Should we just close the budget deficit?

I am sure most people are aware of the difficulties faced by the US government regarding their debt ceiling. It has sparked debates from academics and politicians alike on the best way to deal with state debt.

A nice lesson of how fiscal policy works is summarised by Jeffery Frankel. He discusses the mistakes made by US and UK governments in the 1930's and how that time is applicable now. To summarise:

1. Fiscal expansions can be justified when interest rates are low and unemployment high (usually when a country is growing below potential)
2. Fiscal expansions should be countercyclical (save in good times and spend in bad times). Unfortunately this is usually dependent on output gap calculations
3. A 1 dollar increase in government purchases grows the economy by more than 1 dollars. I.e. the fiscal multiplier is larger than one
4. High debt is not always bad, unless markets perceive it as bad. Expectations are more important than the actual number

How does this story apply to South Africa? 

1. The SA government has run countercyclical policy (automatic stabilisers ensured that tax revenue automatically adjusted and expenditure growth increased)
2. Fiscal multipliers are < 1 but can be big SA fiscal multiplier paper
3. Debt is growing but set to stabilise at around 40% to GDP (SA has been downgraded, and might face another downgrade if debt exceeds this ratio)
4. Unemployment has increased by quite a bit (might have been worse if it was not for fiscal stimulus)

SA GDP growth has been low, and the Budget Reviews are revised frequently (under collection in taxes). The output gap is closing, but expenditure growth is not moderating (will have to see when the new Budget Review comes out in February). So how does SA go about consolidating its budget deficit (if it is warranted). For one you need to either increase tax rates (see previous post on this) or cut spending. Cutting spending is not that easy given that government is committed to social objectives such as reducing inequality and unemployment. It would be a very tough sell to cut back on wages and transfers to households (more than 80% of government expenditure is government consumption and transfers). This leaves one with very little room to cut back spending (mainly investment). 

SA's VAT rate has remained constant for quite a while (maybe for good reasons). Maybe government could increase the rate on VAT to finance the current expenditure path. On the other hand, tax collections should increase as the economy recovers...

For the next time I will talk about the impact of debt on the economy (for those skeptics out there who think that debt is not necessarily bad).