
the political and institutional attitude toward
public deficit.
 During recessions, tax revenue tends to fall,
public budget usually degrades.
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 Some governments react by reducing public
expenditure and freezing employment and
wages in the public sector.
 Other decide to spend more to stimulate the
economy.
 The former risks to worsening GDP dynamics
and causing a vicious cycle, which can be broken
by international trade dynamics, financial
inflows or other variables.
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 The second would provoke a deep public deficit,
waiting for a GDP rebound and, possibly, new
taxes.
 Still, real world data show often little reaction of
public expenditure to the cycle.
 Most cycles show public expenditure as a
stabilizing tool just keeping the same dynamics
when the rest "goes wrong".
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 There is compelling evidence indicating that
government expenditure tends to grow in
absolute and relative terms as per-capita income
increases.
 Over-time, as expenditure rises, it also changes
its composition.
 We now summarise international cross-sectional
evidence on the composition of government
expenditure at different levels of development.
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 Low income countries
 The bulk of government spending is typically
directed at:
 capital investment in infrastructure,
 stimulation of industrial development through various
incentives, and
 the establishment of primary education and health care
systems.
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 Middle income countries
 Priority is given to education, health care, and
research and development, and also usually begin
to develop a social security system.
 High income countries
 These are characterised by huge increases in the
share of transfer payments, especially social
security related ones, which are typically
compensated for by reduced public investment.
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10.2 Theories of Public Expenditure Growth

