Topic 8

Fiscal policy, the deficit, and the national debt

JB Nnyanzi, Ph.D.
26th June, 2022

Outline
• Introduction: Definition and objectives of fiscal policy
• Government Budgets
- Government Revenue and sources (Taxes, Government borrowing)

- Government Expenditure: Types and Determinants

- Budget balance, budget deficits/Surplus

• The Government Debt

• Fiscal Policy
- Tools of Fiscal Policy and Multipliers

- Expansionary and Contractionary Fiscal Policy

- Discretionary Fiscal Policy vs. Automatic Stabilizers

- Fiscal sustainability

- Fiscal Policy Management in Uganda

A. Introduction: Definition and objectives of fiscal policy

Definition
Fiscal policy refers to the taxation, expenditure and borrowing by the government. The
economists now hold the government intervention through fiscal policy is essential in the matter
of overcoming recession or inflation as well as of promoting and accelerating economic growth.
The fiscal policy is concerned with the raising of government revenue and incurring of
government expenditure. The government frames a policy called budgetary policy or fiscal
policy. So, the fiscal policy is concerned with government expenditure and government revenue.
Fiscal policy has to decide on the size and pattern of flow of expenditure from the government to
the economy and from the economy back to the government.
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Objectives of Fiscal Policy
Governments have several objectives in mind when deciding on fiscal policy. The principal ones
are listed below, though they are not necessarily considered in the same fashion in all countries.
1) Full Employment or employment generation
One of the government’s main objectives is to keep and get people into work. Not only do
governments benefit from higher taxes, but also from lower expenditures on social security. An
expansionary policy may look to invest in infrastructure which would directly create
employment. Alternatively, it may reduce taxes to give consumers more money to indirectly
stimulate employment from their purchases.
Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and
duties on small and medium industrial (SMEs) units encourage more investment and
consequently generates more employment.
2) Economic Growth
As an economy grows, its citizens, on the whole, become more prosperous. So this is an
important objective. At the same time, governments must be careful. An aggressive expansionary
fiscal policy could prove detrimental in the long-term.
Economic growth objective can be achieved by effective mobilization of financial resources via:
a) Taxation: Through effective fiscal policies, the government aims to mobilize resources by
way of direct taxes as well as indirect taxes because most important source of resource
mobilization is taxation.
b) Public Savings: The resources can be mobilized through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.
c) Private Savings: Through effective fiscal measures such as tax benefits, the government
can raise resources from private sector and households. Resources can be mobilized through
government borrowings by ways of treasury bills, issue of government bonds, etc., loans from
domestic and foreign parties and by deficit financing.
3) Control Debt
Running a budget deficit is not necessarily bad. However, over time it creates more and more
debt. If economic growth and tax receipts do not increase it line, a nation faces an unsustainable
level of debt. A rational fiscal policy would aim to control this before having to take drastic
action.
4) Price stability and Control of Inflation
When an economy is growing strongly, it may experience high levels of inflation (this may
also depend on monetary policy). As 2 percent is generally the target, anything above this is
a cause for concern: particularly if it is consistently above. Even though inflation is a
monetary phenomenon, there are steps governments take to try and stem such. With that said,
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 there is little fiscal policy can do if the money supply has been let loose. Nevertheless,
governments try by increasing taxes to reduce disposable incomes and hence consumption.

Therefore, the government always aims to control the inflation by reducing fiscal deficits,
introducing tax savings schemes, productive use of financial resources, etc.
5) Re-distribution/ Reduction in Inequalities of Income and Wealth
Another aim of the government is to transfer wealth from the rich to the poor. Higher taxes
on the rich can sometimes result in high tax receipts, but this is not always the case. Evasion
and avoidance may occur, or they may in fact just leave the country. Although small
incremental increases may not have such a significant impact in the short-term.

Fiscal policy aims at achieving equity or social justice by reducing income inequalities
among different sections of the society. The direct taxes such as income tax are charged more
on the rich people as compared to lower income groups. Indirect taxes are also more in the
case of semi-luxury and luxury items, which are mostly consumed by the upper middle class
and the upper class. Then government invests a significant proportion of its tax revenue in
the implementation of Poverty Alleviation Programmes to improve the conditions of poor
people in society.

6) Efficient Allocation of Financial Resources

Governments often try to make efficient allocation of financial resources. These resources
are allocated for development activities, which includes expenditure on railways,
infrastructure, etc. While non-development activities include expenditure on defense, civil
servants’ salaries, interest payments, subsidies, etc.
7) Balance of Payments
Reducing the Deficit in the Balance of Payment Fiscal policy attempts to encourage more
exports by way of fiscal measures like exemption of income tax on export earnings,
exemption of central excise duties and customs, exemption of sales tax, VAT, etc.
8) Political
Fiscal policy has inevitably become a political tool that many incumbent governments use in
a bit to get re-elected. A loosening of fiscal policy and greater spending can often win some
‘floating voters’ over.

B. The Government Budget

• The word budget is derived from the Old French bougette (“little bag”). This is a
summary of the central government’s proposals for spending, taxes and the deficit. It is
the major summary document describing fiscal policy in a country. Thus, it is a forecast
by a government of its expenditures and revenues for a specific period of time. In
national finance, the period covered by a budget is usually a year, known as a financial or
fiscal year, which may or may not correspond with the calendar year.

