Income tax is levied on the income of households and businesses.

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1 Fiscal Policy: Taxing and Spending Simply stated, fiscal policy consists of taxing and spending the taxes being necessary to finance the spending. This section reviews the purposes of public spending, how it is financed, and the role (and financing) of budget deficits and government borrowing. The Purposes of Public Expenditure Public expenditure, a measure of the value of goods and services bought by the state, plays five principal roles in the economy: contributing to demand for the economy s products and services; stabilizing the economy; increasing the public endowment of goods; redistributing wealth; and creating positive externalities for the economy and society, especially through capital investments. Public expenditure can be classified according to the type of goods and services purchased (capital goods, consumption goods, personnel), the official body that finances the expenditure (central government ministries; regional and local authorities), and the macroeconomic purpose the expenditure is designed to serve (justice and public order, education, health). No single level of government spending can be said to fit all circumstances. But the aggregate level of spending must be consistent with the country s macroeconomic framework. If it is not, persistently high or rising budget deficits can result in various forms of macroeconomic imbalances. For example, as we discuss later, excessive budgets can give rise to inflation and crowd out private investment. Financing Public Expenditure The government finances its expenditures through taxation, fees, revenues from state-owned enterprises, borrowing, grants (such as foreign aid), and the creation of new money. In developed countries, most government revenue is raised through taxation. In some developing countries, however, where the tax system is not well developed, nontax revenue may be the primary source of government finance. Nontax revenue comprises fees levied by government (such as customs and excise duties) as well as profits and dividends from state-owned enterprises. Taxes are commonly divided into the following categories: Income tax is levied on the income of households and businesses. Corporate income tax is levied on firms profits. Sales and excise taxes are levied on commodities. It is important to maintain a balance between direct and indirect taxes. Direct taxes are generally a better tool for improving income distribution: those who earn more pay more. By

2 contrast, indirect taxes, such as sales or value-added taxes (VAT), although they tend to generate revenues more easily and are conducive to macroeconomic stability, are considered regressive because all purchasers pay the same tax on a given transaction, regardless of their income and ability to pay. That is, they impose a disproportionate burden on the poor. This inequity is often addressed by exempting certain basic goods, such as food, from taxation. The same is true for other indirect taxes, such as international trade duties, which tend to be easy to collect but are regressive. Government revenue may also come in the form of foreign grants, as discussed in chapter 7. Grants may be either transfers of cash or provisions of goods and services from bilateral or multilateral donors. Grants have obvious benefits: they do not detract from private sector incomes in the recipient country, nor do they generally affect interest rates and inflation. But the costs can sometimes be high: grants tend to create a dependency on international aid that may impede development of the domestic market and other institutions. In addition, they often come with conditions that compromise the autonomy of a government and may be costly or distracting to fulfill. The ideal tax system generates a stable and assured source of revenue at a low cost (relative to the revenue it generates). Its simple structure makes compliance easy. It is understood by both taxpayers and administrators. It is broad-based in its application and does not distort production, consumption, or trade. It distributes the tax burden in a manner that is perceived to be fair and equitable (box 4.1). Box 4.1 Five desirable characteristics of any tax system 1. Economic efficiency. The tax system should not interfere with the efficient allocation of resources. 2. Administrative simplicity. The tax system ought to be easy and relatively inexpensive to administer. 3. Flexibility. The tax system should be able to respond easily (in some cases automatically) to changed economic circumstances. 4. Political responsibility. The tax system should be designed so that individuals know or can learn what they are paying for, so that there is no disconnect between the preferences of individuals and the actions of the state. 5. Fairness. The tax system ought to be fair in the way it treats all individuals. Source: Stiglitz, Raising revenues from a few taxes with simple rate structures helps to contain administrative and compliance costs and avoids the perception of excessive taxation. Broadening the tax base and providing limited exemptions makes it possible to raise revenues at lower rates and makes the revenue stream more predictable. For example, a value added tax or a single-stage sales tax, when levied at a low and uniform rate on a broad base, is efficient and avoids cumulative taxation of goods as they move along successive stages of production (a phenomenon know n as