 It is argued that economic development is
associated with a shift in the economic
composition of government expenditure.
 That is, from capital expenditure to consumption
expenditure, including transfer payments.
 The functional counterpart of this trend is a shift
from administration and economic services to
social services.
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 Before we look at the theories, let us discuss the
principal reasons of growing public expenditure.
 1. Increase in area and population
 In the first place, the increase in public
expenditure is due to the fact that the physical
boundaries of the states have been widened.
 Also, in certain cases, even if the area has not
increased, the population figures have
considerably gone up.
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 1. Increase in area and population
 Governments have, therefore, to cater the needs
of millions of more people scattered perhaps over
a much wider area.
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 2. Growth of state functions
 Modern states are now regarded as welfare states
and this has resulted in a tremendous increase in
their functions.
 However, old functions such as administrative
and those relating to internal security and
protection against aggression are now being
performed more intensively.
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 2. Growth of state functions
 There are also numerous new functions being
undertaken such as optimum utilization of
national resources, economic growth, reduction of
poverty and economic inequalities.
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 3. Higher price level and rising costs of public
services
 Another reason which accounts for the mounting
public expenditure is the higher price level.
 Governments, like individuals, have to find larger
amounts of money to pay for the commodities
and the services they have to purchase.
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 4. Increase in national wealth
 There has been almost a continuous improvement
in agriculture, trade and industry in every
country.
 There has also been a steady increase in the per
capita income and consequently, an improvement
in people’s standards of living.
 Therefore, there has been a corresponding
improvement in public revenues and public
expenditure.
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 5. Ability to tax
 In a low income economy, it is relatively difficult
to impose and collect taxes.
 But as the economy develops, a much wider
range of taxes are made available to the state.
 As state revenue swells, public expenditure also
increases.
 Ability to tax raises the ability to spend.
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 6. Provision of public utility services
 Governments are providing more and more
public utility services, e.g. water, electricity,
transport services.
 It has also been realised that some of the
important wants of man can be satisfied more
efficiently and economically if they are supplied
collectively rather than each individual making
their own arrangements.
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 It is not considered desirable or economical that
in a town, there should be different companies
supplying these services on a competitive basis.
 However, these public utility services are best
provided by the central government or local
authority.
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 Naturally, public expenditure goes up as a result
of an expansion in social services.
 In modern times, there has been a remarkable
expansion in social services like water, education,
public health measures and medical aid.
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 Now that we know some of the reasons for
increased public spending, we can now discuss
theories that explain the reasons for growth in
public expenditure.
 The discussions will be under macro and macro-
models of public expenditure growth.
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 Therefore, one way of explaining the growth in
public expenditure is to use macro models.
 These macro models attempt to explain the broad
patterns of government expenditure with regards
to aggregate variables such as GDP.
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 1. Development Models
 These comprise of Musgrave and Rostow’s stages
of development.
 The premise is that public expenditure is a pre-
requisite for economic development.
 Thus, it is directly related to the stages of
economic development.
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 In the first stage of development, public
expenditure is bound to increase because of the
need to provide basic infrastructure such as
roads, railways, etc.
 This helps the government to create a conducive
environment to economic development.
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 During this stage, the private sector is relatively
small hence the need for government to actively
participate in the economy.
 In the middle stages of development, public
investment will continue to increase but private
investment will also start to take off due to the
positive external effects from the first stage.
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 Market failures will start to arise and therefore,
government expenditure will continue to rise.
 During the last stage of development, capital
investment by government as a percentage of
GDP will decrease as most of the necessary
infrastructure is now in place.
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 However, public expenditure will continue to
rise but with a change in composition.
 Expenditure on education, health, welfare
services and transfers will tend to rise due to the
high income elasticity of demand of such
expenditure.
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 2. Wagner’s Law
 This is also called the law of increasing state
activities.
 According to Wagner’s law, as per capita income
grows; the relative size of the public sector will
also grow.
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 This growth in the relative share of public
expenditure is assumed to be due to three
factors:
 First, a growing country will experience a need to
expand administrative and protective services.
 This refers to, among others, law and order, internal
and external security aimed at creating an
environment conducive for economic growth and
development.
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 Secondly, there will be an increase in expenditure
concerning re-distributional issues, i.e. subsidies,
unemployment benefits, etc.
 As per capita income increases, the demand for
these expenditures increases by a higher
percentage because such goods and services are
income elastic.
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 A greater need to control monopolies and other
forms of market failure in order to promote
economic efficiency.
 This contributes to the increase in the share of
government expenditure in GDP.
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 There are many studies which have tested
Wagner’s law.
 Many of these tests used cross-sectional as well
as time series analysis.
 Wagner’s law has been confirmed in some
countries while no evidence for it has been found
in others.
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 An empirical investigation into Wagner’s law at
country level involves testing for cointegration
between public expenditure and per capita
income.
 If cointegration is found, then there is a long-run
relationship between the two variables and
Wagner’s law is confirmed.
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 3. Peacock and Wiseman
 Their thesis maintains that public expenditure
shows a gradual upward trend under normal
conditions.
 However, increased outlays during war or social
disturbances permit permanently higher post-
war civilian expenditures.
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 Public expenditure is financed by higher taxation
during periods of stress, and this expenditure is
displaced upward after the war or social
disturbance.
 National crises may cause a rapid increase in
government expenditure as the citizens will be
convinced of the need to pay more taxes.
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 After the upheaval or crisis has subsided,
government expenditure is expected to return to
pre-crisis levels.
 However, this is unlikely as government
expenditure could remain at the new post-crisis
level given that taxpayers would have become
used to the higher level of taxation.
 This is referred to as the displacement effect.
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 Besides the displacement effect, there could be an
inspection effect.
 An inspection effect arises because the citizens
would become more aware of social problems
during the crisis.
 Therefore, they would require government to
expand its scope of its services to improve the
situation.
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 Thus, the combination of both the displacement
and inspection effects will cause an increase in
government expenditure.
 In addition to the displacement and inspection
effects, Peacock and Wiseman, also give
narration about a concentration (scale) effect.
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 It refers to the apparent tendency for the central
government economic activity to become an
increasing proportion of total public sector
economic activity when it is experiencing
economic growth.
 This occurs because central government has to
initiate a number of measures to sustain higher
economic activity.
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 Since each major disturbance leads to a situation
in which the central government assumes a
larger proportion of the total national economic
activity, the net result is “the concentration
effect”.
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 Wiseman – Peacock hypothesis appears to be
quite relevant.
 At the outlet, the hypothesis looks quite
convincing.
 It emphasizes jerks and jumps in public
expenditure, on account of unusual and
abnormal situations.