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 • In most parliamentary systems, the budget is presented to the legislature and often
requires approval of the legislature. Through this budget, the government implements
economic policy and realizes its program priorities. Once the budget is approved, the use
of funds from individual chapters is in the hands of government, ministries and other
institutions. Revenues of the state budget consist mainly of taxes, customs duties, fees
and other revenues. The budget in itself does not appropriate funds for government
programs, hence need for additional legislative measures.
• The budget is the principle instrument or primary document of fiscal policy. Budgetary
policy exercises control over size and relationship of government receipts and
expenditures. Because Parliament modifies the proposals and because of unanticipated
events, the actual budget differs considerably from the proposed budget.
• Fiscal policy is the use of the central government budget to achieve macroeconomic
objectives such as full employment, sustained long-term economic growth, and the price
level stability.
Proposed Budget versus the Actual Budget
The budget the president submits is only a proposal. The actual amount of tax revenues and
spending during the fiscal year are quite different from what is proposed. There are two main
reasons for this difference.
• First, parliament usually modifies the president’s budget, adding some programs and
deleting others. Parliament deliberates on specific items in the president’s budget
proposal for months before the fiscal year actually starts. After the president’s budget has
been debated and modified, it is passed by parliament. Only when the president signs the
legislation is the budget enacted into law. Because of this parliamentary modification, the
enacted budget is always different from the proposed budget.
• Second, because of changes in the economy and other unanticipated events such as wars
and natural disasters, the actual amounts of spending and taxes will be different from
what is enacted. After the fiscal year has begun and the budget has been enacted, various
supplementals are proposed and passed. A supplemental is a change in a spending
program or a change in the tax law that affects the budget in the current fiscal year. In
addition, recessions or booms always affect tax revenue and spending to some degree.

Government Revenue and sources

• The main sources of government revenues are taxes (personal income taxes, corporate
income taxes, indirect taxes, investment income) and social contributions made directly
by or on behalf of employees.
• A lower share of revenues comes from sales by the general government (e.g. user fees for
the provision of services), grants, and other sources (e.g. property income).

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Budget Balance:
The government’s budget balance is equal to its revenues minus its outlays. Outlays or
expenditure are classified in three categories:
• Transfer payments i.e. payments to individuals, businesses, other levels of government,
and the rest of the world. Examples: unemployment cheques, welfare payments to
individuals, farm subsidies, grants to local governments, aid to other countries, dues to
international organizations such as United Nations.
• Expenditures on goods and services. Examples – national defense, computers for
Customs and Revenue agency, government cars, highways etc.
• Debt interest i.e. interest on the government debt
Thus, taxes to pay for the spending programs are also included in the budget. As part of the
budget, the president may propose an increase or a decrease in the taxes. Tax revenues are the
total amount of money the government receives from tax payers each year.
• A surplus budget occurs when there is greater tax revenue than government spending or
outlays (T>G).
• A balanced budget occurs when tax revenue is exactly equal to government spending or
outlays (T=G).
• A deficit budget occurs when tax revenue is less than government spending or outlays
(T<G). Here the government must borrow to pay the difference.
Budgetary Policy
• The budget is the principle instrument of fiscal policy. Budgetary policy exercises control
over size and relationship of government receipts and expenditures. There are two
common budget policies that can be adopted for stabilizing the economy.
a) Budget Deficit-Fiscal Policy during depression
• Deficit budgeting is an important method of overcoming depression. When government
expenditures exceed receipts, larger amounts are put into the stream of national income than
they are withdrawn. The deficit represents the net expenditure
of the government which increases national income by the multiplier times the increase in net
expenditure. Thus the budget deficit has an expansionary effect on aggregate demand
whether the fiscal process leaves marginal propensities unchanged or whether a redistribution
of disposable receipts occurs.
• Budget deficit may also be secured by reduction in taxes and without government spending.
Reduction in taxes tends to leave larger disposable income in the hands of the people and
thus stimulates increased consumption expenditure. This, in turn, would lead to increase in
aggregate demand output, income and employment. However, reduction in taxes is not so
expansionary via increased consumption expenditure because the tax relief may be saved and
not spent on consumption.
b) Surplus Budget-Fiscal Policy during Boom

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 Surplus in the budget occurs when the government revenues exceed expenditures. The policy
of surplus budget is followed to control inflationary pressures with in the economy. It may be
through increase in taxation or reduction in government expenditures or both. This will tend
to reduce income and aggregate demand by the multiplier times the reduction in government
and private consumption expenditure. There may be budget surplus without government
spending when taxes are raised. Enhanced taxes reduce the disposable income with the
people and encourage reduction in consumption expenditure. The result is fall in aggregate
demand, output, income and employment.