3 cascading ). By contrast, preferential tax rates and other fiscal incentives for investment are usually found to be ineffective in most developing countries. Government revenue collection depends not only on the structure of the tax system, but also on its efficient administration, something that is often missing in developing economies. Perhaps for this reason, recent studies have shown that a country s government revenue, measured as a percentage of GDP, correlates positively with its per capita income (figure 4.1). Figure 4.1 Central government revenue (% of GDP) and log per capita GDP in 105 developing countries Source: Gupta, Deficits and Borrowing When a government spends more than it collects in revenue and grants, it is said to be running a budget deficit. The standard theory of fiscal deficits holds that if a government cuts taxes and runs a budget deficit, then the private sector, including households, will respond to the increase in disposable income by saving and consuming more, according to each household s marginal propensity to consume, a concept introduced in chapter 2. But since savings by households rise by only a fraction of the budget deficit, national savings (both private and public) must decline under deficit conditions. In a closed economy with no inflow of foreign savings, national savings are equal to domestic investment. In such an economy, a decline in national savings will push up real interest rates and reduce investment demand, raising private saving a cycle known as the crowding out of investment. An accumulation of budget deficits leads to a buildup of public debt. Unless the government s budget deficit is covered by private savings minus investment, it will create (in an open economy) a current-account deficit with the rest of the world, obliging the country to

4 increase its net foreign debts to cover the deficit. 1 If the government cannot finance the deficit by borrowing, pressure will build to finance it through depreciation of the currency. Depreciation of the currency will lead to greater exports and hence reduce the current-account deficit. But depreciation also leads to inflation, which cuts purchasing power usually with serious political consequences. Depreciation also increases the cost of servicing debts denominated in foreign currency. Financing Public Deficits Several options exist for financing public deficits, but not all of them will be available or appropriate in a particular context. The options include the following: Issuing or selling debt instruments or obtaining domestic bank loans. Issuing debt or borrowing from local banks means that the government is borrowing from its citizens. This may be appealing, since costs are deferred while the government preserves its autonomy visà-vis the outside world. In addition, there is no risk of inflation in the short run. But selling debt competes for private savings at home, channeling money away from investment and raising the cost of borrowing for the private sector. Borrowing from abroad. In recent years, some wealthier developing countries have gained access to international capital markets by obtaining a favorable credit rating from one of the large international rating firms. For most low-income countries, however, multilateral development banks (such as the World Bank, the Asian Development Bank, and the African Development Bank) and bilateral donors remain the only source of international finance. Regardless of its source, foreign borrowing defers the costs of government programs without crowding out domestic investment or causing inflation, but it carries risks if the loan must be repaid in foreign currency. Foreign borrowing also obliges the borrower to comply with the lender s conditions. Asset sales. The sale of government property to the private sector ( privatization ) is another way of financing public deficits. Privatization s appeal lies in the fact that the government need not make plans for repayment, since assets are being exchanged for revenue. They can be sold only once, however, so privatization cannot continue indefinitely. Printing money. Printing money has the obvious appeal of immediately increasing the supply of ready cash, but its pernicious consequences last much longer making this the last resort for most governments. Printing money has the perverse effect of lowering the amount of credit available to the private sector as investors, sensing risk, prefer to purchase safer government securities. Even if more money is available overall, it is a harbinger for inflation, which distorts prices and erodes the value of household savings. 1 This was examined in the discussion of absorption, savings, and the current-account deficit in chapter 2.

5 The Uses of Fiscal Policy The government may attempt to use fiscal policy to smooth business cycles and redistribute income. While these are good goals, overreaching can crowd out private investment and trigger inflation. This section discusses these important issues. Fiscal Policy and the Business Cycle Governments often have tried to smooth the business cycle through expansionary or contractionary fiscal policy. Under expansionary policy, the government spends money (or forgoes tax revenue) to stimulate aggregate demand in the economy, thereby boosting economic activity. The initial response of aggregate demand is typically greater than the government expenditure (or loss of tax revenue) employed to induce it because of the so-called multiplier effect. When the government raises spending or lowers taxes to increase aggregate demand, business responds to the increased demand by increasing investment. As businesses invest more, they hire more workers, increasing employment. There are now more workers with a paycheck, and their spending creates a further increase in demand for goods and services. Businesses respond to that increase by investing more. As they do so, they hire more workers and increase employment the multiplier effect. With contractionary fiscal policy, the opposite happens. The fiscal policy the country chooses will depend on its economic situation and the time frame envisaged by policy makers. Short-run fiscal policy may aim at smoothing the business cycle or reducing poverty, but over the long run the aim should be to keep the deficit at a low and stable level to help underpin economic growth. As we will see, high and sustained deficits can discourage investment, ignite inflation, and cause balance-of-payments problems. Investment, Inflation, and the Effects of Deficits We have seen that unchecked government spending and expansionary fiscal policies harm the economy by causing inflation and crowding out private investment. Under expansionary fiscal conditions, inflation is likely to rise as aggregate demand (spending) outstrips the aggregate supply of goods and services. Under such conditions, businesses have difficulty keeping up with orders and respond to the excess demand by raising prices. Under tight labor-market conditions, employers may also be forced to raise wages to attract new workers and retain existing ones. Consider the same problem from the financing side. High and sustained fiscal deficits, if financed by printing money, set the stage for higher inflation. If the government finances its deficits by borrowing in the bond market or from private banks, rather than from the central bank, interest rates will increase or the terms on private bank loans will become more stringent. Either way, private investment is likely to be crowded out as investors and lenders prefer the sovereign borrower because it poses lower risk.

