The governance of federal debt in the united states of America

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The United State of America has been experiencing high debt to GDP ratio of more than 100% and these Public debts are detrimental. The main purpose of this study was to examine the shocks of the variables on others in the USA economy by using quarterly data. The variance decomposition and the Generalised Impulse Response Function techniques were employed to analyse the data. The result revealed that high variation of shocks in real federal debt is explained by their own innovations in the short run, by CPI followed by real federal debt its self. In the long run, this leads to CPI and real government spending. The GIRF reveals that in the short run, real federal debt responds negatively to shocks from CPI, real federal interest payment and real federal government tax receipts and positively to real federal debt and real government spending. In medium term, only real federal government tax receipts are negative while the others are positive. In the long run, the response are all positive to shock from the independent variables. The results lead to the recommendation that the US government should focus on real federal debt in the short run. In the medium term, US government should focus on increasing real government spending and reducing only real federal government tax receipts. In the long run the target should real be federal debt, CPI, real federal interest payment, real government spending and real federal government tax receipts.

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Risk governance & control: financial markets & institutions / Volume 7, Issue 1, Winter 2017
THE GOVERNANCE OF FEDERAL DEBT IN THE
UNITED STATES OF AMERICA
Gisele Mah*
* School of Economics and decision sciences, North West University, Mafikeng campus, South Africa
Abstract
The United State of America has been experiencing high debt to GDP ratio of more than 100%
and these Public debts are detrimental. The main purpose of this study was to examine the
shocks of the variables on others in the USA economy by using quarterly data. The variance
decomposition and the Generalised Impulse Response Function techniques were employed to
analyse the data. The result revealed that high variation of shocks in real federal debt is
explained by their own innovations in the short run, by CPI followed by real federal debt its self.
In the long run, this leads to CPI and real government spending. The GIRF reveals that in the
short run, real federal debt responds negatively to shocks from CPI, real federal interest
payment and real federal government tax receipts and positively to real federal debt and real
government spending. In medium term, only real federal government tax receipts are negative
while the others are positive. In the long run, the response are all positive to shock from the
independent variables. The results lead to the recommendation that the US government should
focus on real federal debt in the short run. In the medium term, US government should focus on
increasing real government spending and reducing only real federal government tax receipts. In
the long run the target should real be federal debt, CPI, real federal interest payment, real
government spending and real federal government tax receipts.
Keywords: Sovereign Debt, Variance Decomposition, Generalised Impulse Repulse Function and United
States of America
JEL Classification: H62, H63, H71, C32
DOI: 10.22495/rgcv7i1art12
1. INTRODUCTION
It is argued that in the early 21th century,
sovereign debt increased due to President Bush’s tax
The United State of America (USA)’s public debt has
been increasing in recent years with value of
102.98% to gross domestic product (GDP).This has
been stated by the United State (US) Bureau of
public debt. Thornton (2012) argues that the USA
had a large deficit which was lower, it was mainly as
a result of wars (1812 war, the Civil War and the
First and the Second World Wars). Abel, Bernanke
and Croushore (2008) suggest that the debt to GDP
increased to more than 100% during World War II
and later reduced over a 35 year period. Another
huge deficit occurred in 1933 during the Great
Depression whereby the USA had a deficit of 6.6%
(IMF, 2013). According to Thornton, the problems
started when the government increased spending
significantly without corresponding tax revenue
increases in the 1970s. From mid-1974, the
Congressional Budget Act was reformed such that
the congress could not challenge the president’s
budgets. This led to difficulties in the control of
deficit. As a result in 1980, the USA experienced a
rise in debt due to budget deficit lower than 50%
(Abel et al., 2008). From 1980 to 1989 military
spending was increased while taxes were lowered
and the congressional democrats blocked any
attempt to reverse spending on social programmes.
Later on public debt was reduced due to decreases
in military spending after the Cold War from 1993 to
2001 (Thornton, 2012).
cuts, increase in military spending due to two wars
and the entitlement Medicare programme. As a
result from 2001 the USA public debt stood at $5.7
trillion and by the end of 2008, it rose to $10.7
trillion mainly because of Bush’s actions.
Furthermore, public debt increased due to the Global
Financial Crisis (GFC) that started in 2008. In 2010,
the debt increased due to a decrease in tax revenues
and tax cuts and by early 2012, the sovereign debt
was estimated at $15.5 trillion, about 101.99% of
GDP (Baccia, 2013). Despite the debt ceiling of $15.2
trillion in 2011 that increased to $16.4 trillion in
2012 by the Budget Control Act of 2011, debt of the
USA kept on increasing. In February 2013, the
president and the congress suspended the debt limit
and in May 2013, the debt ceiling was increased to
$16.7 trillion (Baccia, 2013). By October 2013, the US
government had to increase the May 2013 debt limit
in order to avoid default.