C. Fiscal policy – tools, types and management

Instruments of Fiscal Policy / Fiscal policy tools
• There are two main policy tools that federal governments have at their disposal in order
to regulate their economies, both in the short-run and long-term: taxation and spending.
These two tools are referred to collectively as “fiscal policy.”
• Whilst they are somewhat interlinked, they are not completely dependent on each other.
Fiscal policy through variations in government expenditure and taxation profoundly
affects national income, employment, output and prices.
a) Taxation as a Fiscal Tool
• Governments use taxation as a way of funding expenditures. However, higher taxes are
generally unpopular with voters. Yet they generally want greater spending in areas such
as education, defense, and healthcare. So there is a tough balancing act that most
governments don’t follow; frequently spending more than they receive in taxes.
• The ‘big’ types of taxation such as sales and income are generally left untouched.
However, governments have developed other means that are less politically sensitive. For
instance, inheritance tax, corporation tax, land tax, and so on. In turn, these types allow
government to raise revenue without drastically affecting its popularity among the
masses.
• Consequently, these methods are used to essentially control their expenditure, allowing
greater flexibility at a lower political cost. However, higher taxes do not necessarily mean
higher revenue – as the Laffer Curve demonstrates. So governments must tread a fine line
in maximizing revenue.
Uganda’s case:
Taxes Total tax collections for the period July 2021 to April 2022 amounted to UShs. 16,248.81 billion
against a target of UShs. 16,923.20 billion resulting in a shortfall of UShs.674.39 billion. Cumulatively,
income tax collections amounted to UShs. 5,425.78 billion against a target of UShs. 5,661.46 billion
registering a deficit of UShs. 235.68 billion. Despite the shortfall, there was a growth of 6.9percent
(UShs. 349.11 billion) compared to the same period of FY 2020/21. Deficits were mainly registered under
the categories of corporate income tax (UShs. 214.44 billion), withholding tax (UShs. 126.74 billion) and
rental income tax (UShs. 122.14 billion). Consumption taxes collections amounted to UShs. 4,033.28
billion against the target of UShs. 4,788.87 billion registering a shortfall of UShs. 755.59 billion. Despite

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the shortfall, there was growth of 9.2percent in revenue collections compared to FY 2020/21. On the
upside, however, trade taxes have registered a cumulative surplus of UShs. 206.30 billion against the
target of UShs 6,778.62 billion. This also represents a 12.0percent growth in revenues collections as
compared to the same period FY 2020/21. The annual projected tax collection is estimated at UShs.
19,941.1 billion.

General Aims of Taxation

• The general aim of taxation as fiscal policy is to fund expenditure.
• However, it is also used to help stimulate the economy; particularly during a recession.
Governments can do this by reducing the level of taxation.
- To explain; more money in private hands can boost consumer confidence and
spending. If each household has an additional $1,000, that means more money can be
spent in the economy.
- At the same time, more money in private hands means less for government spending.
However, it is far cheaper to reduce taxes in a recession than an economic boom. This
is because there are fewer jobs (lower income tax receipts) and lower corporate
profits (lower corporate tax receipts). So the opportunity cost is lower.
There are also several other non-revenue objectives of taxation:
i) Regulating Consumption
Governments may look to dis-incentivize the consumption of demerit goods such as
cigarettes or sugary soft drinks.
ii) Protecting Domestic Industries
Tariffs or taxes on imported goods make international alternatives more expensive. In turn,
domestic companies can compete more effectively on price.
iii) Encourage Investment
Surcharges on goods such as oil and gas make it more expensive for consumers. In turn, this
can impact on consumption, thereby reducing profits. Such companies may then look to
diversify into other areas such as renewable energy where the tax regime is not so strict. iv)
Reduce Inequality
Perhaps one of the most prominent aims in society today is for taxation to reduce inequality.
b) Spending as a Fiscal Tool
• Government spending is another type of fiscal policy and plays an important part in
shaping the overall economy.
• An increase in public expenditure during depression add the aggregate demand for goods
and services and leads to a large increase in income via the multiplier process, while a
reduction in taxes has the effect of raising disposable income thereby increasing
consumption and investment expenditures of the people.
• On the other hand, a reduction of public expenditure during inflation reduces aggregate
demand, national income, employment, output a nd prices while an increase in taxes
tends to reduce disposable income, and thereby reduces consumption and investment
expenditures.

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 • Thus the government can control deflationary and inflationary pressures in the economy
by a judicious combination of expenditure and taxation programmes.
Aims of Government Spending
The general aim of government spending is to deliver on its key responsibilities such as defense,
and law and order. However, over the past 100 years, it has developed into a social structure to
protect the poor, vulnerable, and needy.
The aims of government spending developed from the desire to obtain social justice and
redistribution. They can be summarized below:
i) Reduce Inequality
Social security is a prominent method by which governments aim to reduce inequality
through redistribution.
ii) Public Support
Governments spend money in order to gain public support. If the public see more ‘free’
public services opening, they are more likely to favour the existing government.
iii) Increase Economic Growth
Higher government spending has the potential to increase economic growth. However, it
depends at what point of the business cycle it occurs at. For instance, when going through an
economic boom, it is unlikely to help as it starves private firms of capital. At the same time, if
spending is stimulated through borrowing, it may improve the economy in the short-term, but
will cause greater problems in the long term. iv) Defense
There is a constant global threat from international powers. Not only physically, but also in
terms of intellectual property and other non-physical attacks. For instance, cyber-crime has
become an increasingly prominent issue in national defense.
v) Law and Order
Traditionally seen as a service that the private sector would be unable to offer. Therefore, it is
in the interest of all parties to ensure there is a deterrent.

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Expansionary and Contractionary Fiscal Policy
There are two types of fiscal policy:
a) Contractionary fiscal policy
• Contractionary fiscal policy is a type of fiscal policy in which the government collects
more money in tax revenue than it spends—these types of policies are usually used
during times of economic prosperity. To enact contractionary fiscal policy, the
government may decrease spending, increase taxes, and enact a combination of decreased
spending and increased taxation.
• Contractionary policy is used in times of economic prosperity because it: i) Slows
inflation
During times of high economic growth, inflation can often jump to dangerous rates,
quickly devaluing currency and worrying consumers. To slow inflation, governments
may enact contractionary fiscal policy in order to decrease the money supply and
aggregate demand, which will lead to decreased output and lower price levels.
ii) Paces economic growth
While economic growth is a sign of a healthy economy, the ideal growth is slow and
steady—if, on the other hand, economic growth spikes too severely, it can mean that
a recession will follow in order to compensate. To ensure a slow, steady pace through
the business cycle (a term in Keynesian economics for the natural boom-bust
economic rhythm), governments can enact contractionary fiscal policy to maintain the
aggregate demand curve, reduce citizens’ disposable income, and continue a healthy
economic growth rate at 3 percent.
iii) Keeps unemployment at optimal levels

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 Lowering the unemployment rate may seem like an important issue for governments,
but zero unemployment can actually have a negative effect on the economy. A
concept known as the natural level of unemployment—the level in which an economy
is perfectly balanced between workers and employers— suggests that there will
always be some level of unemployment, whether or not the economy is performing
well. If unemployment dips lower than the natural level of unemployment, businesses
start to struggle to find employees—and the economy suffers. Contractionary fiscal
policy stops the unemployment rate from going below optimal levels, maintaining it
at what economists call “full employment,” which is when unemployment reaches its
lowest point without causing inflation.
iv) Reduces government debt
When the economy is booming, governments may make use of contractionary fiscal
policy in order to reduce the government’s budget deficit and the national debt,
saving money for future times when expansionary policy may be necessary.
b) Expansionary fiscal policy
• In expansionary fiscal policy, the government spends more than it taxes—either by
decreasing tax rates, increasing transfer payments, increasing spending, or all three.
• This type of fiscal policy is best used during times of economic downturn, and it can
increase a country’s gross domestic product (GDP) through a principle called the “fiscal
multiplier” (or the amount in which government spending can increase the national
income).
• Expansionary fiscal policy is the opposite of contractionary fiscal policy.

Compensatory Fiscal Policy

• The compensatory fiscal policy aims at continuously compensating the economy against
chronic tendencies towards inflation and deflation by manipulating public expenditures
and taxes. It, therefore, necessitates the adoption of fiscal measures over the long run
rather than once for all measures at a point of time.
• When there are deflationary tendencies in the economy, the government should increase
its expenditures through deficit budgeting and reduction in taxes. This is essential to
compensate for the lack in private investment and to raise effective demand employment,
output and income with in the economy.
• On the other hand, when there are inflationary tendencies, the government should reduce
its expenditures by having a surplus budget and raising taxes in order to stabilize the
economy at the full employment level.

Discretionary, Automatic and Fiscal Policy Multipliers

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 • Fiscal policy actions can be either automatic or discretionary. That is, the compensatory
fiscal policies have two approaches: Discretionary fiscal policy and Nondiscretionary
fiscal policy or automatic stabilizers.
Discretionary fiscal policy
• Discretionary fiscal policy means deliberate change in the government expenditure and
taxes to influence the level of national output and prices.
• It is a policy actin that is initiated by an act of Parliament. It requires a change in tax laws
or in some spending programs. E.g. a cut in tax rates or an in increase in defence
spending.
• Discretionary fiscal policy uses two tools. They are the budget process and the tax code.
• At the time of recession, the government increases its expenditure, cuts down taxes, or
adopts a combination of both. On the other hand, to control inflation the government cuts
down its expenditure or raises taxes. In other words, to cure recession expansionary fiscal
policy and to control inflation contractionary fiscal policy is adopted.
• When the government adopts expansionary fiscal policy to cure recession, it raises its
expenditure without raising taxes or cut down taxes without changing expenditure or
increases expenditure and cuts down taxes as well. With the adoption of any of these
types of expansionary fiscal policy government’s budget will have a deficit.
• Thus expansionary fiscal policy to cure recession and unemployment is a deficit budget
policy. On the other hand, to control inflation, government reduces its expenditure or
increases taxes or adopts a combination of the two, it will be planning for a budget
surplus. Thus policy of budget surplus or at least reducing budget deficit is adopted to
remedy inflation.
• Discretionary fiscal policy requires deliberate changes in the budget by such actions as
changing tax rates or government expenditures or both. It may generally take three forms:
i) Changing taxes with government expenditure constant, ii)
Changing government expenditure with taxes constant and iii)
Variations in both expenditures and taxes simultaneously.
• The First method is, when taxes are reduced, while keeping government expenditure
unchanged, they increase the disposable income of household and businesses.
- This increases private spending, but the amount of increase will depend on whose
taxes are cut, to what extent and on whether the taxpayers regard the cut temporary or
permanent.
- If the beneficiaries of tax cut are in the higher middle-income group, the aggregate
demand will increase much.
- If they belong to the lower income group, aggregate demand will not increase much.
- If they are businessmen with little incentives to invest, tax reduction will not induce
them to invest.
- Lastly, if the tax payers regard tax reductions as temporary, this policy will again be
less effective so this policy is more effective in controlling inflation by raising taxes

