ARTS AND S
LR FISCAL POLICY AND BUDGET DEBT

LR FISCAL POLICY AND BUDGET DEBT - Chapter 6 Long-run...

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Chapter 6 Long-run aspects of fi scal policy and public debt We consider an economy with a government that provides public goods and services and fi nances its spending by taxation and borrowing. The term fi scal policy refers to policy that involves decisions about the government’s spending and the fi nancing of this spending, be it by taxes or debt issue. The government’s choice concerning the level and composition of its spending and how to fi nance it, may aim at: 1 a ff ecting resource allocation (deliver public goods that would other- wise not be supplied in a su cient amount, correct externalities and other markets failures, prevent monopoly ine ciencies, provide social insurance); 2 a ff ecting income distribution, be it (a) within generations and/or (b) between generations; 3 contribute to macroeconomic stabilization (dampening of business cycle fl uctuations through aggregate demand policies). The design of fi scal policy with regard to the aims 1 and 2 at a disaggre- gate level is a major theme within public economics. Macroeconomics deals with aim 3 and the big-picture aspects of 1 and 2, like policy to enhance economic growth. In this chapter we address the issue of fi scal sustainability and long-run implications of debt fi nance. The is relates to one of the conditions that constrain public fi nancing instruments. To see the issue of fi scal sustainability in a broader context, Section 6.1 provides an overview of conditions and factors that constrain public fi nancing instruments. Section 6.2 introduces 201
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202 CHAPTER 6. LONG-RUN ASPECTS OF FISCAL POLICY AND PUBLIC DEBT the basics of government budgeting and Section 6.3 de fi nes the concepts of government solvency and fi scal sustainability. In Section 6.4 the analytics of debt dynamics is presented. As an example the Stability and Growth Pact of the EMU (the Economic and Monetary Union of the European Union) is discussed. Section 6.5 looks more closely at the link between government solvency and the government’s No-Ponzi-Game condition and intertemporal budget constraint. This is applied in Section 6.6 to a study of the Ricardian equivalence proposition; applying the Diamond OLG framework we address the question: Is Ricardian equivalence likely to be a good approximation to reality? If not, why? 6.1 An overview of government fi nancing is- sues Before entering the more specialized sections, it is useful to have a general idea about circumstances that constrain public fi nancing instruments. These circumstances include: (i) fi nancing by debt issue is constrained by the need to remain solvent and avoid catastrophic debt dynamics; (ii) fi nancing by taxes is limited by problems arising from: (a) distortionary supply-side e ff ects of many kinds of taxes; (b) tax evasion (cf. the rise of the shadow economy, tax havens used by multinationals, etc.).
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