One of the important aspects of coordination between fiscal and monetary policies, which was the topic of this year NBU conference, is public debt. During the Great Depression the majority of developed countries have drastically increased their debt-to-GDP ratios. This has implications for both fiscal and monetary policies. Higher debt-related payments imply less money for other government expenses and/or a need to increase taxes.
Thus, governments have incentives to “inflate out” their debts. At the same time, raising interest rates (which is inevitable under “normalization” of monetary policy and in order to control inflation) implies higher cost of servicing government debt and thus may limit governments’ room for fiscal expansion in response to the next crisis.
These issues were discussed by Alan Auerbach (University of California, Berkeley), Stefano Gnocchi (Bank of Canada) and Jonathan Ostry (the IMF).
Dr. Auerbach in his keynote lecture specifies three main problems faced by many countries of the world, including Ukraine:
- Population aging (and thus increased public expenditures for the old-age support in the future)
- Rising inequality (and thus the need for more active redistribution policies)
- Increasing international capital mobility (and thus lower ability of governments to tax corporate profits, on the contrary – competition between countries in “business-friendliness”)
Increased old-age dependency ratios in the future coupled with large debt stocks today suggest that countries have to act now to bring future debt-to-GDP ratios under some reasonable limits. In other words, countries need to aim at closing their fiscal gaps[1] in order to at least keep their debt-to-GDP ratios at the current level. Assuming government interest rates of 3% and real growth rates of 2%, Dr. Auerbach and Dr. Gorodnichenko calculated fiscal gaps through 2050 for a number of countries (e.g. fiscal gap for Ukraine reaches 5% of GDP, while for US it is over 9% of GDP, and for Germany about 1% of GDP). Future pension payments make the largest contributions to fiscal gaps in all of the considered countries.
Assuming government interest rates of 3% and real growth rates of 2%, Dr. Auerbach and Dr. Gorodnichenko calculated fiscal gaps through 2050 for a number of countries (e.g. fiscal gap for Ukraine reaches 5% of GDP, while for US it is over 9% of GDP, and for Germany about 1% of GDP). Future pension payments make the largest contributions to fiscal gaps in all of the considered countries.
Another problem that has amplified in the recent time, especially in the US, is income inequality. Redistribution programs slightly mitigate this problem (thus, inequality in after-tax income is lower than that of pre-tax income), but, as demonstrated by Dr. Auerbach and his colleagues, lower-income people also have lower life expectancy – so inequality has dimensions other than income. An obvious response to this problem would be progressive taxation. However, an obstacle to this are constantly falling corporate tax rates in developed countries. Despite OECD BEPS project[2], countries have incentives to allow lower effective corporate tax rates in order to attract investment. Taxes on wealthy also very often miss their goals because of capital mobility. An option would be to rely on consumption-based taxation since, unlike capital, consumption is hard to relocate. Thus, countries increasingly rely on the VAT. However, VAT is not progressive. To address this, Dr. Auerbach proposes (and his proposal has been partially adopted in the US) a destination-based cash flow tax (DBCFT).[3]
The challenges faced by fiscal authorities increase their incentives to try to use monetary instruments to solve them. But monetary policy instruments are ill-suited for addressing ageing and inequality, which strengthens the case for central bank independence.
Dr. Stefano Gnocchi elaborates on the issue by considering impact of inflation targeting on public debt. He shows that inflation has a budgetary cost if public debt is positive and if monetary policy authority response to inflationary fiscal policies is strong enough. This means that whenever a government inflates, the monetary authority raises policy rate enough to offset the inflationary reduction of the value of public debt or even exceed it – so that if the government inflates, its budgetary constraint tightens. Thus, aggressive defense of inflation target reduces the steady-state level of debt and increases steady-state welfare. In a short run weaker central bank independence may induce a boom at the expense of higher debt. But this will result in a higher steady-state debt and lower growth.
Whenever a government inflates, the monetary authority raises policy rate enough to offset the inflationary reduction of the value of public debt or even exceed it – so that if the government inflates, its budgetary constraint tightens.
On the other hand, Dr. Jonathan Ostry (International Monetary Fund) challenges the need for a government to reduce its outstanding debt. He shows than in the “no risk of default” environment the government should aim at increasing the denominator of the debt-to-GDP ratio (e.g. financing infrastructure to increase future GDP) rather than at lowering the numerator (i.e. repayment of outstanding debt) because the latter means higher taxation and thus lower growth.
Dr. Ostry calculates that the cost of inherited debt is 2p.p. permanently lower GDP. However, repayment of debt is also costly since it reduces consumption. So if there is no default risk and no slack in the economy, there are no incentives to raise taxes or to cut investment in order to reduce debt.
But what if there is a non-zero default risk which depends on debt-to-GDP ratio but also on the trust of other countries into a government’s ability to service debt? The model shows that the benefits from reduction in the probability of default which stems from lower debt-to-GDP ratio are considerably smaller than the cost of additional taxation used to repay the debt.
The model shows that the benefits from reduction in the probability of default which stems from lower debt-to-GDP ratio are considerably smaller than the cost of additional taxation used to repay the debt.
Dr. Ostry concludes that when fiscal space is ample, a country should simply live with the debt, paying it down gradually when there are non-distortionary (non-tax or unexpected) revenues. Otherwise debt should be used to smooth consumption and to finance lumpy government expenditures. However, if lack of fiscal space is a concern, then a government should consider debt management policies described in Benford, Ostry and Shiller (2018), such as issuing GDP-linked bonds or extending debt maturity.
The Great Recession has stripped the governments of many of their counter-cyclical policy instruments. Already large debt-to-GDP ratios make increased government spending at the expense of additional borrowing costlier. Shrinking share of economically active population further increases fears that debts may become too burdensome for the developed world. On the other hand, since the majority of central banks still keep their interest rates near zero, they are essentially left with only unconventional instruments to counteract the next recession.
Fiscal and monetary policies often have offsetting effects, so their coordination is desirable. But this coordination should not undermine the independence of monetary authorities. The challenges of population ageing and inequality as well as profit shifting, increase the need for fiscal authorities to come up with unconventional solutions to these challenges. A necessary prerequisite for these solutions is thinking “long” – much longer than to the next elections. And this is one thing that governments can learn from central banks within the course of their cooperation.
Notes
[1] Fiscal gap is calculated as the difference between the present values of all government future financial obligations (expenditures) and revenues (including tax and interest revenues).
[2] BEPS stands for Base Erosion and Profit Shifting – aimed at reducing “tax optimization” practices of corporations.
[3] DBCFT changes the way taxable profits are calculated – it does not allow companies to deduct expenditures on imports while at the same time excluding their export revenues from the revenue base. The tax effect is similar to taxing imports and subsidizing exports. Therefore, it is discussed whether introduction of such a tax violates the WTO rules. DBCFT (if introduced) would also have implications on the exchange rates (USD will appreciate which would affect other countries, especially those holding large stocks of US debt and intensively trading with the US) but the magnitude of these changes is being debated.