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 Peacock and Wiseman expenditure growth is
sporadic rather than constant and revenues
create their own expenditures.
 However, we must not forget the fact that
depending on the level of advancement of the
economy, and the structural changes therein,
there are constant and regular increments in
public expenditure and revenue.
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 The regular and dynamic changes in state activity
and public spending caused by the following
macro variables are major factors giving a big
push to an upward trend in public expenditure:
 population growth,
 urbanization,
 awareness of civic rights on the part of citizens and
 political and social commitments on the part of democratic
governments voted to power.
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 However, the influences of these factors on
government spending were not systematically
analysed by Wiseman and Peacock in their
hypothesis.
 Therefore, Bernard. P. Herber argues that the
Peacock -Wiesman hypothesis of governmental
spending trends is much more modest in what it
intends to explain than the Wagner’s hypothesis.
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 The fact is that both the Wagner’s and Peacock-
Wiseman narrations contribute a lot to the
understanding of the process of public sector
growth in industrialized nations.
 Their analysis is essentially short term, explaining
the upward displacement of the expenditure
function but it does not provide a firm theory of
the determinants of the displaced function.
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 4. Colin Clark’s Critical Limit Hypothesis
 Another hypothesis relating to the growth of
public expenditure is provided by Colin Clark.
 The hypothesis is basically concerned with the
tolerance level of taxation.
 Colin Clark developed this immediately after the
Second World War.
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 The hypothesis draws conclusions from the
empirical data drawn from several Western
countries for inter-war period.
 Clark pointed out that in an economy; inflation
emerges when the share of the government sector, as
measured in terms of taxes and other receipts, exceeds
25% of the aggregated economic activity in the
country.
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 When public expenditure reaches 25% of the total
economic activity or aggregate amount of
expenditure in the country, the tax payers’ ability
to pay more tax is exhausted.
 Public expenditure beyond this limit means
disincentive to producers and fall in production
due to taxation beyond tolerance level.
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 The hypothesis rests upon the following two
institutional factors:
 (a) When tax collection by government exceeds the critical
limit of 25% of GNP, the income earners are badly affected
by reduced incentives and decrease in their productivity.
 They produce less than what they are capable of leading to
reduced supply.
 In short, taxation beyond the critical limit adversely affects
the incentive to produce and invest.
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 The hypothesis rests upon the following two
institutional factors:
 (b) On the other hand, even if the budget remains
balanced, increase in government expenditure would
constitute rising demand.
 Therefore, inflation is generated from the mal-adjustment
between demand and supply.
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 Even though Colin Clark’s critical minimum
effort thesis is well accepted by the business
community, its significance in the academic circle
is very limited.
 Colin Clark gave undue emphasis on his critical
limit of 25%.
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 In the modern world, a number of countries are
incurring public expenditure much beyond their
limit, without facing worse situation of
inflationary pressure.
 The impact of budgetary spending on the
generation of an inflationary situation depends
on the manner and nature in which public
expenditure is incurred.
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 Inflation is a complex economic phenomenon
influenced and characterized by a number of
mutually exclusive and inter-dependent factors.
 Hence, we can only fairly conclude that in a
market economy, increasing state activity may
create inflationary pressure.
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 5. Meltzer-Richard Hypothesis
 This approach looks at the importance of the
impact of redistribution policies on the growth of
government expenditure.
 Meltzer and Richard’s model assumes that
majority voting determines the magnitude of income
distribution and as a result, the share of government
expenditure in the economy.
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 According to this model, the most important
reason for the growth of government
expenditure can be attributed to the extension of
the franchise which brings about a change in the
median (decisive) voter.
 The median voter plays an important role in
determining the size of the government sector in
a democracy.
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 The median voter is important because in a two-
party democracy, he or she will determine which
party will win the election.
 According to the M-R hypothesis, there will be
pressure for redistribution in income if the income of
the median voter lies below the average income.
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 To gain support of the median voter, political
parties will emphasise redistribution policies
which could result in higher taxes and higher
expenditure on social services.
 The median voter thus effectively determines the
tax level.
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 The model however does not allow for unlimited
redistribution because it assumes that the voters
are aware of the disincentive effects associated
with high taxes and redistribution.
 We can now consider some micro models of
public expenditure growth.
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 7. Baumol’s Unbalanced Productivity Growth
 The ‚Baumol effect‛ can be considered as one
explanation of public expenditure growth.
 It may have some significance in explaining the
heavy wage bills of the public sector in some
developing countries.
 Baumol divides the economy into two sectors,
the progressive and non-progressive sectors.
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 The progressive sector experiences productivity
growth while productivity in the non-
progressive sector is constant.
 The basic difference between the two sectors
resides in the role played by labour in the
activity.
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 In some sectors, labour is an instrument to
produce the final product while in others; labour
itself is the end product.
 Manufacturing is an example of the former type
of activity, whereas there are services, such as
teaching, where labour is an end in itself.
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 Services tend to be labour intensive and offer less
scope for technological change that improves
productivity.
 The concept of a non-progressive sector may
apply to public service labour activity.
 Let us consider education and law and order as
an example.
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 The aim is to achieve a certain pupil-teacher ratio
or a certain number of law-enforcement officers
per thousand of the population.
 According to Baumol, technological changes do
not have such an important impact on the
productivity of such services compared to those
of the progressive sector.
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 It may actually be counter-productive to try and
increase the productivity in the education
services by halving the time students spend in a
classroom.
 As a result, there are only sporadic
improvements in productivity in the non-
progressive sector.
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 The Baumol model can be summarised in the
following propositions:
 The output of the non-progressive sector is
produced only by labour with constant
productivity.
 The output of the progressive sector is a function of
labour productivity which grows at an exponential
rate.
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 The Baumol model can be summarised in the
following propositions:
 Wage rates are equal in the two sectors and increase
at the same rate as productivity in the progressive
sector.
 Since productivity in the non-progressive sector is
less than in the other sector, the cost per unit of
output of the non-progressive sector will rise without
limit while that in the other will remain constant.
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 Therefore, Baumol's model provides an
explanation of expenditure growth in the public
sector if we assume that the public sector is
labour intensive and has constant productivity.
 Further, the public sector wages must move at a
rate similar to that of wages in the progressive
sector, which uses capital intensive technology.
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 Government wage costs are therefore the major
cause of public expenditure growth in this model.
 Baumol's model is intuitively appealing but
difficult to quantify in most developing countries.
 This is because the public service is popularly
perceived as inefficient and cumbersome, more
bureaucracy-oriented than service-oriented.
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 Despite the difficulty of estimating productivity
in the public service, one can still regard the
Baumol effect as a plausible explanation of the
large wage bills of the public sectors of these
countries.
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 8. Brown and Jackson’s Microeconomic Model
 This model tries to explain the level of publicly
produced goods and services and hence public
expenditure by looking at the demand and
supply of the goods in question.
 The model observes that government expenditure
increases without there being a corresponding
change in the level of service.
1 - 97

