Kim Heng Tan

Fiscal Policy in Dynamic Economies deals with some fundamental issues of fiscal policy.

Why does public debt tend to rise over time in capitalist democracies? A simple basis for this observation is to ground it on welfare considerations. An increase in public debt to finance tax cuts favors the working electorate. An increase in debt to finance an increase in government consumption benefits the electorate since they benefit directly from the provision of the public good or service. An increase in debt to finance an increase in social security benefits not only the retirees but also the workers since the latter are not taxed to finance the increase in pension benefits. Increases in public debt however harm future generations who have to be taxed to service or retire the debt. While the contemporaneous electorate favor deficit financing, future generations of the electorate being unborn or disenfranchised at the time of the debt increase have no voice to express dissent. As debt extracts resources from the future, it is no wonder that debt increases are favored in capitalist democracies where political competition is intense.

Why is there a tendency for government spending on consumption and on social security to be favored by politicians? Government spending on consumption and on social security is a vote-enhancing policy instrument. If a dominant political party faces a weak and fragmented opposition, it can most likely commit to a level of government consumption or social security as prescribed for by the optimal policy in the long run and maintain consistency in fiscal policy over time. However, if political parties vying for accession to political office face an effective opposition, then any incoming government would not commit itself to the level of government consumption or social security as prescribed for by the long-run policy. The reason is that the marginal social cost for the first generation of electorate in any new spending program is less than that for all future generations of electorate. The reason for this is slightly technical. For more on this, please read the book. Since the marginal cost is lower for the first generation, spending a larger amount by any incoming government provides a higher level of welfare to the electorate and garners votes. With every change of government, the incoming government would re-optimise to set a higher level of spending for the contemporaneous electorate and render fiscal policy time inconsistent. As a vote-enhancing policy instrument, government spending on consumption and social security tends to exceed optimal long-run levels.

Why do governments fail to invest in public capital adequately? Commencing a new program of public investment can be problematic. The reason is that no productivity gains accrue to the electorate at the time of commencement of the program as it takes time to build public capital and for the productivity gains to be realised. Compared to tax cuts, government consumption and social security, public investment confers no immediate benefits. As a non-vote-enhancing policy instrument, public investment is anathema to political parties who are dependent on the electorate for votes unless they face no effective opposition.

Should a dollar transferred from the young be treated as a dollar transferred to the old under social security? In income-transfer programs, economists who favor equity over efficiency attach a higher weight to a dollar transferred to low-income earners and a lower weight to a dollar transferred from high-income earners. On the other hand, economists who favor efficiency argue that a dollar should be treated as a dollar and that equity can be taken care of by progressive taxation. In my book, I have provided a theoretical basis for the finding that a dollar is a dollar only in the first-best world of no economic distortions, but that a dollar is not a dollar in the second-best world which is always subject to some economic distortion. I must emphasise that the notion that a dollar is not a dollar is not imposed as an assumption into the theoretical framework. Rather it emerges as a finding from a consideration of the optimal policy of social security in a second-best world. This finding has been arrived at without any value judgements and is based purely on efficiency arguments. The significance of the finding is that failure to treat a dollar as not a dollar can result in sub-optimal outcomes for social-security policy.

Can international differences in fiscal policy drive persistent trade imbalances and international indebtedness? Sociological explanations of such imbalances would trace them to cultural differences in attitudes towards thrift, arguing for instance that East Asian nations have been able to run persistent current-account surpluses because they have a culture that emphasises thrift whereas other nations do not embrace such a culture. While I do not deny that cultural differences in attitudes towards thrift may cause external imbalances, my book focuses on international differences in fiscal policy in driving such imbalances. In particular, differences in the levels of government spending, taxation and transfers as well as public borrowing across borders are the drivers of persistent imbalances in trade and international indebtedness.

It is well known from the literature on public debt that a large open economy need not necessarily improve its welfare in the long run by unilaterally cutting its public debt. If a nation cannot rely on cutting public debt unilaterally to attain long-run welfare improvement, can reliance be placed on the international coordination of austerity, at least among a group of nations, to achieve welfare improvement in the long run? This issue is of relevance to economies, such as the Eurozone countries, that have been engaged in austerity in the wake of the Eurozone debt crisis. In a fiscal union, such as the USA, a transfer to the poorer member states would have helped these states under austerity situations. For countries that are not a fiscal union, like the Eurozone, is austerity accompanied by aid from the richer nations to the peripheral nations superior to austerity unaccompanied by such aid? Our findings can be summarised as follows. If an open economy could not rely on unilateral austerity to achieve welfare improvement in the long run, it would have to rely on the international coordination of austerity. Whether austerity should be accompanied by aid or not depends on whether the richer-donor nations of aid are net external creditors or debtors. If they are net external creditors, relying on two policy instruments, namely austerity and aid, is no better than relying on the single policy instrument of austerity. However, if the richer-donor countries are net debtors, then there is a case for relying on the two policy instruments to enhance the welfare benefits of austerity in open economies in the long run. The use of two policy instruments is, of course, predicated on whether aid to the peripheral nations is politically acceptable to the richer-donor nations.

These are a sample of the issues and findings from the book that the author hopes will whet your appetite to read it.