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Public finance and financing development

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Public finance and financing development the role of budget deficits in development strategies
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Department of Economics

School of Oriental and African Studies

University of London

SOAS

Laurence Harris

Public Finance and Financing Development: The Role of
Budget Deficits in Development Strategies
March 1992
Working Paper no. 10





This working paper series is intended to disseminate research in progress by staff
members and associates of the Department of Economics at SOAS. If you would like to
subscribe to the series or obtain extra copies of a particular working paper please
write, giving full details of your name, position and postal address, to:

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PHONE 071 323 6180 FAX 071 436 3844

Previous papers in the series:

1. Laurence Harris, 'New theories of international trade and exchange rates', February
1992

2. Ben Fine, 'Linkage and the State: the case of South Korea' February 1992

3. M Karshenas, 'Environment technology and economic development: a conceptual
framework' February 1992

4. Ben Fine, 'Coal, diamonds and oil: towards a comparative theory of mining' February
1992

5. Ben Fine, 'The political economy of South Africa in the interwar period* February
1992

6. Joshua Doriye and Marc Wuyts, 'Aid, Adjustment and Sustainable Recovery: The Case
of Tanzania', March 1992

7. Vo Nhan Tri and Anne Booth, 'Recent Economic Development in Vietnam', March 1992

8. Costas Lapavitsas, 'A Model of Money Hoard Formation in the Circuit of Capital",

March 1992

9. Costas Lapavitsas,'The Banking School and the Monetary Thought of Karl Marx', March
1992

10. Laurence Harris, 'Public Finance and Financing Development: The Role of Budget
Deficits in Development Strategies', March 1992

11. Terence Moll, 'Macroeconomic Policy in South Africa: Apartheid and After', March
1992

12. Ben Fine, Total Factor Productivity versus Realism; The Case of the South African
Mining Industry', March 1992

13. Ben Fine, 'The Military-Industrial Complex and Economic Change', March 1992

14. Ben Fine, 'Economic Development and Technological Change: From Linkage to Agency',
March 1992




Public Finance and Financing Development:

The Role of Budget Deficits in Development Strategies

Laurence Harris

Department of Economics
SOAS

University of London
London WC1H0XG
Fax: +44 71 436 3844


2

The Role of Budget Deficits in Development Strategies

1 Alternative Roles for the Public Sector

Government budget deficits are at the centre of development strategies, but,
while they were seen at one time as a positive instrument of development policy, it is
now universally believed that a mark of good policy is a reduction of budget deficits or
the achievement of a budget surplus1.

This rejection of deficit financing is part of a more wide ranging conventional
wisdom that became fully established in the past decade. Its development strategy is
twin pronged: reduce the state's role in economic decisions and avoid budget deficits.

In addition to the support it has among academic economists, the main international
agencies, and the governments of the main economic powers, this conventional
wisdom has been embraced, at least nominally, by most less developed countries'
governments. The conventional wisdom is even accepted by those states which in the
1970s were strongly opposed to Fund stabilisation programmes based on it; the
collapse of the programme for a New International Economic Order, followed by the
climax of the debt crisis in 1982, ended such opposition.

A different view, with roots in a broadly Keynesian tradition, has survived
among some development economists and in "unofficial" political discourse. In
contrast to the conventional wisdom, it argues for a strong state role in development
and a belief that deficit financing is an acceptable means for financing that role; as we
might expect from its opposition-type role this "dirigeist state/deficit financing" strategy
is the mirror image of the conventional wisdom's "minimalist state/fiscal orthodoxy"
strategy.

The dirigeist state/deficit financing strategy also has a real history which
nourishes it; it reflects the strategies pursued by many less developed countries until the
1980s. Long independent states in Latin America pursued industrialisation strategies

1The arguments in this paper have gained from comments made by the participants in the Political
Economy Seminar, School of Oriental and African Studies, University of London. In addition I have
had valuable discussions with Prabhat Patnaik, John Sender, and Massoud Karshenas on specific
points.


3

based upon protection, state ownership, and various forms of corporatism or
repression in the interests of private investment. At the same time, the post war
decolonisations created countries where direct control of the economy seemed to be
both the key to sovereignty and the only possible source of dynamic accumulation.