 The following are the forces at work apart from
viewing this as a sign of inefficiency:
 (1) Changes in service environment
 For example, an increase in the crime rate can call for
additional funding due to the need for extra policing
in order to maintain the same level of law and order.
 Changes in the size and density of the population and
its age structure may also influence the service
environment.
1 - 98

 (2) Population growth
 This may lead to an increase in the demand for
publicly provided goods and services since for pure
public goods, the marginal cost of an additional
consumer is zero.
 This channel may also be compounded by effects of
the disease burden e.g. HIV/AIDS, TB, malaria, etc.
1 - 99

 (3) Quality of goods and services demanded by the median
voter
 A good of superior quality is that which requires
more inputs in its production process, ceteris paribus.
 Thus, increases in quality may put pressure on
government expenditure if additional costs cannot be
recovered from the users.
1 - 100

 The micro model of Brown and Jackson identifies
combined important and relevant factors that
may influence the supply and demand of publicly
provided goods and services.
 The model provides a useful starting point for
anyone interested in modelling government
expenditure and identifying the explanatory
variables that will determine trends in
government expenditure. 1 - 101
10.3 Domestic and External Debt

 The national debt is the amount of money that the
government owes those from whom it has
borrowed and changes each year.
 The portion of a government’s indebtedness
owed to its own citizens is an internal or
domestic debt.
1 - 102

 Repayment of internal debt represents a
redistribution of purchasing power from certain
groups of citizens who pay taxes and other
citizens who in the past have been creditors of the
government.
 When a central government borrows mainly from
it citizens, the opportunity cost is forgone
consumption and investment in this country
rather than from foreign sources.
1 - 103

 The portion of a government’s indebtedness
owed to the outside world is external or foreign
debt.
 When external debt is repaid, resources
necessarily flow out of the nation, with a
consequent loss in productive opportunities.
 The external debt varies with local interest rates
relative to those that can be earned on funds
abroad and the balance of international trade
with the rest of the world. 1 - 104

 When much of the debt is an internal debt, many
argue that repayment will not involve export of
economic resources.
 Those who hold this view further argue that only
little concern is justified about the total volume of
the debt and its interest charge.
 This is because any refunding or payment of
interest on the debt at maturity involves merely a
redistribution of purchasing power among
citizens. 1 - 105

 To be presented at some point in class:
 Trends in the portion of internal and foreign debt in
Zambia.
1 - 106

 External debt grows faster if:
 a country continues to run balance-of-trade
deficits, which put local currency into the hands
of foreigners.
 interest rates increase significantly above those
available on competing securities (both foreign
and domestic).
1 - 107

 Conversion of the national debt into one that is
increasingly more external can have serious
consequences for future growth opportunities.
 This is particularly worrying if taxes must be
raised to pay foreigners for past loans to the
government.
 Under such circumstances, paying off the debt
would involve outflows of funds and real losses
in productive opportunities rather than mere
redistributive effects. 1 - 108

 There is also concern that heavy reliance on
foreign borrowing can cause real interest rates to
rise in the local economy if foreigners become
concerned about the foreign exchange rate of the
local currency.
 If the local currency falls in value, the investment
income return to foreign holders of the debt
denominated in the local currency will be worth
less in foreign currency.
1 - 109

 If foreigners become reluctant to acquire local
debt for that reason, then interest rates would
have to rise to compensate them for foreign
exchange risks.
 The higher interest rates could reduce real
private domestic investment thereby slowing
future growth in the local economy.
1 - 110

 We hope to get your potential employers, MoF,
to come and share with us the following:
 General overview of debt.
 Sources, causes, management and financing of
debt.
 Methods of Debt Redemption.
 Any other relevant information.
1 - 111
10.4 Fiscal Sustainability and Debt Sustainability

 Fiscal sustainability analysis is an important
component of macroeconomic analysis for many
developing countries and has attracted
considerable attention in the recent years.
 Furthermore, assessing fiscal sustainability is
important because the lack of it is a clear signal
for future policy changes.
1 - 112

 We need to answer questions like:
 Why worry about fiscal sustainability?
 When can we say that the fiscal policy stance is
unsustainable?
 What advice can we give on the operational
indicators for fiscal sustainability to guide
policymakers?
1 - 113

 Fiscal sustainability is a concept, intimately
linked to the concept of solvency and liquidity.
 Solvency usually refers to the government’s
ability to service its debt obligations without
explicitly defaulting on them.
 Liquidity refers to government’s ability to roll-
over its maturing liabilities with its liquid assets
and available financing.
1 - 114