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 because high rate of taxation will reduce disposable income of individuals and
businesses there by curtailing aggregate demand.
• The second method is more useful in controlling deflationary tendencies,
- when the government increases its expenditure on goods and services, keeping taxes
constant, aggregate demand goes up by the full amount of the increase in government
spending.
- On the other hand, reducing government expenditure during inflation is not so
effective because of high business expectations in the economy, which are not likely
to reduce aggregate demand.
• The third method is more effective and superior to the other two methods in controlling
inflationary and deflationary tendencies.
- To control inflation, taxes may be increased and government expenditure reduced.
- On the other hand, taxes may be increased and government expenditure be raised to
fight depression.
Non-discretionary fiscal policy – Automatic stabilizers
• This is a change in fiscal policy that is triggered by the state of the economy. E.g., an
increase in unemployment triggers an automatic increase in payments to the unemployed. A
fall in incomes triggers an automatic decrease in tax revenues.
• That is, this type of fiscal policy adjusts automatically.
• It is a built-in tax or expenditure mechanism that automatically increases aggregate demand
when recession occurs and reduces aggregate demand when there is inflation in the economy
without any special deliberate actions on the part of the government. These are built-in-
stabilizers.
• The technique of built-in flexibility or stabilizers involves the automatic adjustment of the
expenditures and taxes in relation to cyclical up swings and down swings with in the
economy without deliberate action on the part of the government. Under this system changes
in the budget are automatic and hence this technique is also known as one of automatic
stabilization.
• The various automatic stabilizers are corporate profits tax, income tax, excise taxes, old age,
survivors and unemployment insurance and unemployment relief payments.
• In the downward phase of the business cycle when national income is declining, taxes which
are based on a percentage of national income automatically decline, thereby reducing the tax
yield. At the same time, government expenditures on unemployment relief and social security
benefits automatically increase.
• Thus there would be an automatic budget deficit, which would counteract deflationary
tendencies.
• On the other hand, in the upward phase of the business cycle when national income is rising
rapidly, the tax yield would automatically increase with the rise in tax rates. Simultaneously,
government expenditures on unemployment relief and social security benefits automatically
decline. These two forces would automatically create a budget surplus and thus inflationary
tendencies would be controlled automatically.

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In conclusion, automatic stabilizers reduce the intensity of business fluctuations, which is both
recession and inflation; however, the automatic or built-in stabilizers cannot alone correct the
recession and inflation significantly. Therefore, the role of discretionary fiscal policy, namely,
deliberate and explicit changes in tax rates and amount of government expenditure are required
to cure recession and curb inflation.

Fiscal policy multipliers

• The fiscal multiplier measures the effect that increases in fiscal spending will have on a
nation's economic output, or gross domestic product (GDP). In general, economists define
fiscal multipliers as the ratio of a change in output to a change in tax revenue or government
spending.
• Generally, they are defined as the ratio of a change in output (ΔY) to a discretionary change
in government spending or tax revenue (ΔG or ΔT).
- Thus, the fiscal multiplier measures the effect of a $1 change in spending or a $1
change in tax revenue on the level of GDP.
• Multipliers commonly used:
Y
Government expenditure multiplier 
G

Y MPC
Autonomous tax multipl rie  
T 1 MPC

Y MPC
Autonomous transfer payments multiplier   TR 1
MPC

where t can be a quarter or a year depending on the frequency of the data that is used in the
study.
The “overall” multiplier describes the output response to an unspecified fiscal shock, while the
“revenue” (“spending”) multiplier relates output to a discretionary change in revenue (spending).

D. The Deficit and Government Debt

Figure 1: Evolution of Debt in Uganda

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 • The government borrows to finance its deficit.
• Government debt is the total amount of government borrowing.
• It is the total amount of outstanding loans owed by the central government. If the
government runs a surplus, the debt comes down by the amount of the surplus. If there is
a deficit, the debt goes up by the amount of the deficit.
• It is the sum of the past deficits minus the sum of past surpluses.
The Debt to GDP Ratio
• When looking at the debt and the deficit over time, it is important to consider the size of
the economy. For example, a $4 trillion debt may not be much of a problem for an
economy with a GDP of $10 trillion but could be a problem overwhelming for an
economy with a GDP of $1 trillion.
• An easy way to compare the debt to the size of the economy is to measure the debt as a
percentage of GDP – the debt to GDP ratio. It is appropriate to consider the ratio of debt
to nominal GDP rather than real GDP because the debt is stated in current dollars just as
nominal GDP.
• The debt to GDP ratio is a good overall gauge of how government is doing in managing
its fiscal affairs.
Debt and capital
• When government borrows, (i.e. incurs a debt), it does so to buy or buy capita (i.e. assets
that yield a return) in addition to consumption expenditure.
• Some government expenditure is thus used for investment – purchase of public capital
that yields a return.
• Highways, major irrigation schemes, public schools and universities, public libraries and
the stock of national defence capital – all yield a social rate of return that probably far
exceeds the interest rate the government pays on its debt.

