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Methods of financing the deficit and use of a surplus

This tutorial was written by
Ken Edge
Head Teacher Social Science
Cardiff High School

Outcomes
Overview
Content
Review exercises
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Outcomes

HSC Topic Four: Economic Polices and Management is described in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 40 to 42. The specific outcomes from the syllabus for this tutorial are listed below.

A student:

H1	demonstrates understanding of economic terms, concepts and relationships
H2	analyses the economic role of individuals, firms, institutions and governments
H5	discusses alternative policy options for dealing with problems and issues in contemporary and hypothetical contexts
H6	analyses the impact of economic polices in theoretical and contemporary Australian contexts
H7	evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments.

Overview

The main economic objectives of the Government are to maintain an underlying cash balance, increase the level of national savings, reduce government debt and improve the current account deficit (CAD).

However, the Commonwealth Government, like any other business or household, has to find other sources of funds when its level of expenditure is greater than its income. Such a situation occurred during the early and mid 1990s.

The fiscal stance of the Labor government during that time was expansionary, in its attempt to counter the impact of the 1990–91 recession. Tax cuts and increases in expenditure generated budget deficits of over $17 billion in 1992–93 and 1993–94. Commonwealth net debt reached a peak of over 19% of GDP in 1995–96.

With the election of the Coalition government in 1996 came a tightening in fiscal stance. From 1996–97 to 1999–00, the Howard Government introduced large cuts in budget expenditure, and turned a $5.2 billion underlying cash deficit in 1996–97 into a surplus of $12.6 billion in 1999–00.

However, the effects of the Asian financial crisis (1997) and the associated slowdown in the world economy in 1998 and 1999 impacted on the budget to the extent that fiscal policy became expansionary, with large income tax cuts in 2000 and spending increases in 2001. The global slow down caused by recession in the USA, Japan and Germany saw the surplus vanish, and by 2001–02 the budget was back in deficit. Despite weaker world growth, the government adopted a less expansionary fiscal stance in the 2002–2003 budget.

With a succession of budget surpluses the level of debt has steadily declined to around 5% of GDP, and with sale of the remaining 51% of Telstra, Commonwealth net debt is planned to become negative by 2005–06.

Methods of financing the Budget

A budget deficit occurs when government expenditure (G) is greater than revenue (T) (G>T).

There are three main ways the government can finance a deficit.
1. Firstly, the government can borrow funds from the other sectors of the economy. This involves the selling of new Commonwealth Government Securities (CGS) such as treasury bonds through a tender system.
  
  Click here for more information relating to this area on Monetary Policy.
  
  This is the preferred government method of raising funds, as it does not add to net foreign debt, because the government is not borrowing from overseas. However, there is a disadvantage to this form of debt financing.
  
  When the Federal Government sells CGS it competes with the private sector for domestic savings, creating what is referred to as a “crowding out effect”. A shortage of funds in the domestic market can result and domestic investors may need to borrow funds from overseas. Government borrowing has then, effectively “crowded out” private investment. Private investment may be postponed as interest rates and the cost of credit rise.
  
  Rising domestic interest rates will also impact on other areas of the economy. For example, higher interest rates encourage overseas investment, increasing capital inflow and causing an appreciation in the value of the Australian dollar. An appreciation in the value of the Australian dollar can cause problems with the current account, as exports become more expensive for overseas buyers and imports cheaper for domestic consumers.
2. The second method of financing a deficit is for the Commonwealth Government to sell CGS to the Reserve Bank. This form of borrowing from the Reserve Bank basically means that the government prints money to finance the deficit. The Government has not used this method of deficit financing since the deregulation of the Australian financial market in 1982.
  
  This is because when the government spends the money, there is an increase in the money supply. If the economy is near full employment, demand inflation occurs, as there is too much money chasing a limited supply of goods.
3. The third method used to finance a budget deficit is for the government to borrow funds from international financial markets. The government has not borrowed from overseas since the late 1980s to finance the deficit. When using this method, the Reserve Bank sells new CGS to overseas buyers, and receives foreign funds that are converted into Australian dollars. This method of financing the deficit adds to foreign debt when interest is paid on the securities (net income component of the balance of payments).
  