 Liquidity problems can be triggered by contagion
effects from crises in other countries, without any
fundamental reason within the country.
 Vulnerability to such problems is related to
structure of debt (when debt is skewed towards
short-term debt).
 However, it is often hard to make a clear
distinction between solvency and liquidity.
1 - 115

 Therefore, fiscal sustainability is defined as the
government’s ability to maintain the same set of
fiscal and monetary policies without becoming
insolvent.
 The idea that the government is always solvent is
unquestionable, as long as it can/will adjust its
fiscal and monetary policy to avoid default.
1 - 116

 It is also important to find out what sort of
adjustments are needed to ensure sustainability
and the implications of these adjustments for
meeting goals other than solvency (e.g. SDGs,
optimal policy, etc.).
 The fundamental building block of all tools for
fiscal sustainability is the ‚flow‛ the government
budget constraint.
1 - 117

 This constraint implies that any excess of
expenditure over current revenues has to be
financed by:
 asset sales,
 public borrowing (foreign or domestic) or
 money creation.
 Recall that the macroeconomic impact of the
government deficit very much depends on the
way the deficit is financed.
1 - 118

 For example excessive:
 foreign borrowing could lead to an external debt
problem, depletion of foreign exchange reserves - to an
exchange rate crisis.
 domestic borrowing especially in underdeveloped
capital markets may lead to high real interest rates,
which through automatic debt dynamics, may have a
snowballing effect on public debt.
 money creation may lead to high and volatile inflation
with all the negative consequences for growth.
1 - 119

 We need to answer questions like:
 Why worry about fiscal sustainability?
 When can we say that the fiscal policy stance is
unsustainable?
 What advice can we give on the operational
indicators for fiscal sustainability to guide
policymakers?
1 - 120

 Fiscal Sustainability: Why Worry?
 Excessive debt (debt overhang) is bad for growth and
development.
 A rising share of revenues devoted to debt-service
payments weakens a government’s ability to implement
desired policies.
 Heavy debt service obligations make a country more
vulnerable to interruption of commercial or official flows
(sudden stops, shift in aid policies).
 Debt restructuring can be highly disruptive to economic
activity and undermines the development of a credit
culture. 1 - 121

 Potential vicious circle for fiscal unsustainability
1 - 122

 By now, there is a broad agreement that fiscal
policy is unsustainable if the present and prospective
fiscal stance results in a persistent and rapid increase
in the public debt-to-GDP ratio.
 Therefore, the size and growth rate of the debt-
to-GDP ratio is a key indicator of fiscal
sustainability.
1 - 123

 Indeed, high debt ratios are costly and will
eventually become unsustainable as creditors
alter their expectations when realising that
present policies are not credible and will have to
be revised.
 As the market realises that the higher debt
servicing costs will make it more difficult for the
government to meet its budget constraint, it will
be increasingly difficult for the government to
sell its debt. 1 - 124

 This will increase the risk of monetising the
deficit or debt default.
 Therefore, fiscal sustainability analysis leads to
conclusions about the appropriateness of fiscal
policy.
 This is often characterised in terms of the balance
between revenue and expenditure given the
government’s public sector debt level, its
inflation, exchange rate and growth projections.
1 - 125

 Over the last few years, the US and many
European countries have been facing major
economic, financial and fiscal crises.
 For some, this has resulted in steep decline in
output and rise in unemployment and public
debt.
 The effects of these crises are still being felt with
many countries such Greece and Ireland are not
able to meet their debt obligations and have to be
bailed out by other countries. 1 - 126

 These events have brought to the fore the issue of
sustainability of public debt and financial system.
 The 2008/09 crisis originated in the financial
sector.
 Banks and other financial institutions had to be
rescued by governments and central banks.
 This required massive infusion of public
resources in financial institutions and in many
cases outright government takeover.
1 - 127

 Central banks had to resort to unconventional
monetary measures (e.g. quantitative easing) in
order to avoid depression and shore up public
confidence.
 Financial crisis severely reduced real activities
and tax revenues and substantially increased
public expenditure.
1 - 128

 This led to rapid increase in government debt
with many countries facing fiscal deficit running
in double-digits.
 In 2009, the debt-GDP ratio for the U.S. was
87.5%, for Britain 80.6%, Japan 214%, and Greece
125%.
 This massive run up in debt has raised the
question of sustainability of public debt.
1 - 129

 Therefore, we formally analyse the issue of
public debt sustainability then the twin issues of
fiscal and financial sustainability.
1 - 130

 Dynamics of Public Debt
 We first examine the dynamics of public debt in a
partial equilibrium deterministic model.
 This model is quite useful in understanding
inter-linkages among fiscal deficit, public debt,
rate of growth of GDP and interest rate.
1 - 131

 The questions we ask are:
 Can a government run a persistent fiscal deficit?
 Can public debt grow forever without
bankrupting a country?
1 - 132
1 - 133
1 - 134
1 - 135
1 - 136
1 - 137
1 - 138
1 - 139
1 - 140
1 - 141
1 - 142
1 - 143