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 • But this government debt might be much larger than the value of the public capital stock.
This means that some government debt has been incurred to finance public consumption
expenditure.
• From figure below:
- On average, the total government debt in East Africa was estimated at 72.5 percent of
the region's Gross Domestic Product (GDP) in 2021, increasing from 61 percent in
2020.
- From a country perspective, the debt in 2021 might range from 26.8 percent of the
GDP in Comoros to 175.6 percent of the GDP in Eritrea.
- Except for Tanzania, government debt was projected to increase in all East African
countries in comparison to 2021.

Figure 2: Government debt as a share of the Gross Domestic Product (GDP) in East Africa in 2020 and 2021, by country

Monetizing the debt

This refers to the purchase of new debt from the Treasury by the central bank reserve. A policy
of monetizing the debt risks causing inflation, especially if the increase in the money supply is
large and continues over a long period. An indebted country must repay the principal on its debt
and service it with interest payments. To do so, it must either engage in new borrowing, raise tax
revenues, or monetize the debt.
Twin deficit

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As we have seen, a deficit can refer to a government’s finances (budget deficit) or to a country’s
trade balance (trade deficit). Twin deficit identity is used to refer to a nation’s current account
deficits and a simultaneous fiscal deficit.
If a country has positive net exports, it means that it will have a surplus of funds (foreign
exchange) to lend to other countries. If, in contrast, a country has negative net exports, it
typically must borrow from foreigners, essentially to pay for the difference. If the government
budget is in deficit, this tends to create or increase a trade deficit, unless it is financed by a
surplus of domestic savings—which has generally not been the case for the Uganda. Thus, while
the two deficits do not move together in lockstep, they will usually broadly move in the same
direction.

Problems Measuring the Deficit

1. Inflation

• To see why inflation is a problem, suppose the real debt is constant, which implies a zero
real deficit. In this case, the nominal debt D grows at the rate of inflation: D D/  
or  D D
- The reported deficit (nominal) is πD even though the real deficit is zero.
- Hence, should subtract πD from the reported deficit to correct for inflation.
• Correcting the deficit for inflation can make a huge difference, especially when inflation
is high.
• Example: If nominal deficit = $28 billion, inflation = 8.6%, debt = $495 billion D
0.086 $495b $43b real deficit  $28b$43b  $15 b surplus

2. Capital assets

• Currently: deficit = change in debt

• Better: Capital budgeting deficit = (change in debt) − (change in assets)
• Example: Suppose government sells an office building and uses the proceeds to pay
down the debt.
- Under current system, deficit would fall
- Under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in
assets
• The problem with capital budgeting is determining which government expenditures count
as capital expenditures.
3. Uncounted liabilities

• Current measure of deficit omits important liabilities of the government:

- future pension payments owed to current govt workers
- future Social Security payments
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 - contingent liabilities (though hard to attach a dollar value when the outcome is
uncertain)
4. The business cycle

• The deficit varies over the business cycle due to automatic stabilizers (unemployment
insurance, the income tax system).
- These are not measurement errors, but do make it harder to judge fiscal policy stance.
• EX: Is an observed increase in deficit due to a downturn or expansionary shift in fiscal
policy?

NOTE:
Based on the above, we must therefore exercise caution when interpreting deficit figures.
Standard figures on the deficit are imperfect measures of fiscal policy because they
- are not corrected for inflation
- do not account for changes in government assets
- omit some liabilities (e.g. future pension payments to current workers) - do not
account for effects of business cycles

Is the government debt really a problem?

• Two viewpoints:
1) Traditional view
2) Ricardian view
The traditional view of a tax cut & corresponding increase in government debt
• In the Short run, GDP increase and unemployment reduces (↑Y, ↓u)  In the Long run:
- GDP (Y) and unemployment (u) are back at their natural rates
- For a closed economy, interest rates increase and investment falls: ↑r, ↓I
- For an open economy, exchange rates increase and net exports fall: ↑ε, ↓NX (or
higher trade deficit)  In the Very long run:
- there is slower growth until economy reaches new steady state with lower income per
capita
• In summary: In the traditional view, a debt-financed tax cut increases consumption and
reduces national saving. In a closed economy, this leads to higher interest rates, lower
investment, and a lower long-run standard of living. In an open economy, it causes an
exchange rate appreciation, a fall in net exports (or increase in the trade deficit).

The Ricardian View

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 - due to David Ricardo (1820), more recently advanced by Robert Barro
- According to Ricardian equivalence, a debt-financed tax cut has no effect on
consumption, national saving, the real interest rate, investment, net exports, or real
GDP, even in the short run.
- In summary: The Ricardian view holds that debt-financed tax cuts do not affect
consumption or national saving, and therefore do not affect interest rates, investment,
or net exports.
The logic of Ricardian Equivalence
- Consumers are forward-looking, i.e. know that a debt-financed tax cut today implies
an increase in future taxes that is equal---in present value---to the tax cut.
- Thus, the tax cut does not make consumers better off, so they do not raise
consumption.
- They save the full tax cut in order to repay the future tax liability.
- Result: Private saving rises by the amount public saving falls, leaving national saving
unchanged.
Problems with Ricardian Equivalence
• Myopia:
- Not all consumers think that far ahead, so they see the tax cut as a windfall.
• Borrowing constraints:
- Some consumers are not able to borrow enough to achieve their optimal consumption,
and would therefore spend a tax cut.
• Future generations:
- If consumers expect that the burden of repaying a tax cut will fall on future
generations, then a tax cut now makes them feel better off, so they increase spending.
Evidence against Ricardian Equivalence? US Economy
• Early 1980s:
- Huge Reagan tax cuts caused deficit to rise.
- National saving fell, the real interest rate rose, the exchange rate appreciated, and NX
fell.
• 1992:
- President George H.W. Bush reduced income tax withholding to stimulate economy.
- This merely delayed taxes but didn’t make consumers better off.
- Yet, almost half of consumers used part of this extra take-home pay for consumption.
• Proponents of R.E. argue that the Reagan tax cuts did not provide a fair test of R.E.
• Consumers may have expected the debt to be repaid with future spending cuts instead of
future tax hikes.
• Private saving may have fallen for reasons other than the tax cut, such as optimism about the
economy.