6 By contrast, low and stable fiscal deficits send a positive message about the government s ability to service its debt. Such a stance may thus prevent the probability of economic crises. Macroeconomic stability associated with a low probability of economic crises yields further benefits, as well in higher rates of investment, growth, and educational attainment; in greater distributional equity; and in reduced poverty. Fiscal Policy and the Poor In a developing economy, taxation is generally less effective than spending in promoting growth and improving the lot of the poor. The rich generally have ways of avoiding high taxes on their income. Even exempting some staple items from consumption taxes (sales tax or VAT) may not benefit the poor, because the rich can afford to spend a larger absolute amount on the exempted good, so they derive the largest benefit. In such cases, repealing the exemption could yield revenue that could be spent in a more pro-poor way. On the other hand, there is evidence that increased spending on physical and human capital formation can promote economic growth and reduce poverty. Even during times of fiscal consolidation, protecting investment in physical and human capital tends to be a better than the alternatives (increasing public sector wages, for example) for protecting long-term economic health. Increased government spending on health and education contributes to the well-being of a population and increases worker productivity. Reducing communicable disease also increases worker productivity and helps to promote tourism and attract foreign direct investment. Governments regulate and prioritize public expenditure through the national budget. By ensuring participation of the poor in allocating resources, tracking expenditures, and monitoring service delivery the budget can be made more demand-driven and pro-poor. Participatory budgeting has been used in many Brazilian municipalities since the mid-1980s. It involves, first, checking that the previous year s budget was executed in line with stated policies, and, second, bringing together people from different geographical areas and interest groups to set spending priorities for the next budget. Participatory budgeting has allowed public expenditure to more closely reflect citizens preferences. In Brazil, for example, participatory budgeting is predominant at the local government level. It has resulted in a large shift toward investment in water and sanitation, the top priorities expressed by its citizens (Goldfrank, 2007). Conclusion In this chapter the first describing facets of public policy we describe the many roles that the government can play in an economy, through fiscal policy and other means. The chapter first analyzed the primary functions of government in providing the legal framework and services needed for the effective operation of a market economy. These include providing public goods, regulating economic activity, stabilizing the economy, and redistributing income the most

7 fundamental roles of government. We then looked at fiscal policies, including expenditure and taxation policies, before turning to the impact of fiscal policy on the business cycle and other economic phenomena, including inflation and the crowding out of private sector investment. We concluded by examining the ways in which fiscal policy can benefit the poor primarily through government expenditure. References and Reading List Flug, K., A. Spilimbergo, and E. Wachtenheim Investment in Education: Do Economic Volatility and Credit Constraints Matter? Journal of Development Economics 55 (2): Goldfrank, Benjamin Lessons from Latin America s Experience with Participatory Budgeting. In Anwar Shah, ed, Participatory Budgeting. Public Sector Governance and Accountability Series. World Bank, Washington, DC. Gupta, Abhijit Determinants of Tax Revenue Effort in Developing Countries. IMF Working Paper WP/07/184. July 2007 Rebelo, S., and W. Easterly Marginal Income Tax Rates and Economic Growth in Developing Countries. Policy Research Working Paper Series 1050, World Bank, Washington, DC. Ray, D Development Economics. Princeton, NJ: Princeton University Press. Stigler, George J The Case, If Any, for Economic Literacy. Journal of Economic Education 1 (2): Stiglitz, Joseph E Price Rigidities and Market Structure. American Economic Review 74: