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Fiscal sustainability

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Fiscal sustainability

Fiscal sustainability, or public finance sustainability, is the ability of a government to sustain its current spending, tax and other policies in the long run without threatening government solvency or defaulting on some of its liabilities or promised expenditures. There is no consensus among economists on a precise operational definition for fiscal sustainability, rather different studies use their own, often similar, definitions.[1][2][3] Many countries and research institutes and have published reports which assess the sustainability of fiscal policies based on long-run projections of country's public finances (see for example,[4][5] and [6]). These assessments attempt to determine whether an adjustment to current fiscal policies that is required to reconcile projected revenues with projected expenditures. The size of the required adjustment is given with measures such as the Fiscal gap.

Government's inter-temporal budget constraint

There is no consensus among economists about the correct criterion/definition to be used for fiscal sustainability. The most commonly used criterion is the government's inter-temporal budget constraint or inter-temporal equilibrium condition:

B_t = \sum_{i=1} ^ {\infin} (1+r)^{-i} PB_{t+i} ,

where B_t is the stock of public debt, r is the interest rate of public debt and {PB}_t is the primary balance (negative of primary deficit or government revenues minus government expenditures excluding interest expenditure).

The government's inter-temporal budget constraint states that the initial debt level should be equal to the present value of future surpluses. That is, the government debt must be backed by expected future cash flows.

Many economists have voiced grave concerns over using inter-temporal budget constraint as a de facto definition or criterion for fiscal sustainability.[7][8][9] Also, it has been shown that under plausible assumptions the inter-temporal budget constraint is in fact not the correct criterion for sustainability.[7][10][11]

Indicators of fiscal sustainability

There are many different indicators of fiscal sustainability. The indicators measure the fiscal adjustment required to bring public finances back to sustainable track. Specifics of the indicator depend on the operational definition of fiscal sustainability and the underlying economic modelling framework employed in a study. Some of the most commonly used indicators are so-called tax gaps. For example, the infinite horizon tax gap, or S2 sustainability indicator in European Commission phraseology is defined as:

ITGAP = \frac{(r-g) (b_t - \sum_{i=1} ^ {\infin} (\frac{1+g}{1+r})^{i} pb_{t+i})}{1+g},

where b_t is the debt-to-GDP ratio, r is the interest rate of government debt, g is the growth rate of the economy and pb_t is the primary balance to GDP ratio.

The infinite horizon tax gap gives the adjustment required to satisfy the inter-temporal budget constraint in terms of a permanent one-time change to projected path of primary balance to GDP ratios. Thus, if ITGAP = 5%, primary balance must be greater than projected by 5% of GDP for each future year. This could be achieved by permanently raising taxes or cutting expenditures 5% of GDP. For derivations and more information, see for example,[1][4][12] or.[13]

See also

References

  1. ^ a b Krejdl, A., 2006. Fiscal Sustainability – Definition, Indicators and Assessment of Czech Public Finance Sustainability (Working Papers No. 2006/3). Czech National Bank, Research Department.
  2. ^ Balassone, F. and Franco, D., 2000. Assessing Fiscal Sustainability: A Review of Methods with a View to EMU. In Fiscal Sustainability, ed. Banca d’Italia, 21–60. Rome: Bank of Italy
  3. ^ Theoretical Prerequisites for Fiscal Sustainability Analysis – Burnside, 2005. Chapter. 2 in Craig Burnside, "Fiscal Sustainability in Theory and Practice," World Bank.
  4. ^ a b European Commission, 2009. Sustainability report 2009. European Commission.
  5. ^ Congressional Budget Office, 2010. The Long-Term Budget Outlook. The United States Congressional Budget Office.
  6. ^ Office for Budget Responsibility (United Kingdom), 2011. Fiscal sustainability report – July 2011.
  7. ^ a b Bohn, H., 2005. The Sustainability of Fiscal Policy in the United States (CESifo Working Paper Series No. 1446). CESifo Group Munich.
  8. ^ Bagnai, A., 2004. Keynesian And Neoclassical Fiscal Sustainability Indicators, With Applications To Emu Member Countries (Public Economics No. 0411005). EconWPA.
  9. ^ Roubini, N., 2001. Debt Sustainability:How to Assess Whether a Country is Insolvent.
  10. ^ Persson, T., 1985. Deficits and intergenerational welfare in open economies. Journal of International Economics 19, 67–84.
  11. ^ Wigger, B.U., 2009. A note on public debt, tax-exempt bonds, and Ponzi games. Journal of Macroeconomics 31, 492–99.
  12. ^ Escolano, J., 2010. A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates. Technical notes and Manuals. International Monetary Fund.
  13. ^ Sarvi, T., 2011. Some Approaches for Assessing the Sustainability of Public Finances. Master's thesis. Aalto University School of Economics.

Further reading

External links

  • Councils and institutions that focus on fiscal issues and sustainability among other things
  • IMF Fiscal monitor
  • The World Bank: Fiscal Sustainability, Risks and Vulnerabilities
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