Whenever I am required to do an introductory lecture on government budget, I find it pedagogically helpful to begin with highlighting the similarities between a household budget and the government budget. Since every household has an (implicit or explicit) budget, it is easier to focus on the essential aspects of a national budget by reference to the same aspects of a household budget. Despite the massive difference in scale and the consequent complexities, the essentials of both budgets are similar. Both the household and the government plan their expenditures on the basis of expected or forecasted income or revenue. Should the desired expenditures exceed the income or revenue, the household or the government can resort to one or more of the following three options: (a) borrow money, (b) sell assets or (c) increase income or revenue. If none are feasible, expenditures must be reduced.
Some economists are of the opinion that household budget is fundamentally different from the national budget because the government has the ability to determine the level of its revenue (income), and hence its expenditure is not restricted by its current revenue. This is so because the government has the statutory authority, something that the household lacks, to raise revenue by taxing its subjects or by printing money.
The ability of the government to arbitrarily raise the amount of its revenue is greatly overstated in such discussions. In any modern state, the government has little manoeuvrability to raise the trajectory of revenue in a short time. Any significant change in the tax regime requires years of campaigning in the public domain to garner support for the change and then months, if not years, of debate in the legislature to pass a tax bill.
A study of the history of tax efforts of the mature economies will reveal the difficulty with any significant increase in the tax rates (reductions are of course easier). For example, during the period 2000 to 2013, the average tax rate in OECD (Organisation for Economic Cooperation and Development) countries actually declined from 34.3 per cent to 33.7 per cent and that in Australia from 30.4 per cent to 27.3 per cent (OECD Revenue Statistics 2014).
Even in developing countries that have typically much lower tax rates than that of the more advanced economics, it is very difficult to increase the tax rates quickly. Despite great efforts, Bangladesh, which has one of the lowest tax rates in the world, has not succeeded in increasing the average tax rate by more than 2.0 per cent of gross domestic product (GDP) since the beginning of the millennium. And since 2011-12, the government revenue-GDP ratio has declined by about a percentage point despite all the bravadoes of the Minister of Finance. He almost came to blows, metaphorically speaking, with the otherwise docile business community when he expressed his determination to implement the VAT laws unaltered.
It is even more difficult to mobilise resources through printing money. A central bank can create money by virtue of the fact that it is the statutory authority to print money, and in the case of fractional reserve banking, commercial banks are required by law to hold reserves with the central bank. There is a normal growth of money to sustain the trend growth of the economy. Any increase in money in excess of this amount will cause an inflationary spiral. Excessive growth of money leads to hyperinflation. Those countries that tried to acquire resources through printing money (Latin American countries in the 70's and 80's) not only not succeeded in acquiring additional real resources, but invariably encountered double or triple digit inflation. Zimbabwe is the most recent example of the damage excessive money printing can do to money itself and the economy.
Curiously, it is the individual households that have the ability to increase their incomes indefinitely. When a miner strikes gold or an unemployed person finds a good job, his income may increase several fold. Many households have the option of increasing their incomes substantially by working overtime or on an additional job. No government can increase revenue the way households can increase their income. However, if we consider the average household income of the entire population, then the increase in income of the household sector is not likely to be too different from that of government revenue.
When reduced to its bare essentials the budget, whether of the government or of the household, looks the same as shown in the table below:
The total amount of resources available to the government (the household) is derived from taxes and other revenue earnings of the government (income earned by the household), money from the sale of any assets that it owns or borrowing from domestic or external creditors. Resources obtained in this manner are distributed among current spending (consumer spending), purchase of assets and payments of principal and interest on outstanding debts.
We do not carry out extensive chemical tests to find out whether the pudding is sweet. All we do is taste it; if it tastes sweet, it is sweet; if not, it is not. Similarly if the government could raise revenue substantially by increasing the tax rates or introducing new taxes or by printing money we would have observed many governments resorting to these methods to meet their ever-increasing expenditure aspirations. There are few examples of governments succeeding in increasing their revenue in a short time through these means. Those who tried had met with very adverse outcomes such as popular revolt, teetering economy or runaway inflation.
A budget, whether of a government or of a household, is in deficit whenever actual revenue (income) falls short of actual expenditure. The deficit is financed by borrowing, i.e., by accumulating debt. Budget deficits are neither uncommon nor necessarily harmful; it must be understood that the household or the government must have the capacity to service the debt liabilities. If the deficit is large, it becomes increasingly difficult to service the debt liabilities, and the creditors become wary about extending fresh credits. Not only credits dry up, but the cost of credit may also go up. At this point discipline is imposed on the budget externally, since internal mechanisms did not work. In the case of the household, the discipline may take the form of foreclosing on the mortgage or confiscation of the collateral, which leaves the household much worse off.
When a debt-default situation arises some governments may be tempted to ride out of the difficulty by printing money. This invariably results in high inflation or hyperinflation, and in the end such efforts of the government cannot muster additional real resources. But the economy suffers terribly when inflation, especially hyperinflation, takes hold.
In recent years the world has witnessed the sad consequences of unbridled government spending financed by both borrowing and printing money. Greece had borrowed for a long time to finance extravagant government budget deficits. Eventually the debt grew to such a level that the Greek government did not have the resources to finance the debt liabilities and creditors were unwilling to lend it more, especially after it admitted that the original deficits were cooked. Facing the stark reality of sovereign default (the first by any developed country) Greece had to accept an externally imposed economic bailout programme to avoid default.
The most recent example of a government trying to garner additional resources through printing money is Zimbabwe. The consequence was a hyperinflation that the world has not experienced since the German hyperinflation of 1921-23. Not only that the government was unable to raise real revenue through printing Zimbabwean dollar, it turned the currency worthless such that it had to be abandoned. The economy suffered terribly.
Each country has a sustainable rate of budget deficit depending on its economic growth rate. Only when the actual deficit exceeds the sustainable rate, the economy blunders into a crisis. Since there is a long gestation period between irresponsible fiscal behaviour and consequent economic crisis, the government that creates the crisis may not bear the brunt of it. The last few governments which tried desperately to rescue Greece from the debt crisis are not the ones that created it. No responsible government should engage in such irresponsible fiscal behaviour as would leave the future governments vulnerable and the prosperity of the future generation severely compromised.
The writer is Professor, Department of Economics, University of Dhaka.