Budgets . . . and irresponsible fiscal behaviour

Published : 25 May 2017, 03:23 AM
Updated : 25 May 2017, 03:23 AM

To most people, a budget is something that the Minister of Finance ceremonially presents to the national parliament once every year in summer. It appears to be a complex document full of arcane economic jargon far beyond the comprehension of the ordinary public. Discussions in the news media and TV talk shows do not really help to clear the confusion. However, the essential aspects of a budget are actually quite simple. Every household and every organisation has to draw up an explicit or implicit budget that defines the framework of its activities. Whenever I am required to do an introductory lecture on the government budget, I find it pedagogically helpful to begin with highlighting the similarities between a household budget, with which everyone is familiar to some degree, and the government budget.

Despite the massive difference in scale and the consequent complexities, the essentials of both budgets are similar. Both the household and the government plan their expenditures on the basis of expected or forecast income or revenue. Should the desired expenditures exceed the expected income or revenue, the household or the government will have to resort to one or more of the following three options: (a) borrow money, (b) sell assets or (c) increase income or revenue. If none of these is feasible, expenditures must be reduced.

Some economists are of the opinion that a household budget is fundamentally different from the national budget because the government has the ability to determine the level of its revenue (income), and hence its expenditure is not restricted by its current revenue. This is so because the government has the statutory authority, something that the household lacks, to raise revenue by taxing its subjects or by printing money.

The ability of the government to arbitrarily raise the amount of its revenue is greatly overstated in such discussions. In any modern state, the government has little manoeuvrability to raise the trajectory of revenue in a short time. Any significant change in the tax regime requires years of campaigning in the public domain to garner support for the change and then months, if not years, of debate in the legislature to pass the tax bill.

A study of the history of tax efforts of mature economies will reveal the difficulty with any significant increase in the tax rates (reductions are of course easier). For example, during the period 2000 to 2013, the average tax rate in OECD countries actually declined from 34.3 percent to 33.7 percent and that in Australia from 30.4 percent to 27.3 percent (OECD Revenue Statistics 2014).

Even in developing countries that have typically much lower tax rates than those of the more advanced economies, it is very difficult to increase tax rates quickly. Despite great efforts, Bangladesh, which has one of the lowest tax rates in the world, has not succeeded in increasing the average tax rate by more than 2 percent of GDP since the beginning of the millennium. And since 2011-12, the government revenue-GDP ratio has actually declined by about a percentage point despite all the bravado on the part of the Minister of Finance. He almost came to blows, metaphorically speaking, with the otherwise docile business community when he expressed his determination to implement VAT laws unaltered.

It is even more difficult to mobilise resources through printing money. A central bank can create money by virtue of the fact that it is the statutory authority to print money and commercial banks are required by law to hold reserves with the central bank (in the case of fractional reserve banking). The central bank can manipulate these levers to increase the money supply.

There is a normal growth of money to sustain the trend growth of the economy. Any increase in money in excess of this rate will cause an inflationary spiral. Excessive growth of money leads to hyperinflation. Those countries that tried to acquire resources through printing money (Latin American countries in the later decades of the last century) not only did not succeed in acquiring additional real resources, but invariably encountered double or triple digit inflation. Zimbabwe is the most recent example of the terrible damage that excessive money printing can do to the economy and ironically to money itself.

Curiously, it is individual households that have the ability to increase their incomes indefinitely. When a miner strikes gold or an unemployed person finds a good job, his income may increase several fold. Many households have the option of increasing their incomes substantially by working overtime or being on an additional job. No government can increase revenue the way households can increase their income. However, if we consider the average household income of the entire population, then the increase in income of the household sector is not likely to be too different from that of government revenue.

When reduced to its bare essentials the budget, whether of the government or of the household, looks the same, as shown in the table below:

The total amount of resources available to the government (the household) is derived from taxes and other revenue earnings of the government (income earned by the household), money from the sale of any assets that it owns or borrowing from domestic and external creditors. Resources obtained in this manner are distributed among current spending (consumer spending), purchase of assets and payments of principal and interest on outstanding debts.

We do not carry out extensive chemical tests to find out whether the pudding is sweet. All we do is taste it; if it tastes sweet, it is sweet; if not, it is not. Similarly, if the government could raise revenue substantially by increasing tax rates or introducing new taxes or by printing money we would have observed many governments resorting to these methods to meet their ever increasing expenditure aspirations. There are few examples of governments succeeding in increasing their revenue in a short time through these means. Those who tried met with very adverse outcomes, such as popular revolt, a teetering economy or runaway inflation.

A budget, whether of a government or of a household, is in deficit whenever actual revenue (income) falls short of actual expenditure. The deficit may be financed by borrowing, i.e., by accumulating debt. Budget deficits are neither uncommon nor necessarily harmful. It must be understood that the household or the government must have the capacity to service debt liabilities. If the deficit is large, it becomes increasingly difficult to service debt liabilities, and creditors become wary of extending fresh credits. Not only do credits dry up, but the cost of credit may also go up. At this point discipline is imposed on the budget externally, since internal mechanisms did not work. In the case of the household, the discipline may take the form of foreclosing on the mortgage or confiscation of the collateral, which leaves the household much worse off.

When a debt-default situation arises some governments may be tempted to ride out the difficulty by printing money. This invariably results in high inflation or hyperinflation, and in the end such efforts of the government do not muster additional real resources. But the economy suffers terribly when inflation, especially hyperinflation, takes hold.

In recent years, the world has witnessed the sad consequences of unbridled government spending financed by both borrowing and printing money. Greece had borrowed for a long time to finance extravagant government budget deficits. Eventually the debt grew to such a level that the Greek government did not have the resources to finance debt liabilities and its creditors were unwilling to lend it more, especially after it admitted that the original deficits had been cooked. Faced with the stark reality of sovereign default (the first by any developed country), Greece had to accept an externally imposed economic bailout program to avoid default. The most recent example of a government trying to garner additional resources through printing money is Zimbabwe. The consequence has been a hyperinflation that the world has not experienced since the German hyperinflation of 1921-23. Not only that, the government was unable to raise real revenue through printing the Zimbabwean dollar; it turned the currency worthless such that it had to be abandoned. The economy suffered terribly, GDP falling by 40 percent.

Each country has a sustainable rate of budget deficit depending on its economic growth rate. Only when the actual deficit exceeds the sustainable rate does the economy blunder into a crisis. Since there is a long gestation period between irresponsible fiscal behaviour and consequent economic crisis, the government that creates the crisis may not bear the brunt of it. The last few governments which tried desperately to rescue Greece from the debt crisis are not the ones that created it. No responsible government should engage in such irresponsible fiscal behaviour as would leave future governments vulnerable and the prosperity of future generations severely compromised.