Fiscal policy is at the center of current policy discussions. Governments face a
ID: 1129463 • Letter: F
Question
Fiscal policy is at the center of current policy discussions. Governments face a difficult choice. Reduce deficits rapidly and reassure markets that they will pay their debt at the risk of lower growth, or reduce deficits more slowly to avoid further slowing down the recovery at the risk of destabilising the market risk perception of debt sustainability. In this context, (i) What is “fiscal gap”?
(ii) What is the correct measure of budget deficit?
(iii) How is rate of change in government debt related to primary deficit?
(iv) Consider the following scenario: Starting from a situation where, until year 1, the government has balanced budget, so that initial debt is equal to zero. Suppose that during year 1, the government decreases taxes by 1 unit (think of 1 billion euros, for example). Letting the real interest rate to be equal to , calculate the size of the primary surplus the government must run in order to repay the debt fully in year 2.
Explanation / Answer
i) What is fiscal gap ?
The fiscal gap is an estimate of how much the government’s spending and debt obligations exceeds its revenues over a specified period of time. The fiscal gap is calculated by various government agencies for example the Congressional Budget Office, Government accountability office etc. This fiscal gap play as a means of quantifying long-term fiscal and debt sustainability of a country.
ii) What is the correct measure of budget deficit?
A budget deficit is an indicator of financial position or health in which expenditures exceed revenue. The term budget deficit is most commonly used to refer to government spending. When referring to accrued federal government deficits, the deficits are referred to as the national debt.There are generally different types budget deficit measurement and these are revenue deficit, fiscal defit and primary deficit. Revenue deficit is excess of total revenue expenditure of the government over its total revenue receipts. It is related to only revenue expenditure and revenue receipts of the government. So we can say Revenue deficit = Total revenue expenditure - Total revenue receipt. Fiscal deficit is defined as excess of total budget expenditure over total budget receipts excluding borrowings during a fiscal year. In other words, it is an amount of borrowing the government has to take to meet its expenses. Generally we take fiscal deficit as a measurement of budgetary deficit because it denotes the level of borrowing it has to take to meet its deficit. Fiscal deficit = Total expenditure – Total receipts excluding borrowings = Borrowing of govt. Last we would say about measurement of primary deficit and Primary deficit is defined as fiscal deficit of current year minus interest payments on previous borrowings. So Primary deficit = Fiscal deficit - interest payment.
iii) How is rate of change of government debt related to primary deficit ?
Primary deficit is the difference between fiscal deficit and interest payment for previous borrowing. Now if government debt increases then the primarimary deficit falls. It means it is negatively related with government debt and when government debt falls primary deficit increases. It means it is a indicator of primary shortage of revenue or receipt over expenditure. To know the amount of borrowing on account of current expenditure over revenue, we need to calculate primary deficit. So rate of change in government debt affecting the primary defict. When debt icreasing more and more more interest will be paid and as interest paid increases primary deficit falls and vice - versa.
iv) When there will be decrease in tax rate there will be immediate fall in revenue receipt and it imply rise in revenue deficit and as well as rise in fiscal deficit because there will be fall in total receipt of the government given that expenditure level is at least at previous level. Now when we will face fall in total receipt we have to fill the defecit by taking loans and borrowing. When there will rise in borrowing the primary deficit will fall by that amount. It means the fall in receipt is 1 billion euros and there will be borrowing of 1 billion eros and the fall in primary deficit will be equal to 1 billion euro. So the primary surplus will be equal to 1 billion euro.
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