 These results show that whether a country can
run a persistent fiscal deficit depends on the rate
of interest and the rates of growth of GDP and
public debt.
 Therefore, a fiscal deficit is likely to be
unsustainable in countries with low GDP
growth.
1 - 144

 The level of fiscal deficit itself plays a crucial role.
 The higher the fiscal deficit, the less likely the
deficit is going to be sustainable.
1 - 145

 Debt Trap
 There are cases in which a country is caught in a
‘’debt trap".
 This is a situation in which the government has
to borrow to even to pay interests on the public
debt.
 To analyse the issue of debt trap, we modify the
environment slightly.
1 - 146
1 - 147
1 - 148
1 - 149
1 - 150

 So far, we have analysed a deterministic model of
public debt with fixed interest rate.
 However, in the real world, the rate of interest
paid by a government depends on the magnitude
of public debt and fiscal deficit.
1 - 151

 Debt Crisis and Default
 It has been observed that countries with higher
debt levels and fiscal deficits pay higher rates of
interest and are more likely to default.
 Further, fiscal crises and debt default happen
suddenly.
 We now develop a model to analyse the
interaction among debt level, rate of interest and
default probability.
1 - 152
1 - 153
1 - 154
1 - 155
1 - 156
1 - 157
1 - 158
1 - 159
1 - 160
1 - 161

 There are number of implications of this model:
 Firstly, small differences in fundamentals can lead
to large differences in interest rates and default
probabilities.
 Secondly, the model suggests that when default
occurs, it may occur quite unexpectedly.
 Finally, default depends not only on self-fulfilling
beliefs, but also on fundamentals.
1 - 162

 In particular, an increase in the amount that the
government wants to borrow, an increase in the
safe interest rate, and a leftward shift in the
distribution of potential revenue all make default
more likely.
1 - 163
10.5 The Role of Public Borrowing in a

Developing Economy
 A developing economy has all total possible
sources to mobilise sufficient financial resources
for the implementation of its economic
development plans.
 It has to utilise revenue surplus for the purpose,
seek external aid, and pitch up its level of
taxation and resort to public borrowing in
addition.
1 - 164

Developing Economy
 But taxation and public borrowing are the two
major instruments of resource mobilization.
 Public borrowing has one advantage over
taxation.
 Taxation, beyond a certain limit, tends to affect
economic activity adversely owing to its
disincentive effect.
1 - 165

Developing Economy
 There is no such danger in public borrowing.
 It does not have any unfavourable repercussions
on economic activity by being disincentive,
partly because of its voluntary nature and party
because of expectations of return and repayment.
 According to expert opinion, taxation should
cover at least current expenditure on normal
government services.
1 - 166

Developing Economy
 Borrowing should be resorted to finance
governed expenditure which results in creation
of capital assets.
 In that case, growing public debt will not be a
burden on the economy, because such a debt is
self liquidating.
 But there is a limit to public borrowing, which is
considered safe.
1 - 167

Developing Economy
 Additional taxation is also necessary to
implement the development plans.
 Thus, in an under developed economy, public
borrowing, if prudently managed and skilfully
operated, can become a powerful instrument of
economic development.
1 - 168

Developing Economy
 Besides, growing public debt provides the people
opportunities to hold their wealth in the form of
safe and stable incoming yield assets i.e.,
government bonds.
 Growth and composition of public debt provides
the monetary authorities with assets which they
can manipulate to give effect to a monetary
policy considered desirable in context of
economic development. 1 - 169

Developing Economy
 Thus, monetary policy, which is considered
essential for achieving the objectives of economic
policy, becomes vitally related to public
management.
 The management of public debt is used as a
method to influence the structure of interest
rates.
1 - 170

Developing Economy
 Thus, a growing public debt, in an
underdeveloped economy, has become a
powerful tool of developmental monetary policy.
 There are two important ways in which the
governments of underdeveloped economies raise
resources through public loans.
1 - 171

Developing Economy
 (1) Market borrowing, i.e., sales to the public of
government bonds (long term loans) and treasury
bills (short term loans) n the capital market.
 (2) Non market borrowing, i.e., issue to the public
of debt which is not negotiable and is not bought
and sold in the capital market.
 E.g., issue of national savings certificate; and national
plan bonds and accepting deposits in the government
post offices.
1 - 172
10.6 Difficulties of Public Borrowing in

 Public borrowing however has to face special
difficulties in under developed countries:
 There are no organised capital and money
markets and, where they exist, they constitute a
very small portion of the total capital and money
markets in the country.
 Also, there may be no organic relationship
between the organized and unorganized markets.
1 - 173

 In addition, the resources of the organized capital
market are too inadequate to fulfil the capital
needs of the economy.
 Special difficulties of public borrowing in
underdeveloped countries arise from the fact that
the people have partiality in favour of investment
in real estate.
 This gives them social prestige and for jewellery because
it can easily be concealed and can easily be converted
into cash in case of need. 1 - 174