Such interventionism frequently involved deficit financing either as a consciously
chosen policy instrument, or as a result of a political 'fiscal crisis' which restricted the
state's ability both to raise taxation and cut expenditure. The dismantling of colonial
monetary systems and the break up of the fixed exchange rate system at the start of the
1970s removed the main systemic constraints on individual governments' domestic
monetary and fiscal policy; thereby facilitating that expansion of fiscal deficits in many
third world countries2.

Radical economists are often identified with support for a strong state and,
therefore, with an acceptance of budget deficits; the tradition of dirigeist state and deficit
financing is widely seen as the left wing riposte to the minimalist state/fiscal orthodoxy
strategy although it is not the only one3. In this paper I argue that it is not a sustainable
radical position and it should be replaced by a strategy biased toward budget balance.
That is not the same as a strategy which gives free enterprise rather than the state the
leading role; on the contrary I argue that avoiding systematic deficit financing of current
spending is a precondition for the state having a strong role in development. In other
words the linking of free enterprise with budget stringency in orthodox programmes
and the alternative strategy's linking of dirigeism with deficits creates a false
dichotomy; moreover it is doubtful whether either is sustainable. By contrast, a
combination of dirigeist state and fiscal orthodoxy is a sustainable strategy capable of
realising radical goals.

Currently that strategy is envisaged in the programmatic documents4 of the
African National Congress. As the ANC works out how to achieve the radical
transformation of South Africa it intends to construct its instruments around a dirigeist

2However, fiscal deficits have not been a universal strategy even for strongly dirigeist states. India, for
example, had a notably orthodox fiscal stance at least until the 1980s.

3 One different tradition is derived from narodnik conceptions, and is associated with populist
programmes opposing state direction (see G.Kitching Development and Underdevelopment in Historical
Perspective London, Methuen, 1982). Another is the perspective adopted by Indian economists which
gives a dirigeist role to the state while financing it through taxation instead of deficit finanncing (see
K.S.Krishnaswamy "The Evolution of Tax Structure in a Development Policy" in A. Peacock and
G.Hauser (eds) Government Finance and Economic Development, Paris, OECD 1965. And even in
Latin America, where criticism of budgetary orthodoxy has been strong, Stephanie Griffith Jones'
critical analysis of deficit financing in Chile is significant (S. Griffith-Jones, The Role of Finance
in the Transition to Socialism, London, Pinter, 1981)

4 Draft Economic Policy Document, Harare, September 1990 pp 12 -13. This document is a draft
policy programme which is to be the basis for discussions leading to the adoption of an economic
programme by a Conference of the ANC in 1991.


4

state with fiscal orthodoxy. It is a strategy quite different from the deficit financed "war
economy" model that economists have formerly advocated for strategies of rapid
transformation5. The ANC plans "to transform the public sector into a vehicle for
development", to have government initiate a process of planning, and to reconstruct
local government to "become a powerful tool of development"; overall the "future
democratic, non-racial government will have the duty to lead the restructuring process".
But at the same time the ANC is committed to fiscal orthodoxy: "A future democratic
government would need to avoid large budget deficits and break from the practice of the
present government of financing budget deficits by large loans" and it emphasises the
importance of raising tax revenues to finance spending while cutting administrative
costs and staffing levels6. The strong state and bias against deficits are seen by the
ANC as means toward achieving the radical goals of redistribution of income and
wealth. The goals include overcoming racial and gender inequalities; meeting basic
needs in education, housing, health and welfare; land reform; cutting unemployment
and achieving economic growth.

A strategy like that, based on complementarity between budget orthodoxy and
the achievement of radical goals through a strong state, requires theorising and the
puipose of this paper is to discuss its theoretical basis. Orthodox theory provides
several reasons for rejecting deficit financing, but in this paper I argue that they are not
a sound foundation for the strategy under consideration. Instead, I suggest deficits are
to be avoided because of their implications for income distribution and economic
power, factors that do not feature in orthodox arguments.

The structure of the paper is this. Orthodox and radical programmes can be
distinguished by their objectives which provide a stylised definition of each. I shall
consider three types:

- orthodox programmes aimed at stabilisation

- orthodox programmes defined by the goal of high sustained growth

- socialist programmes defined as having goals of sustained growth,
distributional equality, and planning.

