Question

In: Economics

Many people are out of work as a result of COVID-19. This means that they will...

Many people are out of work as a result of COVID-19. This means that they will not be paying as much money in taxes so government revenue will decrease. At the same time, the government spending has increased as the government bails out businesses, increases spending on healthcare, and provides income assistance to a growing number of people. How does declining tax revenue and increasing government spending impact the government debt?

Solutions

Expert Solution

o When there is an increase in the government spending and a fall in tax revenues, it means the government experiences a Fiscal Deficit. In other words, it refers to a situation of negative balances that arises when the government leaks more money than it injects into the financial system during a fiscal year. This deficit caused due to excess spending, in most of the countries, is financed by government borrowing that results into an increase in the National Debt, also known as Government Debt.

o Fiscal deficits are usually financed through sale of government securities especially treasury bills, (to Individuals, Businesses and other foreign governments) which initially reduces the potential capital stock of the economy. A continuous or a constant deficit in an economy adds up to the national debt which increases the amount that the government owns to the security holders.   Sale of government securities also have a direct impact on the economy’s interest rates i.e. the interest rate shoots up.

o Major consequences of large government debt can be listed as below:

1. It may result into diminished economic activity which could be either by crowding out private capital investment or by a forced increase in distortive tax rates along with a decline in public investment so that repayment can be done.

2. Governments that face high debts might be constrained in responding to any future tribulation such as debt crises, natural calamities, wars or pandemics like Covid-19, etc.

3. Governments, in extreme cases, may even default through explicit debt renunciation or may be inflation; the costs of which include – increased stress on financial institutions, lower international financing for firms operating domestically, and decreased access to export market.

It is argued, that a moderate increase in government debt spurs economic growth, but too much of it increases growth at a speedy rate which initially creates boom but ultimately ends into a bust. With an ever-increasing government debt, the security/debt holders demand larger interest payments due to the rising risk of default. In response to this, business in the debtor country makes lesser borrowing that reduces spending and leads to a fall in aggregate demand. Reduced demand results into reduced prices and lower incomes with high unemployment rate, which pushes the economy towards a recession.

In order to reduce national debt, the government can implement Contractionary fiscal policy either by raising taxes or by reducing spending expenditure, but this can be done only at the cost of slow economic growth. However, such tight policies can make the sluggish economy better off in the long run in paying off debt obligation and securing economic stability in the future.


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