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NOTE:
Because the deficit data is subject to different interpretations, both views of government debt
survive.

Other perspectives on government debt

1) Balanced budgets vs. optimal fiscal policy
• Some politicians have proposed support balanced central government budget every year.
• However, many economists reject this proposal, arguing that deficit should be used to
- stabilize output & employment
- smooth taxes in the face of fluctuating income
- redistribute income across generations when appropriate
• In summary: Most economists oppose a strict balanced budget rule, as it would hinder the
use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across
generations.
2) Fiscal effects on monetary policy
• government deficits may be financed by printing money
• a high government debt may be an incentive for policymakers to create inflation (to
reduce real value of debt at expense of bond holders)  Fortunately:
- little evidence that the link between fiscal and monetary policy is important
- most governments know the folly of creating inflation
- most central banks have (at least some) political independence from fiscal
policymakers
3) Debt and politics
• “Fiscal policy is not made by angels…” - Greg Mankiw, p.424
• Some do not trust policymakers with deficit spending. They argue that
- policymakers do not worry about the true costs of their spending, since the burden
falls on future taxpayers
- future taxpayers cannot participate in the decision process, and their interests may not
be taken into account
• This is another reason for the proposals for a balanced budget amendment, discussed
above.
4) International dimensions
• Government budget deficits can lead to trade deficits, which must be financed by
borrowing from abroad.
• Large government debt may increase the risk of capital flight as foreign investors may
perceive a greater risk of default.
• Large debt may reduce a country’s political clout in international affairs.
• In summary: Government debt can have other effects:
- may lead to inflation
- politicians can shift burden of taxes from current to future generations
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 - may reduce country’s political clout in international affairs or scare foreign investors
into pulling their capital out of the country

Limitations of fiscal policy:

1) Policy Lags:
During the recent times, there is not much argument about the desirability or otherwise of a
discretionary fiscal policy. The burning question in this context is related with the timing of the
fiscal measures. Unless the variations in taxes and public expenditure are neatly timed, the
desired counter-cyclical effects cannot be realized.
There is generally some interval between the time when a particular action is needed and the time
when a fiscal measure has its impact felt. The duration of this interval determines the extent to
which a specific fiscal measure can be effective. This time interval comprises of three types of
lags-recognition lag, administrative lag and operational lag.
(а) Recognition Lag:
This is the interval between the time when action is needed and when it is recognized that action
is needed. This lag may exist when a change in the economy and a report concerning the change
do not coincide. Such a lag has a duration of 3 months. It can be reduced if the forecasting is
satisfactory.
(b) Administrative Lag:
This is the interval between the time when need of an action is recognized and the time when the
action is actually taken. This is perhaps the most difficult lag to deal with. Even when the need of
action has been recognized, the sanction from legislature and executive must take some time and
that may involve about 1 to 15 months of time.
In order to reduce such a lag and to minimize the legislative and executive red-taps, it is
important to keep a shelf of public works in readiness. The recognition and administrative lags
together determine the inside lag of the fiscal policy and its length, according to Willes, is 4 to 18
months.
(c) Operational Lag:
The time interval between when action is taken and when it has its impact on income and
employment is known as the operational or the outside lag. It is possible that a change in
personal income taxes for example produce significant changes in disposable money income and
consumption within a month or two; changes in the corporate tax structure produce changes in
corporate spending in about 3 or 4 months. The outside lag of fiscal policy could have a short
duration of 1 to 3 months only.
2) Forecasting:

