Long-Term Objectives for Government Debt

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Long-Term Objectives for Government Debt

• Alan J. Auerbach
• University of California, Berkeley
• January 29, 2008

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Outline

1. What are the underlying objectives that motivate
   concern about the public debt?
2. Why simple deficit targets and budget rules are
   inadequate
3. Setting long-run targets for fiscal policy

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I. Underlying Objectives

• Intergenerational equity
• Debt that is too large shifts too much of a
  burden onto future generations
• But not clear what too much is when future
  generations will be better off
• Not a question for economists alone to answer

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I. Underlying Objectives

• Economic performance
• Debt accumulation may crowd out domestic
  capital formation or trade surpluses
• The need to service the debt may force
  substantial increases in future marginal tax
  rates, leading to increased distortions of
  economic decisions

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I. Underlying Objectives

• Fiscal sustainability
• If we rule out a bubble in which the government
  can forever service debt simply by issuing more
  debt, higher debt requires higher future taxes
  and/or lower future spending
• But existing policy trajectory may be quite
  inconsistent with this requirement
• If policy is not sustainable, sudden involuntary
  adjustments may follow, causing greater economic
  disruption than planned policy changes

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Weighing the Objectives

• Objectives point to similar, but not identical
  policy paths
• For example, should tax rates be rising (equity)
  or constant (efficiency)?
• Relative importance depends on empirical aspects
  of economic behavior
• If bequest motives are strong, then
  intergenerational equity may be less important
• If responses to tax rates are small, then keeping
  tax rates smooth and low may be less important

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Key Point

• It makes no sense to establish a target deficit
  path without first specifying underlying
  objectives

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Targets or Restrictions?

• Is it enough to determine targets, or are rules
  needed to enforce them?
• Answer depends on the alignment of short-term
  government incentives with long-term objectives
• If alignment strong, targets provide more
  flexibility for short-term action
• If alignment weak, then simple and less flexible
  rules may work better

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II. Inadequacy of Simple Targets

• Several factors weaken and make more ambiguous
  the relationship between debt path and underlying
  objectives

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Government Assets

• Simple answer subtract from government debt
• But a lack of symmetry because assets may not
  provide a revenue stream, so dont offset need
  for tax increases
• Also, what is an asset? Many expenditures (e.g.,
  health, education, etc.) provide future benefits

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Implicit Liabilities

• Isnt the obligation to pay future health and
  retirement benefits similar to a debt obligation?
• Intergenerational redistribution (?)
• Need for future tax increases (?)
• Strength of obligation (?)
• May not present the same problem of
  sustainability if commitment weak, but otherwise
  like debt

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Deferred Tax Assets

• Tax systems that are otherwise equivalent differ
  in their timing of tax collections, and this can
  give rise to deferred tax assets
• Example to encourage saving, can exempt earnings
  on saving or defer initial tax on amount saved
  and tax ultimate withdrawal
• the two approaches have same economic effects but
  differences in timing of tax payments
• deferral approach appears to collect fewer taxes,
  but not if we take account of deferred tax assets

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A Difficulty

• Both implicit liabilities and deferred tax assets
  (or liabilities) must be measured relative to
  some benchmark tax and transfer system

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Variations Along Desired Path

• Targets may vary from year to year because of
  variations in the social value of deficits
• short-term stabilization policy
• other reasons why surges in deficits may be
  valuable
• Wars are an obvious illustration, but also higher
  share of the population in need
• Could justify higher spending on transfers as
  population ages, but only for temporary surges

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Deficits versus Spending

• Given deficit targets, should there also be
  spending targets?
• Logic
• Spending exhaustive, tax cuts arent
• Controlling spending limits government power
• Big logical problem what distinguishes direct
  expenditures from tax expenditures?
• So, spending targets can make sense only to the
  extent that spending is well-defined

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Deficits and Generational Distribution

• Regardless of the adjustments that one makes,
  policies with the same deficit paths can be
  associated with differences in how burden is
  shared among generations
• For example, accounting for implicit liabilities
  may provide a more accurate measure of burden on
  future generations, but wont tell us to whom
  these liabilities are owed or how policy changes
  influence this

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III. Setting Long-Run Targets

• Start with simple assumptions and see how
  complications change prescription

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A Path for Deficits and Spending

• Suppose
• revenue and spending well-defined
• composition of revenue and spending fixed, so
  that only annual levels of each to be determined
• Then each path for deficits and spending will
  correspond to a unique outcome, and we can choose
  from among fiscally stable policies the one that
  best balances equity and efficiency objectives

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A Path for Deficits and Spending

• This path would exhibit variation over time to
  reflect time variations in the value of resources
• for example, we might see large deficits
  accumulate to provide benefits for large elderly
  cohorts, with surpluses both before and after to
  help spread the burden and tax distortions
• this is one interpretation of current spending
  forecasts, but current tax policy would need to
  respond to generate large short-run surpluses

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Notes

• Uncertainty about the need for future spending
  generally points to higher surpluses now
• High current surpluses, even if consistent with
  policy objectives, present additional problems
• political can the surplus be sustained?
• economic how should the surplus be invested?
• Usefulness of spending targets may be limited to
  certain categories

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Adjusting Deficit Targets

• But composition of spending and revenues changes,
  so given path of spending and deficits can
  correspond to many patterns of burdens and
  distortions
• Makes adjustments for government assets, implicit
  liabilities, and deferred tax assets useful
• adjust taxes and spending to neutralize
  differences in the timing of burdens and tax
  distortions
• this gives debt a more consistent meaning as the
  composition of revenues and spending changes
• also, may make deficit targets look more normal
  when there are demographic fluctuations

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Adjusting Deficit Targets

• With adjustments comes subjectivity
• when is a deferred liability more a commitment
  than a plan?
• what is current policy for the future if that
  policy is not explicit?
• Simple procedures for how to draw lines may be
  difficult to define ex ante

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Further Measures

• Even adjusted deficits, as explained before, do
  not provide all available information about
  distortions and distribution of burdens
• Thus, augment using generational accounts,
  which allocate fiscal burdens across cohorts
• more information and calculation required, so may
  not be feasible for very frequent calculations
• but little argument against using in conjunction
  with other measures

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Further Measures

• In principle, only way to determine optimal
  policy path is within the context of a general
  equilibrium model of the economy, which traces
  through all interactions of policy and behavior
  of households and firms
• This will not be feasible without considerable
  simplifying assumptions, but even with such
  simplifications can provide a useful check that
  chosen targets make sense given underlying
  objectives

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Conclusions

• Deficit targets are not an ultimate objective,
  but need to be derived from a weighing of
  underlying economic and social objectives
• Rules may need to complement or supplant targets
  if short-run government incentives diverge from
  longer-run goals
• Targets based on simple measures of debt are
  inadequate to deal with changing composition of
  spending and revenues

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Conclusions

• Adjusted debt measures make more sense but
  adjustments involve subjectivity that must be
  confronted
• More detailed measures, notably generational
  accounts, provide additional information useful
  to evaluate policy
• A full general-equilibrium evaluation to
  determine optimal policy path is not feasible
  without many simplifying assumptions, but is
  still useful