Rising government debt has negative effects on
the economy of a country because they create a
burden for future generations since taxes have to be
raised. Another reason is that high public debt can
cause an economy to go bankrupt. This is based on
Smith’s (1776) notion that a government should not
get into deficit spending because it is not good for a
nation even if the debt is domestic. Smith argues
that when a government borrows and has to repay
the debt, it adopts the following measures: increase
in taxation, increase in the flight of domestic capital
91
t
(
t t
t-1
D
Risk governance & control: financial markets & institutions / Volume 7, Issue 1, Winter 2017
as well as devaluation of the local currency.
Pannizza and Presbitero (2012) maintain that
Dt = (1+ r)Dt1 +Gt T (4)
sovereign debt seriously reduces the growth of a
country towards wealth and prosperity because
resources that could have been used by the private
sector in a positive way are directed to the
government and used in unproductive activities.
Several studies have been conducted on this
topic with a special emphasis on developing
economies and just a little of them have been
directed towards developed economies. This study
will attempt to provide a contribution by adding to
the literature on the response to shocks of
government debt from other variables in a
developed economy. The study will also employ
variance decomposition and GIRF techniques which
have not been used often to analyse the shocks on
government debt. The analysis is envisaged to assist
policy and decision-makers to determine which
variables to target in order to reduce the rising
government debt. We hope that this will go a long
way in building confidence among them in the
implementation of policies and strategies to reduce
the rising government debt.
This paper thus examines the effects of the
response of shocks of government spending and tax
receipts on federal debt in the USA. This is attained
in the following sections: section 2 will be the
theoretical framework and literature review while
section 3 is the methodology. Section 4 presents the
empirical finding and finally the last section 5 is
conclusion and recommendation.
At the end of the period t, debt equals 1+r)
multiplied by the debt at the end of period t 1. The
implication of a one period decrease in taxes for the
path of debt and the future taxes assume that until
year 1. In that case, the government has balanced its
budget so that the initial debt is equal to zero. To
repay such debt, the government must have a
surplus which equals to (1+r)t1 for the year t. If
taxes are reduced by 1 in period 1, this would cause
an increase in taxes of (1+r)t1 during period t. The
effect is that if the government does not change its
spending, there will be an increase in future taxes
and the real interest rates will increase and eventual
taxes will also increase.
Empirical studies such as Heylen et al. (2013)
maintain that both permanent cut in expenditure
and increase in tax contribute significantly to the
reduction of debt in the long run. Cutting down
subsidies and public sector wage bill are effective in
reducing debt when the public sector is efficient in
administration. This has more effects in the long
run as compared to the short run. Von Hagen,
Hallett and Strauch (2002) argue that expenditure
cuts, especially on wage component of public
spending make fiscal consolidation to be more
successful than tax increases.
Alesina and Ardagna (2009) state that when
there is fiscal adjustment, spending cuts are more
effective than tax increase in stabilising debt and
2. THEORITICAL FRAMEWORK AND LITERATURE
avoiding economic
permanent increase
downturns. When there
in tax and/or decrease
is
in
According to Blanchard (2011), deficit is the amount
of money which a government can borrow during a
period of time, and to the budget deficit of the year,
t is given as:
spending, it reduces the danger of costly fiscal
adjustment in the future thus generating a positive
effect on wealth. According to Agnello et al. (2013),
spending-driven fiscal consolidation programmes
have a better chance of success than tax-driven
Deficitt = rD1 +Gt T (1)
fiscal consolidation and cuts in public investment.
At the same time, interests and inflation rates need
to be carefully addressed as a means of obtaining a
where Dt1 is government debt at the beginning
of year t, r is the constant interest rate, rD is the
real interest payment on the government debt in
period t, Gt is the government spending on goods
and services during year t, Tt is taxes minus transfer
during year t.
Furthermore the government budget constraint
is the change in government debt during a period of
time t which is the same as the deficit during year t:
signal of the successfulness of the fiscal
consolidation programme. As emphasised by Heylen
et al. (2013), when the government is efficient, fiscal
consolidation is more effectively realised. Also, a
government that uses expenditure cut is more
significant in fiscal consolidation than other
governments. With the product market deregulation,
fiscal consolidation policies are significantly more
successful because where there is competition, there
is productivity and growth as well. As emphasised
by Agnello et al. (2013), factors that may have an
Dt Dt1 = Deficit(2)
impact on the probability of having successful fiscal
adjustments are timing of austerity measures, and
the size of the austerity as well as its composition.
If a government runs a deficit,
increases and if it runs a surplus,
decreases. This is expressed as:
the
the
debt
debt
When the consolidation is gradual, it is more
successful than when it is done with full force. On
the other hand, Von Hagen et al. (2002) prove that
when fiscal consolidation lasts for a relatively long
Dt Dt-1 = rDt-1 + Gt Tt (3)
period of time, the adjustment process will last for a
relatively long period, the reverse is higher. The size
where Gt Tt =Primary deficit, Dt Dt1 = change
in the debt, r t1= interest payment.
of the fiscal consolidation programme is determined
by the commitment of the government to achieve
long-term sustainability of public debt (Giavazzi &
Pagano, 1996).