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Another most serious limitation of fiscal policy is the practical difficulty of observing the coming
events of economic instability. Unless they are correctly observed the amount of revenue to be
raised, the amount of expenditure to be incurred or the nature and extent of budget balance to be
framed cannot be suitably planned. In fact, success of fiscal measures depends on the accurate
predictions of various economic activities. In its absence, it proves to be a little bit erratic.
3) Correct Size and Nature of Fiscal Policy:
The most important necessity on which the success of fiscal policy will depend is the ability of
public authority to frame the correct size and nature of fiscal policy on the one hand and to
foresee the correct timing of its application on the other. It is, however, too much to expect that
the government would be able to correctly determine the size, nature of composition and
appropriate execution-time of fiscal policy.
4) Fiscal Selectivity:
When monetary policy is general in nature and impersonal in impact, the fiscal policy, in
contrast, is selective. The former permits the market mechanism to operate smoothly. The latter,
on the contrary, encroaches directly upon the market mechanism and gives rise to an allocation
of resources which may be construed as good or bad depending upon one’s value judgements. A
particular set of fiscal measures may have an excessively harsh impact upon certain sectors,
while leaving others almost unaffected.
5) Inadequacy of Fiscal Measures:
In anti-depression fiscal policy, the expansion of public spending and reduction on taxes are
always important elements. The question arises naturally, whether a specific variation in public
spending or taxes will bear the desired results or not. In case the injections or withdrawals from
the circular flow are more or less than what are required, the system will fail to move in the
desired direction. This results in exaggeration of instability in the economy.
6) Adverse Effect on Redistribution of Income:
It is felt that fiscal policy measures redistribute income, the actual effect will be uncertain. If
income is redistributed in favour of the low-income classes whose marginal propensity to
consume is high, the effect will be increase in total demand. But the fiscal action will be
contractionary if larger part of the additional income goes to people having higher marginal
propensity to save.
7) Self-offsetting Effect:
The compensatory fiscal policies of the government may discourage private investment, since the
private entrepreneurs have to face a competition from public enterprises in securing labour, raw
materials and finances. Moreover, increased involvement of the government in economic activity
at the onset of recession strengthens the pessimistic expectations of the private entrepreneurs.
The expansion of public spending may be associated with a curtailment of private spending.
Consequently, the fiscal measures may be self-offsetting.

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8) Reduction in National Income:
Balanced budget multiplier as a fiscal weapon can be gainfully applied during depression is
conditioned by the fact of marginal propensity to spend of the recipients of public expenditure
being larger than or, at least, equal to that of the taxpayers. In case it becomes smaller than the
taxpayers, the fiscal programmes under balanced budget will bring about reduction in the
national income.
9) Solution for Unemployment:
The purpose of fiscal policy will be defeated if the policy cannot maintain a rising supply level of
work effort. The money national income will rise with increase in productive efficiency and
increased supply of work effort. But if the tax measures are stringent and too high, they will
certainly affect the incentive to work. This is an important limitation of fiscal policy.
10) Adverse Effect on debt Management:
The use of fiscal instruments during unemployment and depression is often associated with the
subsequent problem of debt management. Because deficit budgeting is the normal fiscal cure,
public debt is made for financing it. And if the process of recovery from depression is long, the
creation of budget deficit year after year will create a huge problem of debt repayment and debt
management.
11) Adverse Psychological Reaction:
Large deficit programmes financed by borrowings bring about adverse psychological reactions.
Rumors of government bankruptcy discourage investors and often flight of capital takes place.

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 are numerous challenges and threats to the sustainability of public finance which
can range from institutional challenges ranging from creating independent fiscal
institutions, fiscal responsibility laws, fiscal rules and the management of fiscal risks to
changing dynamics in the demographic structure of societies.

Fiscal Policy Management in Uganda: Uganda’s debt

• Based on the CFR, the government has adopted two fiscal rules including (i) reducing the
fiscal balance (including grants) to a deficit of 3 percent of GDP by 2020/21, and (ii)
maintaining the public debt in net present value (NPV) terms below 50 percent of GDP
by 2020/21.

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Review Quiz
1) What are the main items of government revenues and outlays?
2) Under what circumstances does the government have a budget surplus?
3) Explain the connection between a government deficit and a government debt.
4) What is the difference between the national debt and a deficit?
5) What does it mean to monetize the debt?
6) What do we mean by “twin deficits”? How are the two types of deficits related?

i) Disposable income is income minus taxes plus transfer payments. TRUE. ii) When actual
investment is greater than planned investment, the economy will grow.
FALSE. If Actual investment is greater than planned, inventories are building up, so firms will
cut back on production, and the economy will contract. iii) When G – T is positive; the
government budget is in surplus.

FALSE. If G > T, government spending exceeds tax revenues, and the budget is in deficit.
iv) If investment increases, the planned aggregate expenditure line on the Keynesian cross
diagram becomes steeper.
FALSE. It shifts up, but does not become steeper.
v) If the MPC increases, the planned aggregate expenditure line on the Keynesian cross diagram
becomes steeper.
TRUE.
vi) In a simple Keynesian model (with lump-sum taxes and a MPC of 0.8), if the government
increases spending by $400 billion and increases taxes by $400 billion, output will increase
by $400 billion. TRUE. The balanced budget multiplier is one.
vii) In a simple Keynesian model (with lump-sum taxes and a MPC of 0.8), a tax cut of $ 20
billion will have less of an impact on GDP than an increase in government spending of $ 10
billion.
FALSE. The tax multiplier would be -4, so a tax cut of $ 20 billion would lead to GDP
increasing by $ 80 billion. The government spending multiplier is 5, so an increase in G of $ 10
would lead to GDP increasing by $ 50 billion.
viii)When taxes are given as a percentage of income, a higher tax rate implies a higher
government spending multiplier.
FALSE - higher income taxes will lead to a lower multiplier.
ix) In an open economy, the government spending multiplier will be lower than in an economy
without international trade.

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TRUE.
x) Which of the following is not an example of fiscal policy?
a) A reduction in income tax
b) An increase in corporation tax
c) A reduction in government spending
d) Higher interest rates

xi) Quantitative easing...

a) places a tax on foreign goods

b) limits the number of foreign products sold in a country
c) involves purchasing assets using central bank money
d) involves increasing the quantity of tax in a country

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