 A substantial volume of savings in these
countries originates in the rural sector but these
people have no tradition of investment in trade
and industry.
 The rural savings cannot be mobilised effectively
because rural incomes do not move through
monetary channels.
1 - 175

 That is why most of the financial institutions are
concentrated in the urban areas.
 Further, agricultural interests are entrenched
strongly, politically and resist all proposals to tax
them.
1 - 176

 The prevalence of very high rates of interest
works against the flow of funds towards:
 agricultural improvement,
 savings accounts,
 government bonds,
 small scale industry or
 other channels of investment where the yield
cannot be so high.
1 - 177

 The response to government securities is also
poor because of rising prices which reduce the
value of the yield from government securities.
 However, in spite of these difficulties in public
borrowing, it remains a powerful instrument of
resource mobilisation.
 It is not only a necessary supplement to taxation
but also very desirable form of capital formation.
1 - 178
10.7 The Effects or Burden of the Public Debt

 In modern times, public borrowing is both
extensive and intensive.
 Almost all countries resort to public borrowing
and they get deeper and deeper into it.
 The commonly held view that the current
government debt is the burden on the future
generations ignores the fact that some
government bonds are owned by its citizens.
1 - 179

 Therefore, although descendants may face heavy
taxes to pay the interest and principal of the
government debt, these future taxpayers also will
inherit the government bonds.
 Thus they will be the recipients of interests and
principal payments.
 We owe the government debt to ourselves, so the
debt is not a burden in the same sense that it
would be if it were owed entirely to outsiders.
1 - 180

 Lerner (1948) argues that an internal debt creates
no burden for the future generation.
 Members of the future generation simply owe it
to each other.
 When the debt is paid off, there is a transfer of
income from one group of citizens (those who do
not hold bonds) to another (bondholders).
1 - 181

 In case of external debt, the future generation
certainly bears a burden.
 Financial operations, which public borrowing of
modern dimensions involve, are bound to affect:
 production,
 consumption,
 distribution of income
 employment and income,
 national saving,
 income in the country.
1 - 182

 Effect on Production
 Vast sums are raised through public loans by
modern governments both in the domestic
capital market and abroad.
 They are raised to finance productive enterprises
of various kinds, e.g., steel works, multipurpose
projects, construction of ships, railway lines and
national highways, heavy electrical and
engineering works, and so on.
1 - 183

 Effect on Production
 Obviously, such enterprises build up the
economy’s production base and, in course of
time, make an enormous increase in the country’s
output.
1 - 184

 Effect on Consumption
 When people subscribe to government loans,
they generally have to curtail consumption.
 In this way, the propensity to consume is curbed.
 Since investment of funds raised by borrowing
raises the level of employment, and so increases
people’s incomes, their consumption is increased.
1 - 185

 Effect on Distribution
 Public loans transfer money from the rich to the
government.
 But the fiscal operations in modern times are
meant to benefit the poor primarily.
 Either the incomes of the poor increase directly
through increased employment.
1 - 186

 Effect on Distribution
 It can also benefit the poor indirectly through the
enlargement of social services.
 In this way, national wealth comes to be
redistributed in favour of the poor.
1 - 187

 Effect on National Saving
 Economists claim that government deficits reduce
national saving.
 When the government runs a deficit, the economy
accumulates less domestic capital and fewer
foreign assets than it would have if the deficit had
been lower.
 If this argument is correct, deficits will lower the
standard of living for our children, their children
and their children’s children. 1 - 188

 Effect on National Saving
 This is because they will inherit a smaller capital
stock and because they will have to pay more
interest to foreigners than they otherwise would
have.
 This reduction in the future standard of living
would constitute a true burden of the
government debt.
1 - 189

 Effect on Employment and Income
 In modern times, public borrowing is resorted to
in order to raise funds for financing:
 agriculture industry,
 extension of the means of transport and
 communications or for construction of major irrigation
works.
 Sometimes, local development projects are
launched to increase employment opportunities
in rural areas.
1 - 190

 Effect on Employment and Income
 In this way, not only are the economic activities
in the country multiplied but the volume of
employment is also increased hence the level of
incomes.
 However, repayment of the debt affects income
distribution:
 If working taxpayers will be paying interest to the
mainly wealthier groups who hold the bonds, this
probably increases income inequality.
1 - 191
Is the Government Debt Really a Problem?

