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Putting the cart before the horse in the debate over fiscal policy

There is an argument that government spending can create economic growth the private sector won’t provide. Image sourced from

The economic debate during the election period has centred on the costings of the proposed policies of the major parties. Unfortunately what little “debate” we’ve seen has become a bit like a black hole, from which not even light escapes.

As more astute media commentators have noted, the ALP has been snookered for some time now into contortions about generating budget surpluses, with the return to surplus elevated by both politicians and commentators to the status of holy grail. Meanwhile, the opposition has been snookered into ruling out some of the kinds of tax changes (such as the GST) that one would expect to be up for debate in any serious discussion of tax reform.

The only bright spot is that the question of the return to surplus and the status of the budget has itself prompted some important questions about the medium term: about the need to expand the tax base; and about what we can and should expect from governments through public-sector expenditure.

Yet in an important sense, the way such questions – and the likely future debate around them – are framed seems to put the cart before the horse. The debate ignores the potential for the public sector to contribute to economic growth. And it is this role which should be the start of the discussion.

Current debate on fiscal policy and budgets

Mature discussion of fiscal policy and budgets in this country has two elements. The first and most discussed is how fiscal policy is financed: whether the budget should be in deficit or surplus and what level of public debt is “acceptable”.

The second element, inextricably connected to the first, but much less discussed, is what role governments should play in society, in terms of providing services and how much government expenditure is necessary and appropriate.

The second element will tell us the size of the financing task. Society’s view about deficits and borrowing – the first element – will then point to how much we need to find efficiencies in spending and/or broaden the tax base.

Some commentators have pointed to a continuing structural deficit in the budget, given the limited existing tax base and the high cost of programs such as Gonski education reforms and the National Disability Insurance Scheme, as well as ballooning health budgets into the foreseeable future.

If a structural deficit is undesirable, but society deems these big ticket items as essential, it’s vital to improve the revenue base.

This prompts a number of worthy questions, not least the question of what role governments should play in the provision of social welfare.

Nevertheless, framing the debate about fiscal policy, budgets and debt in these terms is problematic.

The first problem is the preponderance of the ideas that the budget must be balanced over time and that the optimal amount of gross public debt over time should be zero. These are not immutable, self-evident truths. As is often the case in discussions of the “real world”, these propositions reflect instead a particular view of how the economy works; in this case, a view which is not uncontroversial.

In a significant sense, the current debate is underpinned by the view that, other than in the short term, the role for government is simply to provide some services which the private sector would be incapable of, or unwilling to provide.

This means its only economic role is a short-term one of letting so-called “automatic stabilisers” take the edge off the economic cycle (for example, during downturns, tapering taxes and automatically increasing outlays like welfare payments, cushioning the economy and lessening the severity of the downturn).

Put simply, the government’s obligation in economic terms is to be seen but not heard.

But is there an economic rationale for public sector activity other than in a limited short-run counter-cyclical role?

What’s missing: the medium to long-term economic role for the public sector

However, a radically different view of government and its role may emerge to the extent that one takes the view that there is no inherent tendency over time for an economy such as our own to grow fast enough to provide for full employment of a growing labour force.

In other words, suppose that over time the growth in private-sector demand - from households and business - will be enough to warrant businesses as a whole fully-employing the growing workforce; and that the growth in our exports can’t provide the missing growth in demand.

The only other possibility is that government must intervene in some way to assist in generating the missing growth.

If this role requires a budget deficit and government borrowing (and with that, the issue of public debt) one might reasonably argue that the deficit should be spent on infrastructure generating a social rate of return - with current expenditures and revenues balanced (possibly requiring radical reform such as the broadening of the tax base).

Understandably, as a medium or long-term role, this will be hard for those arguing for a balanced budget to swallow, in so far as it points to medium to long-term deficits and persistent gross public debt.

Yet the call for balanced total budgets over the cycle is a curious one. It seems to rest on some argument about the optimal level of public debt over time being zero. As some writers, such as post-Keynesian economist Luigi Pasinetti have noted, the notion of zero gross public debt or even zero net public debt as a percentage of GDP being the optimal debt ratio is not a correct deduction from any economic premises – heterodox or orthodox.

Gross public debt as a proportion of GDP is sustainable (i.e. there is no tendency for this ratio to increase) over a range of plausible growth scenarios.

The view above will be similarly hard to swallow for those who rely on the conventional economic wisdom that the path to full-employment is one the private sector can guarantee, it’s just a matter of getting the incentives right.

The former view is an act of faith and not in my view a coherent set of propositions which might underpin part of a discussion about fiscal policy.

I suspect some might be tempted to dismiss this criticism as just more musings of an academic. But as is usually the case and as Keynes most astutely observed in the 1930s, much public and seemingly pragmatic discussion about fiscal policy, budgets and debt is usually the captive of long-lived ideas that emanate from the academe.

If like me, you don’t have the faith, the question is not about whether there is an economic role for the public sector - as distinct from its social role - in the medium to long-term.

The real question instead is about the long-term role of fiscal policy in securing a rate of economic growth that delivers what we know as full-employment; and in a way consistent with equity, efficiency and simplicity in the tax system and sustainable debt.

Fiscal policy to transcend the political cycle

The kind of medium to long-term role for fiscal policy alluded to here faces two considerable challenges, only one of which is economic. This is the task of forecasting across the cycle, and specifically about trend rates of growth in the private sector compared with the likely growth requirements for full employment.

The second challenge is for fiscal planning which in some way transcends the electoral cycle. We don’t bat an eyelid in handing control on interest rates to an independent central bank and absolving the government of the day the responsibility of one arm of macro policy – but we are not prepared to do this with other important aspects of policy.

At its heart this reflects the dominant view in economics that macro policy has little to offer in affecting the long-run growth path of the economy and policy makers in the long-run can only really adjust the time taken to get back to trend and only with monetary policy.

The sooner we shake off this view, the sooner we may be able to have the kind of conversation about fiscal policy that commentators from across the spectrum want – and that Australians deserve.

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