5 B.Higgins "Financing Accelerated Growth" in A. Peacock and G.Hauser (eds) Government Finance
and Economic Development, Paris, OECD 1965

6"The ANC aims to restrict the budget deficit and thereby succeed where National Party governments
have failed, for their lack of control resulted in a severe fiscal crisis in the 1980s. The government
would establish a target level of public sector deficit as a proportion of Gross Domestic Product and
achieve it through budgetary controls, one effect of which is likely to be tight restrictions on staffing
levels in administrative posts." L.Harris, "The Economic Strategy and Policies of the African National
Congress:An Interpretation" in R.McGregor (ed) Economic Alternatives. Johannesburg, Juta Press,
1990


5

I critically examine some of the orthodox theoretical arguments for fiscal orthodoxy in
the first two and suggest that they are not robust (Sections 2 and 3). I then consider the
theoretical basis for fiscal orthodoxy in socialist programmes and suggest that they have
wider application than the term 'socialism' would imply for they would justify a wide
range of 'dirigeist state/fiscal orthodoxy' strategies (Section 4). I discuss the rationale
for fiscal orthodoxy by considering whether, in each model, there are robust arguments
for a negative relation between fiscal deficits and the policy objectives, instead of
seeking the determinants of an optimum deficit; and I define the deficit as a current
account deficit (government dissaving) or total budget deficit as appropriate.

Throughout, I am addressing the role of deficit financing in a fragmented
economy in the sense used by McKinnon7. The markets for products, labour and
finance are incomplete or segmented by geography, social divisions, and monopoly
controls (due to either state regulation or concentration of wide ranging power in the
hands of landlords, merchants or employers). As the literature on sharecropping and
interlinked markets shows, the causes of incomplete and segmented markets may be
located in information assymetries and risk, or in the dynamics of the class structure,
but that is not my concern here. What is relevant for this paper is that the effects of
segmented markets exist: marginal rates of return on capital differ between enterprises,
sectors, and regions, while the law of one price may not hold in product and labour
markets even within the country. I am not presupposing complete segmentation with
rigid differentials for that would indicate a dead society; all that is necessary is that
tendencies to equalisation across markets work so slowly that our models cannot
assume their existence. It is assumed that in such an economy, Ricardian Equivalence
does not hold.

2 Stabilisation Policies

In practice, stabilisation policies are defined by the objective of correcting
external disequilibrium in a 'short' time period, and I shall assume that internal
equilibrium in the sense of maintaining capacity output is also an objective8. External
disequilibrium in less developed countries concerns the current account, since capital

7R.I.McKinnon, Money and Capital In Economic Development, Washington DC, Brookings,1973

8 However defined, capacity output in less developed countries is, of course, often consistent with high
levels of unemployment. The goal of internal equilibrium may include price stability, but neither
policies against inflation nor the use of inflation as a source of state finance are considered in this
paper.


6

account objectives such as reversal of capital flight are dependent on it. External
equilibrium is usually defined as a zero deficit or surplus, but to reach full external
equilibrium it is usually necessary to attain a temporary current account surplus since
most countries adopting stabilisation programmes have disequilibrium levels of foreign
debt to reduce so the immediate objective of stabilisation policy could be defined as a
current account surplus. The "short" time period is best thought of as the eighteen
month span typical of many Fund stand-by agreements9.

The adjustment models on which such stabilisation programmes are based
generate a positive relation between fiscal and external deficits through a number of
mechanisms. Simple Keynesian product market models (absorption approach) allow
the fiscal deficit a direct effect on flow excess demands. If financial markets are
included that may, in the absence of Ricardian equivalence, be supplemented by an
asset effect on private expenditure. The Polak model10 links fiscal deficits to the
product market through monetary growth induced by deficit financing, with the
transmission mechanism completed by constant velocity and propensity to import.
More generally monetary models give such monetary growth a direct effect by defining
the balance of payments in monetary stock-adjustment terms, but since non-
instantaneous stock adjustment requires current account disequilibrium it has a product
market link.

The condition for any stabilisation programme's success is that, at any given
level of production, resources are transferred from the production of non-tradeables to
tradeables and the argument for fiscal orthodoxy as an instrument of stabilisation policy
rests on its ability to achieve that. In the adjustment models referred to, a switch of
resources toward production of import-replacing or export-destined production
ultimately depends upon achieving appropriate relative prices, but fiscal orthodoxy is
necessary to ensure that at capacity output with those relative prices excess demand
does not exist on the product markets. Moreover it can be argued that reducing fiscal
deficits has the potential to shift resources directly away from the production of non-
tradeables since, to the extent that it cuts government consumption, it reduces the
resources absorbed by non-tradeable government services11.

