BUDGET DEFICIT FINANCING, SEIGNIORAGE AND INFLATION TAX

SYED ALAMDAR ALI
Hailey College of Banking & Finance Lahore

May 26 - June 01, 2008

The federal government is facing difficult decisions about its finances with a growing national debt and long-term fiscal problems that could seriously undercut the nation's prosperity. There is a famous axiom, "to govern is to choose." Creating the federal budget is an exercise in making choices, often choices that will make a dramatic impact on individual Pakistanis. Even in an expected federal budget of nearly 2 trillion Rupees, there isn't enough money for everything. And choices made now can have implications for years to come. What happens to the federal budget can determine how much take-home pay will be etc. Whenever the federal government spends more than it takes in, it runs a deficit. To pay the bills, the government borrows money by selling securities or issues new currency notes. Any of the medium to finance borrowing adds to the national debt, which is the total amount the government owes to banks and other governments. The national debt raises several concerns. One is simply making the payments. Debt servicing payments on the debt now account for about half of the total federal budget. That's money that has to be paid (it's like the minimum balance on credit card) and so isn't available for anything else. Apart from all the constraints Budget FY08 will be remembered for its attempts to please all. Focus remained largely on election-oriented relief measures and a continuation of the government's expansionary policies in terms of increased PSDP spending. Attempts have also been made to increase revenue collection by direct and indirect taxes which will be necessary given an ambitious tax collection target of PKR1.02trn. However, substantial short term measures to boost manufacturing/industry, curtail inflation and increase listings on the stock exchange were noticeably ineffective.

The other concern is that much of the national debt is held by foreign countries, particularly USA, who considers such debts as political investment! Some foreign policy experts worry that this gives a potential rival too much leverage over the economy. Others argue that the US is dependent on its strategic interests to Pakistan and so they can't afford to exercise their will with full liberty at present.

There are different schools of thought on budget deficits. One group of economists suggests that deficits have their uses. Moderate, well-managed deficits can stimulate the economy, because additional government spending will create jobs. Other experts argue that it's a bad idea for anyone, including the government, to borrow money to pay year-to-year bills. When deficit spending gets too big or goes on for too long, that government borrowing inevitably raises interest rates, increasing the cost for such things as car loans and home mortgages, while making it more difficult for businesses to borrow money for expansion. Long-term deficits also cramp the government's ability to create new programs and respond to new circumstances.

Still another set of economists, though, feel that surpluses and deficits mean little economies, and that an undue focus on red ink leads to program cuts or higher taxes, which do greater damage. The government says that it is dealing with extraordinary circumstances -- a recession and the war on terrorism -- and that something has to give in order to fuel an economic recovery while coping with an emerging threat to our national security.

We now turn to the question of how and to what extent the government can benefit from inflating the karbovanets. John Maynard Keynes wrote in 1923 of the insidious ability of governments to raise revenues by inflating their currencies. In an oft-cited passage, Keynes wrote about a country's ability to "live for a long time . . . by printing paper money;" indeed, it can "live by this means when it can live by no other" (Keynes, 1923). This maneuver involves nothing short of deceiving the public as to the intrinsic value of its money holdings. The government's advantage in this regard derives from its exclusive right to issue new money. The command over societal resources, or the purchasing power obtained by issuing new money, is known as seigniorage. The reduction in value to holders of existing money balances due to the issuance of new money is termed the inflation tax. The sum of the inflation tax and seigniorage is equal to the real (i.e., inflation-adjusted) change in monetary holdings, or real balances. The relationship between them is Real Balances = Seigniorage + Inflation Tax! Seigniorage can also be seen as a form of tax levied on the holders of a currency and as such a redistribution of real resources to the issuer. The expansion of the money supply causes inflation. This means that the real wealth of people who hold cash or deposits decreases and the wealth of the issuer of the money increases. This is a redistribution of wealth from the people to the issuers of newly-created money (mostly banks) very similar to a tax.

An analysis taking February's baseline scenario includes two quarters of declining real GDP. The forecast decline in real GDP is significant, averaging just 1.3 percent on an annual basis during the financial year 2007-08. This recession can be eliminated with about one year of economic growth and one year of state revenue growth, provided the political conditions of the country are stabilizes. The new federal cabinet stimulus package can be helpful in limiting the recession's length but these come too late to prevent output from declining in the first half of 2008, as the annual GDP growth of the is expected to remain at 5.8 as against targeted 7.1%. Nevertheless, the issue of twin deficits will remain in the near to medium term. This year's fiscal deficit was targeted at 4% of GDP while the actual has turned out to be 5.21% as compared to FY07's 4.2%; the government has overshot this target especially due to wrong projections of incoming and outgoing resources, given the high tax collection target. Therefore, in the next budget what is required is to generate government revenue by bringing larger group of business people into Tax regimes that will help the government in covering its budget deficit from actual recovery of resources instead taking leverage from Seigniorage!