It becomes:
Yet another study was conducted on the
determinants of public debt using panel data for
92
t
Risk governance & control: financial markets & institutions / Volume 7, Issue 1, Winter 2017
various countries by Sinha, Arora and Bansal (2011).
response functions for the 1980s and 1990s in that
Their
results
revealed
the
effect
of
central
study,
he
tested
the
Ricardian
Equivalence
government expenditure, education expenditure and
hypothesis focusing on the effects of government
current account balance on public debt in these
debt on output, price level and interest rates. The
countries.
Similarly,
inflation
and
foreign
direct
results
revealed
significant
negative
relationships
investment of these countries did not determine
between government debt on interest rates, price
public debt in high income groups. It turned out that
level and output.
GDP growth rates were the only variables that affect
While Blanchard and Perotti’s (2002) focus was
debts
the
most
in
all
the
countries.
When
the
on output and private consumption
and Wheeler
average
of
the
public
debt
was
considered,
the
(1999) on interest rates, price level and output; this
forecasts
results
of
countries
with
high
income
study
focuses
on
real
federal
government
tax
revealed a constant increase over the periods while
receipts, real government spending, consumer price
middle income showed that the debt may worsen
index
and
real
federal
interest
payment.
The
over the next 5 years.
question raised and tested is as follows: does the
Two other important studies are by Blanchard
real federal debt respond positively to shocks from
and Perotti (2002) and Agnello et al. (2013) who are
consumer price index, real federal interest payment
of the opinion that positive government spending
as a percentage of GDP, real federal government
shocks increase output and private consumption.
constant tax receipts as a percentage of GDP and
They also contend that the government spending
real government spending as a percentage of GDP in
shocks
have
a
crowding-out
effect
over
private
the USA?
investment while positive tax shocks have a negative
effect on output and private spending. When tax
reforms are implemented alongside labour market
3.EMPIRICAL INVESTIGATION (METHODOLOGY)
reforms, fiscal adjustment increasingly gets
successful. Furthermore, Agnello et al. argue that
3.1.Data and Model Specification
budget deficits, level of public debt, degree of
openness, inflation rates, interest rates as well as
GDP per capital are important to the implementation
of fiscal consolidation. Also, when consolidation is
spending-driven, its implementation period is
shorter than when it is tax-driven. But both types of
fiscal consolidation have longer duration period in
countries out of Europe compared to countries in
Europe which do not significantly affect duration.
Based on the government budget constraint, the
following variables were selected for the US model
using the quarterly data: Federal Debt (FDEBT),
Consumer Price Index (CPI), Federal Interest Payment
(FINTP), Federal Government Current Tax Receipts
(FTAX) and Government Spending on goods and
services (GSPEN).
The functional form of this study is as follows:
Hence, spending cuts bring an economy into
sustainable path for public debt. So far, the studies
FDEBTt = f (CPIt ,FINTP ,GSPENt ,FTAXt )(5)
reviewed by this paper did not examine the effects
of shocks on government debt. The first study to be
considered on the issue is by Blanchard and Perotti
(2002).These scholars carried out a study in order to
identify exogenous changes in fiscal policy and to
further estimate fiscal multiplier both on the tax and
spending side of the government using the
structural VAR. They found out that positive
government spending shocks increase output and
private consumption and have a crowding-out
effects over private investment while positive tax
shocks have a negative effect on output and private
spending. The study is complemented by yet another
which was conducted by Wheeler (1999).This
researcher studied the impact of government debt in
US using variance decomposition and impulse
All the variables are expressed in real terms
and as a percentage of GDP where R stands for real
and Gt for percentage of GDP. As a general trend,
most economic time series tend to exhibits strong
trends with time, hence the data is transformed into
logarithmic values. This brings about a stable
pattern in the data over time and avoids
heteroskedasticity throughout the period of study.
Asteriou and Hall (2006) argue that this brings about
the elimination of fluctuation tendencies when
individual variables are expressed as logarithms. The
coefficients of such variables are interpreted as
elasticities. Therefore, the debt reduction model for
the USA using quarterly data is expressed as follows:
l(RFDEBTt ) = o + 1l(CPIt ) + 2l(RFINTPGt ) + 3l(RGSPENGt ) + 4l(RFTAXGt ) +t (6)
3.2. Estimation Techniques
their low power in their null hypothesis against the
alternative for stationarity (Dejong, Nankervis, Savin
The Variance decomposition and the GIRF are
estimated based on the VAR model to reveal the
dynamics of the variables of interest. The steps
involved are as follows:
and Whiteman, 1992). The NP test deals with these
problems by detrending through the Generalised
Least Square (GLS) estimator. This helps to improve
the power of the test when there is a large
Autoregressive (AR) root and when there is
3.2.1.The Ng Perron (NP) unit root test
reduction in the size of distortion if there is a large
negative Moving Average (MA) root in the
In order to analyse the unit root conditions of the
variables understudy, the NP unit root test was
preferred over the commonly used Augmented
differenced series. Also, NP test modifies lag
selection criteria accounts, hence avoiding the choice
of wrong lag length. After a stationarity test, the
Dickey-Fuller and the Phillip-Perron tests because of
93

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