  The government may decide to borrow funds from overseas to reduce the crowding out effect. Under a floating exchange rate such borrowing has no effect on the domestic money supply. However, exchange rates and domestic interest rates can be affected.
4. The selling of government assets is an alternative method to borrowing that the government can also use to fund a budget deficit. The sale of assets can create a headline budget surplus and reduce the crowding out effect typically caused by the sale of government bonds. The sale of the Commonwealth Bank and Telstra are examples.
Using the Budget surplus

A budget surplus occurs when government revenue exceeds expenditure or G<T. There are a number of ways the government can use the budget surplus.
1. The government can use the surplus to buy back CGS sold to finance the deficit from the private sector. This reduces the crowding out effect and the pressure on interest rates. Interest payments saved by the government can then be used to fund other areas of future expenditure.
2. The surplus can also be used to repay the governments overseas loans reducing net external debt. A reduction in net external debt will decrease the size of net income payments in the current account and as a direct result the CAD.
  
  For example, the surplus created by the one-third sale of Telstra in the 1997–98 budget was used to repay over $5 billion of government debt.
3. The surplus can be used to fund government expenditure on infrastructure and the purchase of assets. For example, in the 2002–03 an additional $138 million was provided for highways and roads of national importance and $1.3 billion over five years to upgrade security in Australia.
4. The surplus can also be used to fund tax cuts. For example, in the 1999–2000 budget when the government introduced The New Tax System (which replaced the wholesale sales tax with a broadly based 10% GST, Goods and Services Tax), the reforms also included the largest personal income tax cuts in Australian history. Most taxpayers (80%) now are facing a top marginal rate of 30%, down from the percentage of taxpayers previously facing rates of up to 47%. Company tax rates were also reduced to 30%.
Reducing government debt and the impact on the economy

Graph 1: Commonwealth government net debt and net interest payments

Graph 1 indicates the ratio of Commonwealth government net debt (the difference between the government’s total or gross debt and the value of financial assets) to gross domestic product. Government net debt as a percentage of Gross Domestic Product (GDP) has fallen consistently since the mid-1990s, from a peak of 19.1% in 1995-96, to an expected 4.6% in 2002–03. In dollar terms, this represents the repayment of around $61 billion of debt since 1995–96.

The reduction in Commonwealth net debt has assisted in lowering interest rates and provided growth in the Australian economy. Lower interest rates have reduced the burden of interest payments on the budget. This has freed up funds to be spent on priority areas such as health, families, industry and defence. Since peaking at $8.4 billion in 1996–97, net interest payments are expected to decline to $3.7 billion in 2002–03, representing annual savings in interest payments of around $4.75 billion.

Importantly, these figures do not include the borrowing activities of the state and local governments, or the borrowing requirements of public trading enterprises (PTEs) such as Australia Post, City Rail or the Sydney Water Corporation.

The overall impact of public sector borrowing is reflected in Australia’s net public sector debt. This reached a peak of 34% of GDP in 1994–95 and is expected to decline to about 10% of GDP in 2002–03. The reduction in debt is the result of privatisation programs and cost cutting measures by the State Governments. The sale of GIO and the State Bank by the New South Wales governments are examples.

Graph 2: General government net debt levels in selected countries^(a)

(a) Data are for the total general government sector (that is, the aggregate of all levels of government).

Graph 2 indicates Australia's general government net debt position compared to other industrialised economies from 1994 to 2003. The ratio of Australia's total general government net debt to GDP is among the lowest in the Organisation for Economic Cooperation and Development (OECD), and is considerably lower than that of Europe, Japan or the United States.

Review

Exercise 1

Using the information from the tutorial and your knowledge of economics answer the following questions.

Outline the main form of deficit financing used by the Commonwealth Government.
Answer
Evaluate the effect of borrowing money from overseas on the economy.
Answer

Hint: When you answer HSC questions you should be aware that the key words such as outline and evaluate have specific meanings. Check the glossary button on the top menu bar for a full list of the Board’s assessment terms and their meanings.

Exercise 2

Refer to the information in graph 1 and graph 2 to answer the following questions.

Account for the trends in Commonwealth Government debt in Australia from the mid-1990s to 2003.
Answer
Briefly explain how the Commonwealth Government’s net debt position compares to other OECD countries.
Answer

Exercise 3

Read the extract and answer the following questions.

“By June 2003 Commonwealth Government net debt will shrink to 4.6% of GDP, its lowest level in more than a decade. The repayment of $60 billion of net debt since 1996–97 has saved around $4.75 billion each year in interest.”

Source: Commonwealth Budget Overview 2003

Explain how the Commonwealth Government has been able to reduce net debt over the last several years.
Answer
Outline the benefits, to the economy, of a reduction in Commonwealth Government net debt.
Answer

Access the 2002–03 Budget web site for more information relating to current and past budget outcomes.

The OECD web site has statistical information on member countries.