 There are two viewpoints regarding this:
 1. Traditional view
 2. Ricardian view
 Let us briefly discuss each one of them here.
1 - 192
10.8 Traditional View

 The traditional view of a tax cut and
corresponding increase in government debt
argues that this depends on whether you are in
the short run, long run and very long run.
 Short Run
 In the short run, a tax cut and hence increase in
the government debt increases national output
thereby lowering unemployment.
1 - 193
10.8 Traditional View

 Long Run
 National output and unemployment return to their
natural rates.
 In a closed economy, interest rate increases followed by
investment.
 In an open economy, the exchange rate appreciates
reducing net exports i.e. increasing the trade deficit.
 Very Long Run
 Economic growth slows until it reaches a new steady
state with lower income per capita.
1 - 194
10.9 Ricardian Equivalence

 This was developed by David Ricardo (1820),
more recently advanced by Robert Barro.
 According to Ricardian equivalence, a debt-
financed tax cut has no effect on consumption,
national saving, the real interest rate, investment, net
exports, or real GDP, even in the short run.
1 - 195

 Consumers are forward-looking, know that a
debt-financed tax cut today implies an increase in
future taxes that is equal, in present value, to the
tax cut.
 Thus, the tax cut does not make consumers better
off, so they do not raise consumption.
 They save the full tax cut in order to repay the
future tax liability.
 Result: Private saving rises by the amount public saving falls,
leaving national saving unchanged.
1 - 196

 The argument for Ricardian equivalence rests on
the assumption that current government
borrowing will be repaid within the lifetime of
people who are alive today.
 What if some of the debt the government is
accumulating will be repaid not by the people
who receive the tax cut but by their children or
grandchildren?
1 - 197

 Barro (1974) shows, in theory, Ricardian
equivalence may still apply.
 This is despite the current generation receiving
the tax cut and future generations bearing the
burden of repaying the government’s debt.
 Suppose that the gift of debt is a one-off event
and that taxation must be used to service the
debt and to meet its repayment.
1 - 198
1 - 199

 Let us show different assumptions on the
structure of repayment of the debt generating the
same neutrality conclusion.
 First, we consider the case that the bond is paid
off with interest the year after issue and the same
set of consumers is alive in both years i.e.
Ricardian equivalence within generation.
1 - 200
1 - 201

 This is a consequence of the recipients of the
bonds realizing that they face the tax liability for
its redemption.
 The receipt of the bond is therefore not treated as
an increase in wealth.
1 - 202

 Second, we assume a bond that is never
redeemed but on which interest is paid in
perpetuity and consumers who have infinite
lifespans.
 In this case, the discounted tax liabilities must be
equal to the discounted value of the stream of
interest payments.
1 - 203
1 - 204

 As far as the current generation cares about the
well-being of the next generation via altruism, the
current generation would not increase their
consumption in response to a tax cut but transfer the
same amount to their children.
 As a result, deficits created by tax cuts should not
reduce national saving and therefore should not
burden future generations.
1 - 205
10.10 Departure from Ricardian Equivalence

 The main arguments against Ricardian
equivalence are the:
 possible existence of borrowing constraints,
 consumers’ short sightedness,
 failure of some people to leave bequests, and
 non-lump-sum nature of most tax changes.
1 - 206

 1. Borrowing constraints
 A person who wants to consume more, but who is
unable to borrow to do so, will be eager to take
advantage of a tax cut to increase consumption.
 Thus the existence of borrowing constraints may
cause Ricardian equivalence to fail.
1 - 207

 2. Short sightedness (Myopia)
 If people are short-sighted, they may respond to a
tax cut by consuming more, contrary to the
prediction of Ricardian equivalence.
 Most consumers do not understand that increased
government borrowing today is likely to lead to
higher taxes in the future.
 Thus, consumers may simply respond to the
current tax cut, as they would to any other
increase in current income.
1 - 208

 3. Failure to leave bequests
 Some people may not leave bequests because they
expect their children to be richer than they are
and thus not need any bequest.
 If people continue to hold this belief after they
receive a tax cut, they will increase their
consumption and again Ricardian equivalence
will fail.
1 - 209

 4. Non-lump-sum taxes
 Ricardian equivalence holds only for lump-sum-
tax changes, with each person’s change in taxes
being a fixed amount that does not depend on the
person’s economic decisions, such as how much
to work or save.
 Thus non-lump-sum tax cuts will have real effects
on the economy, in contrast to the simple
Ricardian view.
1 - 210
Some Empirics
 Barro, R. (1989)
 Domar, E.D. (1944)
 Doi, T. (1999)
1 - 211
END
1-
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Lecture10 - Public Expenditure and Public Debt-2

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CHAPTER TEN

10 BEC 310: Public

Public Expenditure and Public

 Difficulties of Public Borrowing in

 So far , we have looked at why governments

 Public expenditure is simply the cost of carrying

 Public expenditure plays four main roles:

 In democracy, public expenditure is an

 Public expenditure can be classified in terms of

 In modern states, the expenditure of the different

 Public expenditure can be classified according to

 In different places and over time, those macro-

 1. The minimal state, where only justice, public

 3. The developmental state, where the

 Comparing macro-function shares in public

 Transparency and public monitoring of prices of

 Past choices have relevant impact on public

 In a different political and institutional context,

 In this context, public expenditure would turn

 The rich tend to use less public services and to be

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.1 Public Expenditure Size and Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth

10.2 Theories of Public Expenditure Growth