The self-financing of fiscal deficits
In this paper, Angeletos et al. explore the conditions under which a government can avoid a fiscal adjustment aimed at restoring public debt to its initial level. They argue that self-financing of deficits is possible when an economy exhibits two key features: a) a failure of Ricardian equivalence so that deficits can stimulate aggregate demand; and b) a nominal rigidity, so that aggregate demand can drive real economic activity and thereby also inflation. These two features allow for deficit self-financing by expanding the tax base, which helps generate additional tax revenue without any adjustment in tax rates, and by triggering inflation, which helps reduce the real value of the government’s nominal liabilities. They use a New Keynesian model with overlapping generations of perpetual-youth consumers. The model is calibrated in such a way that consumers (i) discount future disposable income more heavily than in the permanent-income representative-agent benchmark, and (ii) have a larger short-run propensity to consume. Fiscal policy is represented by a rule for how tax revenue (and thereby the primary surplus) responds to changes in aggregate income and public debt while monetary policy is represented by a rule for how nominal rates adjust based on the state of the economy.
Our results have important conceptual as well as practical implications. Conceptually, they suggest that one specific idea from the classical Fiscal Theory of the Price Level—that future tax hikes are not necessary to finance today’s deficits—is more robust than commonly believed. Our accommodation of this idea does not rely on the threat of a government violating its budget constraint, nor is it vulnerable to debates regarding equilibrium selection. Rather, it is grounded in realistic departures from permanent-income consumer behavior, together with sufficient delay in fiscal adjustment. Practically, our results suggest that a meaningful degree of self-financing is empirically plausible, especially in the absence of aggressive monetary policy responses.
Can Deficits Finance Themselves?
Authors: George-Marios Angeletos, Chen Lian, Christian K. Wolf
From: Northwestern, UC Berkeley, MIT
What’s wrong with the standard analysis of the primary surplus-GDP ratio?
Times series from the U.S. since World War II, show that the primary surplus-GDP ratio and the government debt-GDP ratio are nonstationary, a fact that invalidates standard analytical approaches that assume them to be stationary. This is the argument Campbell et al. put forth in this paper. The authors find that although the tax revenue-debt ratio and the government expenditure-debt ratio are also nonstationary, their difference, the primary surplus-debt ratio, is stationary, as is the tax revenue-GDP ratio. They then use these two facts to develop a new framework to analyze the dynamics of debt, tax revenue, and government expenditure in the US and UK since World War II. They find:
Empirically, we find that a deterioration in the fiscal position forecasts a decline in government spending over the long run. It does not forecast increases in tax revenue; nor does it forecast low returns for bondholders. Fiscal adjustment to tax and expenditure shocks occurs primarily through mean-reversion in tax and expenditure growth, with a negligible contribution from expected and unexpected debt returns.
Debt and Deficits: Fiscal Analysis with Stationary Ratios
Authors: John Y. Campbell, Can Gao, Ian W. R. Martin
From: Harvard University, University of St. Gallen, London School of Economics
