Will Fiscal Deterioration Lead to Lower Economic Growth?

Faculty Fellow, RIETI

Achieve growth first and fiscal reconstruction later?

Restoring fiscal sustainability undoubtedly is one of the foremost important economic policy goals for Japan. Although the consumption tax rate was raised twice (in 1997 and 2014), the outstanding balance of public debt has been growing continuously for more than two decades after the bubble economy, and the government has not made sufficient efforts to restore its fiscal health. One major reason why the Japanese policy authority has failed to implement full-fledged fiscal reconstruction efforts for so many years is the perceived causality between the fiscal problem and economic growth. It has been generally perceived that low economic growth and stimulus measures to address the slowing economy cause fiscal deterioration (i.e., low growth to high debt causality) but not vice versa (i.e., high debt to low growth causality).

Based on the perception that causality goes one way from low growth to high debt, the following ideas hold true. First, from the viewpoint of taxpayers, fiscal reconstruction is not an unequivocal goal per se but a means to achieving the sound development of the Japanese economy and people's lives, which is the ultimate goal. Thus, in light of the objective of improving people's lives, it is quite reasonable for the government to postpone fiscal consolidation and prioritize growth boosting measures to revive the dwindling economy in the aftermath of the bubble burst and amidst the adverse effects of low fertility and an aging population. This is the idea that has underpinned the government's decision to implement pump-priming measures while tolerating its fiscal standing and not acting on the ever-increasing cost of social security.

However, in order for this idea to have validity, the high debt to low growth causality cannot exist. Should this causality exist, expansionary fiscal policy such as pump-priming measures implemented by the government would have impaired economic growth at least for the medium to long term horizon. Lower economic growth inhibits improvement in people's living standards, that is, impeding the realization of the ultimate goal of economic policy. In other words, if the high debt to low growth causality exists, the government's economic policy of postponing fiscal reconstruction and pursuing higher economic growth by expanding fiscal spending would suppress economic growth contrary to the intended effect. If this is the case, the promotion of economic growth by means of fiscal stimulus?the fundamental strategy that has been underlying Japan's economic policy over the past two decades?may turn out to be a mistake.

As such, research to identify and explain the causality between fiscal deterioration and economic growth has critical policy implications.

Public debt overhang

Research by Reinhart, Reinhart and Rogoff (2012) on the debt overhang problem made an explicit argument pointing to the adverse effect of public debt accumulation (fiscal deterioration) on economic growth. They examined 26 debt overhang episodes in advanced economies and found that 23 of them coincided with long-term low economic growth that lasted 10 years or more. What is noteworthy is that the relationship between public debt and economic growth is nonlinear. They showed that economic growth is 1.2 percentage points lower when public debt exceeds 90% of the gross domestic product (GDP) than in periods with debt below that level. Also, while little correlation is observed between debt and economic growth when public debt remains small as a share of GDP, there is a clear tendency for economic growth to slow down with an increase in public debt once the public debt to GDP ratio exceeds the 90% threshold. Pointing to this nonlinear relationship, Reinhart, Reinhart and Rogoff (2012) argue for the existence of the high debt to low growth causality, i.e., a cumulative increase in public debt inhibits economic growth.

Furthermore, Reinhart et al. report that interest rates were either lower or unchanged in 10 of their 26 debt overhang episodes, including Japan in the past 20 years. Indeed, over the past 20 years since the burst of its economic bubble, Japan's real interest rates have remained stable at levels below those in the prior period (Japan's real interest rate?measured as the nominal lending rate minus the GDP deflator?has stayed stable at around 3%, a level comparable to or lower than those of the United States and France). The fact that interest rates did not rise in the low growth periods suggest that the ordinary mechanism of crowding out was not working. This infers the possibility that fiscal deterioration may have been working through some sort of indirect mechanism to cause a decline in demand and inefficient economic activities in the private sector.

Simulation results of a theoretical model

I elaborated on a new theoretical model explaining public debt overhang. The details of this model are in Kobayashi (2014), but it is basically designed to consider an economy comprising a productive entrepreneur and a worker (household) as a supplier of labor where the government implements a redistribution policy. The government collects taxes (T) from the entrepreneur, pays subsidies (S) to the worker, and appropriates the remaining tax revenue (T?S) to the payment of interests on government borrowing (B). The model shows that an increase in the value of B, T, and S leads to a decrease in the aggregate yield of the economy (Y) in the case where the entrepreneur is subject to borrowing constraints. A set of charts in the below figure show how the aggregate yield (Y) and other parameters change with an increase in taxes (T) when the amount of subsidies is fixed in proportion to that of taxes (S = 0.5T). We can see that with an increase in taxes (T), government borrowing (B) increases, but the interest rate (r) and the aggregate yield (Y) decrease (It should be noted that the interest rate denoted by r represents a gross interest rate).

Figure: Steady states at S = 0.5T
Figure: Steady states at <i>S = 0.5T</i>

The theoretical model provided in Kobayashi (2014) infers the following:

1) As public debt (government bonds) has a useful function as a liquid asset, an increase in public debt, in itself, has an effect to promote economic growth (i.e., liquidity-enhancing effect).
2) When the government's fiscal policy imposes taxes on productive economic agents and provides subsidies to the labor sector, higher income induces workers to reduce labor supply (i.e., income effect), which in turn causes wages to go up and highly productive companies to cut down on their production. At the same time, as such companies' demand for borrowing falls, market interest rates go down.
3) When the parameter T takes on a particular value, the second and negative effect of the above two types of effects prevail, whereby fiscal deterioration (higher public debt and higher subsidies) leads to lower production and lower market interest rates.

The simulation results of this theoretical model are consistent with the hypothesis that fiscal deterioration is a contributing factor to a long-term economic slump. Higher public debt alone may not cause such chronic economic stagnation. However, when accompanied by a transfer of wealth from the highly productive corporate sector to the labor sector through major government redistribution policies such as increasing social security benefits, it may cause the economy to stagnate over a prolonged period of time. Therefore, in order to restore economic growth, it is necessary to reduce the degree of income redistribution to the labor sector rather than reducing the outstanding balance of public debt. Specifically, as a way to increase the household sector's share of the burden of public finance, the government should reduce social security benefits and impose a greater tax burden on social security beneficiaries, which are likely to be effective in improving economic growth.

These policy implications may have important meaning to Japan's future tax and fiscal policies. We need to further examine and test the public debt overhang hypothesis by conducting more research in the future.

May 7, 2014
  • Kobayashi, Keiichiro (2014) "Public debt overhang in the heterogeneous agent model." Mimeo.
  • Reinhart, Carmen M., Vincent R. Reinhart, and Kenneth S. Rogoff (2012) "Public Debt Overhangs: Advanced-Economy Episodes since 1800," Journal of Economic Perspectives, Vol. 26, No. 3, pp. 69--86.

May 7, 2014

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