CHAPTER II

PUBLIC
EXPENDITURE
POLICY

MARICEL P. GO, MPA

SECOND SEMESTER 2022 - 2023
GOVERNMENT DEBT AND DEFICITS

 Government debt is the stock issued by the government at any time in the past and not yet repaid.
Governments issue debt whenever they borrow from the public; the magnitude of the outstanding debt
equals the cumulative amount of net borrowing that the government has done. The deficit is the
addition in the current period (year, quarter, month, etc.) to the outstanding debt. The deficit is negative
whenever the value of outstanding debt falls; a negative deficit is called a surplus.
 When the government borrows, it gives its creditors government securities stating the terms of the
loan: the principal being borrowed, the interest rate to be paid on the principal, and the schedule for
making the interest payments and principal repayment. The amount of outstanding securities equals the
amount of debt that has not yet been repaid; that amount is called “the government debt.”
 The most important adjustment is for inflation. The real value of that same bond is the
number of units of output that it can buy. The bond’s nominal value is unchanged by
inflation, but its real value is changed. Real, not nominal, values are what matters
because people are interested in how many goods they can buy with the wealth their
bonds represent—which is precisely what the real value measures.
 Another adjustment is for changes in interest rates. The value of outstanding debt
changes as market interest rates change, but newspaper accounts usually report par
values, which do not adjust for interest rate changes. Market values do account for
interest rate changes and can be quite different from par values.
 Conversion to market value can raise or lower the size of the outstanding debt. The market value of
outstanding debt will be greater than the par value if interest rates have fallen on average since the debt
was issued and will be smaller than the par value if rates have risen. The difference between par value
and market value of the outstanding debt is typically a few percentage points. Unfortunately, market
values for the total outstanding government debt are not readily available. Governments do not report
them, which is why newspaper reports rarely mention them.
 More important than the sheer size of government debt are the debt’s effects on the economy.
Economists do not fully agree on what those effects are. When the government borrows, it promises to
repay the lender. To make those repayments the government ultimately will have to raise extra taxes,
beyond what it needs to pay for its other activities. The economic effect of government debt depends
heavily on how taxpayers perceive those future taxes. Perceptions are difficult to measure, and neither
economists nor others understand exactly how people form their perceptions.
 The crucial factor in determining how bond finance affects the economy is whether people recognize
what is going to happen over time. If everybody foresees that future taxes will nullify future payments
of principal and interest, then bond finance is equivalent to tax finance, and government debt has no
effect on anything important.
 If government debt is equivalent to taxation, then most of the public discussion of the “deficit
problem” is misplaced. Under equivalence, government deficits merely rearrange the timing of tax
collections in a way that people can anticipate and offset; no important economic effects arise. With
incomplete equivalence, deficits affect the economy, but the effects are complicated. For example,
suppose people do not recognize any of the future taxes implied by current deficits. In that case,
partially replacing current tax collections with borrowing makes people feel wealthier today, which
induces them to spend more; however, the taxes needed to repay the debt will eventually have to be
collected. Because no one anticipated them, they will come as a surprise, inducing people
unexpectedly to spend less in whatever period the taxes are levied. A deficit or surplus thus has effects
not just in the period when the deficit or surplus occurs, but also in subsequent periods. Predicting the
magnitude and timing of the sequence of effects is difficult.
 In particular, running a deficit in a recession would raise interest rates, which would reduce investment
and economic growth, which in turn would reduce output in the future. Thus, using deficits to
stimulate the economy now to ameliorate a recession comes at the cost of reducing output later.
Whether that is a good exchange is not obvious and requires justification
Advantages of debt financing
 You won’t give up business ownership

One major advantage of debt financing is that you won’t be giving up ownership of the business. When
you take out a loan from a financial institution or alternative lender, you’re obligated to make the
payments on time for the life of the loan, that’s it. In contrast, if you give up equity in the form of stock in
exchange for funding, you might find yourself unhappy about input from outside parties regarding the
future of your business.
 There are tax deductions

A strong advantage of debt financing is the tax deductions. Classified as a business expense, the principal
and interest payment on that debt may be deducted from your business income taxes.
 Low interest rates are available

Credit cards, peer-to-peer lending, short-term loans, and other debt financing isn’t helpful if the interest
rates are sky-high.

 You’ll establish and build business credit

having the ability to build your business credit is a major and crucial advantage to taking out a loan.
When you build your small business’ credit, you reduce the need to rely on your personal credit or other
high-cost business financing options. Good business credit can also help you establish more favorable
terms with vendors.
 Debt can fuel growth

Uses of long-term debt include buying inventory or equipment, hiring new workers and increasing
marketing. Taking out a low-interest, long-term loan can give your company working capital needed to
keep running smoothly and profitably year round. Think of it as the difference of being able to go that
extra mile in your business and make additional profits, opposed to being tied down to a cash-strapped
venture that will never be able to get ahead.
 Debt financing can save a small business big money

Often, small business owners rely on expensive debt, like credit cards, cash advances or lines of credit, to
get their business off the ground. This type of debt cuts into cash flow and can hinder day-to-day
operations. A big advantage of debt financing is the ability to pay off high-cost debt, reducing monthly
payments by hundreds or even thousands of dollars. Reducing your cost of capital boosts business cash
flow.
 Long-term debt can eliminate reliance on expensive debt

There are lenders who use aggressive sales tactics to get businesses to take out short-term cash advances.
Some businesses in need of funds will take five or six cash advances in a row. This strategy can trap a
borrower into a debt cycle with no end in sight. Instead, look to get an SBA loan. SBA loans have low
interest rates, long terms, and low monthly payments. SBA loans can be used to help free small business
owners from borrowing traps.
Disadvantages of debt financing
 You must repay the lender (even if your business goes bust)

When you work with a lender, the rules are pretty clear. You must pay back the loan at the terms agreed
upon. That means, even if your business goes under, you still have to make payments. Since most lenders
require you to guarantee the loan, your assets could be sold to satisfy your debt.
 High rates

Unfortunately, predatory lenders exist and the techniques they use to rope in unsuspecting small business
owners are getting more and more sophisticated. It’s definitely not unique to debt financing, but it is
something to be aware of. Instead of disclosing the true cost of a loan, some unscrupulous lenders will use
methods other than APR. Make sure you are working with a lender who practices transparency and will
give you honest numbers.
 It impacts your credit rating

Each loan you take out for your small business will be noted on your credit rating. Beware, this can cause
your scores to drop. So before you apply for a loan, check with your lender to determine if the credit
check performed to prequalify will affect your score.
 You’ll need collateral

One of the “5 Cs” of lending is collateral. The SBA defines collateral as an additional form of security
that can be used to assure a lender that you have a second source of loan repayment. If an asset can be
sold by the bank for cash, it’s considered collateral. Items like equipment, buildings and (in some cases)
inventory qualify.