Friday Flyer: Elements of a successful fiscal policy Part 1


In the week before the Spring budget, we are all supposed to get excited about the odd change in tax rates or the TV license fee. And worry about the excise duties on various viscous hydrocarbons. In fact, what we ought to be worried about will probably mostly be missed by commentators: that is whether the government is meeting its obligation to reduce risk. Essentially, we ask the government to provide risk sharing services for us. When we cannot buy that insurance ourselves the government can offer transfers through the tax and benefit system that smooths some of life's ups and downs.

    This risk sharing is a form of insurance and most parts of public expenditure, for example, health, education, defence, pensions or even the financial industry can be thought of as such. A large part of the risk sharing is undertaken within the existing population, intragenerationally, with total managed expenditure by the government of some 40% of GDP or just under £750bn in 2014-5. Of which just under 5% of GDP, around £90bn, was net borrowing and intergenerational risk sharing. This is because the government also issues IOUs against future generations, so the costs of that insurance are borne in part by our future, (hopefully) richer descendants. The current level of debt (the accumulated deficits) is around 90% of GDP. The OBR recently published projections of government debt for 50 years that approach the astonishing level of some 250% of GDP, essentially because of ageing. Without the ability to issue debt taxes would be considerably higher and the extent of the government's ability to share risk would be significantly reduced.

    By reducing our current tax burden and issuing IOUs instead, the scale of distortionary taxes that act to reduce the labour supply of present generations is limited. But given we have to tax what we need to do is to try and reduce random variations in tax rates. So what we should be asking is how much public insurance do we need as a society (expenditure) and how much do we need to lay down as an additional claim on future generations (the deficit) subject to the social welfare costs of imposing taxes? In general we do not frame the question in this manner, preferring to talk about contrary notions such as the unsatisfied demand for public services and the need to cut the debt burden.

    We do not have a great theory for public debt (yet). In part this is because macroeconomic theory is dominated by the view that there is a representative agent: a yeoman farmer or a Robinson Crusoe. This person produces, receives income and spends all income. And does not need to self-insure or any services from the government. Of course, many have criticised the reduction of a complex economy into a single agent, arguing that co-ordination by the market cannot be assumed and that important macroeconomic phenomena, such as unemployment, are the result of co-ordination failure. Representative agent models where there is no trade cannot capture the essence of financial markets and asymmetric information and help us understand government policies aimed at distribution.

    There are many assumptions required to arrive at the representative agent but perhaps the biggest is that markets are complete. This is an assumption about risk sharing across different agents. And it states that there are at least as many assets with linearly independent payoff as there are states. If agents have access to these assets they can create securities that provide consumption insurance in different states of nature. In an optimal outcome all individuals will then be able to share risk perfectly. If all these individuals have the same initial endowments (wealth) they will have the equal consumption or equal utility in all states.

    Let us suppose that two agents have the same wealth endowment at time 0. If they face individual shocks (positive or negative) to income over time their consumption paths will not tend to move together. But if they can agree to trade the outcomes so that they both get the average of these two shocks, they can eliminate their personal risk. As a macroeconomists I can then think in terms of this average or representative agent. This construct is very useful for thinking about simple time series representations of the economy in terms of series such as output, inflation and interest rates, but may not allow us to understand extreme outcomes well or points of tension or stress and certainly not what happens when these trades may break down. It is ultimately rather difficult to justify the assumption of complete insurance markets for idiosyncratic consumption risk. But governments may play a role in taxing those who receive positive shocks and spending on those who receive negative shocks. In other words they may help us move towards more complete markets.

    At this point the size of public debt and its maturity may matter. If the state issues a large enough quantity of debt and chooses a long term maturity structure it might be able to insulate the public finances from changes in the state of the economy. The argument from Angeletos (2002) is that "holding long-term debt and investing in a short-term asset can hedge the budget against both random variation in fiscal expenditure and aggregate income, as well as against the risk of refinancing the outstanding debt at variable interest rates". When there is an expenditure shock, rather than increasing taxes the government can then use the short-term asset fund to finance expenditures. The UK government with an average debt maturity of some 14-15 years has managed to meet that objective but the question is whether the level of debt should be larger - ageing may help - so that there is a sufficient return to meet changes in economic risk and whether we have invested in the right forms of short term assets. We shall see but it would be very odd if the looming levels of debt were exactly what we needed to reduce risk, perhaps something is still missing in markets. I shall return to this topic next week.



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Prof Jagjit S. Chadha Research Interests:

His main research interests are developing the links between finance and macroeconomics in general equilibrium models and has published widely in economics journals.  He is also editor of the Cambr