There has been a lot of talk (here, here, here, here, here, and here) about the a potential National government taking on debt for infrastructural investment. Now I’ve got no problem with this, and Roger J Kerr says here we could view it as an intergenerational issue – borrowing allows us the stagger the cost of the capital over time in the same way that the benefits from the capital investment occur over time.
Furthermore, borrowing allows us to fund expenditure that provides economic growth, without having to introduce taxes that limit this growth (although note that future taxes would have to be higher to pay for the borrowing – so we only have a net benefit if growth stemming from the capital investment exceeds the cost of the eventual tax increase!).
However, there are a couple of issue that I hope any government will remember before going into debt to build up infrastructure.
- Only the “right sort” of investment will be beneficial. Fundamentally, the rate of return must be high enough to justify the debt AND the government must be aware of how their investment activity will crowd out private investment.
- Ultimately the tax system still has to be balanced over the economic cycle.
Right sort of investment?
One of the difficulties with government investment is that they don’t see the price signals associated with the optimal level of investment, in the same way that private firms do. As a result, government’s have the propensity to over or under invest, depending on the often fluffy goals that they lay down.
However, the advantage of government investment stems from their ability to improve outcomes when we have a “public good“. As private firms will underinvest in the case of public goods, then the degree of “crowding out” associated with government action is lower (it solely relies on the impact that government involvement has on the price of building inputs). So as long as the rate of return on this investment is high enough to pay for the debt, this is fine.
Balanced tax system?
A balanced tax system is a set of taxes where the government runs a balanced budget over each individual “economic cycle”. This does not mean that the government will always run a balanced budget – in fact, when output is above trend the government should run a surplus, and when it is below trend it should run a deficit. In this (demand driven) view of the economic cycle a surplus or deficit are not an issue – as long as it all balances in the end.
This implies that the government in power needs to realise that there is no free lunch – the debt will need to be paid off in the future. If we are truly borrowing for infrastructure that is fine (given that our first requirement holds), however if we will have to, on average, borrow because spending exceeds taxes, then something has to give!
Another way of viewing a balanced budget is through the lens of supply side shocks. In this case there is no real economic cycle, just a random assortment of supply shocks that give the appearance of a cycle. Here, the positive supply side shocks cause surpluses while the negative ones cause deficits and the tax system does need to adjust to put things back in order. However, from the current standpoint, we do not know whether there will be positive or negative supply shocks in the future, so the best thing to have is a balanced budget.
In truth it is a mix of the demand and supply stories that describes reality – implying that the tax system should remain stable over time, until a sufficiently number of supply shocks force us to move. In a sense this is what Dr Cullen did (although he was effectively increasing taxes by not indexing the them to inflation – thereby breaking this rule!), given the level of expenditure that he wanted to put into place.
As long as National takes this lesson to heart as well then I am sure that no matter which party wins the election, the government finances will remain in good order.