2  Fiscal Sustainability

There are several ways to define the sustainability of a government fiscal programme. One consideration is political sustainability. The focus of this paper is financial sustainability. However, political sustainability is likely to create uncertainty and induce Ricardian effects in the same was as does financial sustainability, and hence in this regard have similar economic implications. A common approach is to define financial sustainability in terms of the feasibility of funding a given expenditure programme under the prevailing taxation structure or taxation-to-GDP ratio.[2] This definition encompasses elements of short-term financial risk (that is, whether a government’s financial position is robust to revenue volatility) and long-term financial sustainability.

To focus subsequent discussion, it is helpful to write down the basic fiscal sustainability condition that emerges from the government intertemporal budget constraint (IBC). In a growing economy, where output grows at the rate (where ), the government flow budget constraint can be expressed as

          (1)

where is the level of nominal government debt at the end of year n - i, G is the sum of government primary expenditure, T is government revenue from taxation and r is the interest rate on outstanding government debt.

Unless there is a limit on the government debt-to-GDP ratio, this expression does not impose any restrictions, from a sustainability perspective, on fiscal policy or the level of debt. Furthermore, consideration of a framework for an optimal level of debt has concluded that there is no single level of debt that can be considered optimal no matter what the particular circumstances are. However, there are other frameworks which government could use to set the appropriate level of debt. One approach is to consider that current consumption should be financed from current taxation, but allow capital expenditure to be financed out of debt. Another approach is to consider debt as the residual of all other budgetary policy decisions. This suggests that an optimal debt policy can be derived by deciding on the desired size of government and on the best financing of this expenditure, be it tax or debt policy or a mix of both, considering the trade-offs that apply (CS First Boston, 1995). Other considerations include the role of debt as an automatic stabiliser and inter-generational equity. Whatever the reasons for raising debt, it is common practice for governments to recognise the need to operate fiscal policy within the bounds of a target level of public debt. The reasons for this are discussed in the next section.

Conceptually, the Government Budget constraint and fiscal gap can be considered over an infinite horizon. However, in practice Governments tend to set themselves goals over a limited horizon. This reflects the fact that fiscal programmes change when governments change and that there is uncertainty about the future. Furthermore, adjusting policy settings today, to account for possible future structural change, is not necessarily optimal. In particular the judgement to make adjustments should take account of the “option-value of waiting” for better information. This approach could take explicit account of the uncertainty of future economic conditions and the potential relative costs of fiscal adjustments made later rather than earlier, in a manner similar to the approach developed, for example, for fixed investment decisions (Dixit and Pindyck, 1994). Furthermore, adjusting policy settings by trying to maintain a constant tax rate over the longer term, when there is structural change, can result in higher government expenditure than would otherwise be the case, and hence suboptimal results (Pinfield, 1998).

Given the discussion above, suppose that there is a binding debt target in some future year N. Using expression (1) and assuming the economy starts in year n = 0 and inherits a stock of public debt of , by substituting forward to year and by imposing a binding debt constraint for year , the government intertemporal budget constraint can be written as

          (2)

where (and ).

Expression (2) is an expression of the constraint that must be satisfied if a government is to satisfy its fiscal sustainability objective. It implies that, if there is a binding debt target in year N, the government intertemporal budget constraint (IBC) requires that the present discounted value of future primary balances must be equal to the difference between initial debt and the present discounted value of terminal debt. It shows the present discounted value of the increase in primary balances necessary to guarantee the IBC is fulfilled.

Expression (2) can be rearranged to define the fiscal gap, FG, in the current year. This represents the gap between two components: (i) the difference between the current debt ratio and the present discounted value of the future binding debt constraint, and (ii) the present discounted value of future primary balances. This gap can be eliminated by some combination of changes to the present discounted value of future taxation and expenditure.

          (3)

Expressions (2) and (3) help put into context the issues relevant to the discussion in the remainder of this section and in sections 3 and 4. In terms of our earlier definition, “the feasibility of funding a given expenditure programme under the prevailing taxation structure or taxation-to-GDP ratio”, by representing the given expenditure programme by the present discounted value of future expenditure component of expression (3), the fiscal gap would represent the taxation revenue gap that would be required to be closed in order to simultaneously sustain this expenditure programme and satisfy the IBC condition.

What is clear from expression (2) is that the lower is the debt target ratio for a given initial debt ratio, the higher is the level of present discounted value of future primary surpluses required to realise that target and satisfy the IBC. Considerations influencing the choice of an appropriate target debt ratio, discussed next, are therefore crucial.

Also crucial is the process for deciding on the efficient level of government expenditure and its path over time. What is more, it is clear from expression (2) that if fiscal policy can have significant leverage over GDP growth by, for example, manipulating the composition of and , then this represents another option for satisfying the IBC while simultaneously contributing to growth (higher growth will raise ). This argument, of course, assumes that government spending does not rise with income growth at a rate that offsets this effect. We discuss in section 3 how the structures of expenditure and taxation impact on growth, and we consider in section 4 how macroeconomic stability contributes to growth and whether fiscal policy has a role to play in enhancing macroeconomic stability.