National Debt
Topic Thirty

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Government Debt

Government debt which is also known as public debt or national debt is the debt owed by a central government. A government is said to have a deficit when it expenditures exceed its receipts in a particular year.  Government debt is when the government borrows to funds its expenditures.  Government debt is one method of financing government operations. The government can also create money to monetize their debts, thereby removing the need to pay interest.

Types of taxes

The government’s main source of revenues is that of taxes.  The following are the different types of taxes:

Proportional tax – This is a tax where the rate of taxation is fixed, as 15 percent or 25 percent and stays a fixed percent of one's income, irrespective of how high or low the income is.   A proportional tax applies the same tax rate across low, middle and highincome taxpayers.

Progressive tax – This is a tax in which the tax rate increases as the tax base increases.  A progressive tax takes a larger percentage of income in taxes from the high-income group than it does from the low-income group.     

Regressive tax – This is a tax imposed in such a manner that the tax rate decreases as the amount of taxable income increases.  In this case, the higher income group pays less in taxes than the lower income group.   A regressive tax impose greater tax burden on the poor relative to the rich. People with low income and low ability to pay, will pay higher taxes.

Indirect Tax - an indirect tax is one that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An indirect tax is most often a percentage of the price of the product and is thought of as a tax that is shifted from one taxpayer to another, by way of an increase in the price of the good.

Why Does Government Borrow

There are several reasons why the government may want to borrow.  The following are some of these reasons:

  • Automatic fiscal stabilizers – in a recession, government tax revenues fall. Also the government may have to spend more on unemployment benefits. Therefore, in an economic downturn, borrowing rises. Without borrowing in a recession, this would make the recession worse and the government will be unable to pay unemployment benefits which are automatic stabilizers.    
  • Investment – the government may invest in public sector investment. For example, building schools, hospitals and better roads. This investment can give a return on the investment which helps to boost productive capacity and increase economic growth.  In this case, the government is acting like a firm who takes out a loan to finance investment.
  • When tax revenues are less than expected - borrowing means the government can meet a temporary shortfall by borrowing when tax revenues are less than expected, rather than having to immediately cut back on spending. Like an overdraft facility, government borrowing gives the government more flexibility which means that they can maintain wages and spending commitments without having to keep cutting spending.

Ricardian Equivalence

The Ricardian equivalence is the idea that increased government borrowing may have no impact on consumer spending because consumers predict tax cuts or higher spending will lead to future tax increases to repay the debt. If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases.  It is argued that if the government borrows money to fund a tax cut, rational consumers realise in the future taxes will have to rise to finance the borrowing. This will mean that they will save the extra income so that they can pay future tax increases.  Consumers will therefore opt to smooth their consumption over the course of their life. Thus if consumers anticipate a rise in taxes in the future they will save their current tax cuts to be able to pay future tax rises.

Laffer Curve

The Laffer Curve is a theory developed by supply-side economist Arthur Laffer to show the relationship between tax rates and the amount of tax revenue collected by governments. The curve is used to illustrate the idea that the more an activity such as production is taxed, the less of it is produced or production will fall.  Likewise, the less an activity is taxed, the more of it is produced. The Laffer Curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause people not to work as hard resulting in a reduction in tax revenue. The government would like to be at point T* in the following graph because this is the point at which it will collect the maximum amount of tax revenue while people continuing to work hard.

Figure 1

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