9 In the 1980s several Fund programmes have had longer time spans especially when linked with
structural adjustment, but the pure stabilisation element essentially has a short horizon.

10 JJ Polak "Monetary Analysis of Income Formation and Payments Problems" IMF Staff Papers Vol
6,1-50 (1957)

11 It is worth noting, however, that defining government services as non tradeable involves a
simplification which is contestable in practice.


7

These adjustment models are not a satisfactory basis for fiscal orthodoxy in a
fragmented economy, for they fail to meet the objective of stabilisation policy in
circumstances of severe external disequilibrium. Because of its fragmentation, such an
economy cannot, within the short term, achieve the required transfer of resources from
non tradeable to tradeable production at a given level of output. If the transfer is not
achieved, the effect of budget deficit reduction is to reduce the level of output,
producing an import squeeze which improves the current account without an increase in
production of exports or import replacements, but a decline of output below its capacity
level is inconsistent with the objective of internal equilibrium.

Note three features of this 'fragmented economy' criticism of the adjustment
models.. First, this criticism appears to be controverted by the fact that in practice
some economies have succeeded in achieving stabilisation goals in the form of rapid
reduction of external current account deficits; perhaps the most outstanding example is
the adjustment of the Mexican economy in 1983 and 1984 (in which a reduction of
government dissaving was a key policy). However, examples like Mexico do not
negate the criticism: its migratory and rapidly urbanising labour force, and its extensive
manufacturing, commercial and financial sectors indicate a low degree of fragmentation
compared with sub saharan Africa and other poor countries; and, because fragmentation
does exist, adjustment was achieved to a large extent by reductions in output rather than
a rapid switch of resources to the production of tradeables at a given level of output.
Second, the 'fragmented economy' criticism is based upon obstacles to the transfer of
resources in production; doubts about the models' demand side transmission
mechanisms are excluded12. Third, it is based on accepting the objectives of
stabilisation programmes, not on a critique of those objectives for their neglect of
growth or distributional objectives13.1 turn now to consider fiscal orthodoxy where
long term growth is the objective.

3 Sustained Growth

Structural adjustment programmes have sustained growth as their objective, and
are based on models requiring fiscal orthodoxy in the form of cuts in government
dissaving to achieve it14. Underlying fiscal orthodoxy in most structural adjustment

12 They may be discussed in terms of the stability of the underlying behaviour functions or the validity
of those functions in quantity constrained markets.

13 Hence it differs from the "adjustment with a human face" literature, G.Comia, RJolly and
F.Stewart, Adjustment with a Human Face Oxford, OUP, 1987

14 In practice structural adjustment programmes include short term stabilisation goals, too, but here I
am concerned only with the "pure" growth arguments for fiscal orthodoxy.


8

programmes is a crowding-out model, for sustained growth requires efficient
accumulation of capital. However, the transmission mechanisms through which fiscal
deficits prevent this in crowding-out models are not valid for a fragmented economy.

Crowding-out implies that government current account deficits reduce private
sector investment since, by increasing the demand for "loanable funds savings" 15,
they price private sector investment projects out of the market for loanable funds. The
interest rate mechanism through which that occurs in orthodox models is, however,
inappropriate for fragmented economies. With incomplete and fragmented financial
markets, deficits are financed by money supply growth which prevents excess demand
for loanable funds rising to cause increases in interest rates. Moreover, in such
economies, quantity constraints reduce the significance of price variables so that we
may expect private investment to be financed by retained profits and have low elasticity
with respect to the cost of capital16.

If the relative price effect of interest rates does not cause crowding out in a
fragmented economy it should not be assumed that current account fiscal deficits cause
it through the alternative route of quantity constraints - an excess demand for loanable
funds - when financed without monetary expansion. Fragmentation generally involves
a chronic excess supply of loanable funds; excess liquidity results from supply
constraints or other quantity constraints restricting consumption and investment
expenditure in the product market. Therefore if deficit financing is achieved through
non-monetary credit, it does not create excess demand for loanable funds. In a
fragmented, quantity-constrained economy, deficit financing may, in fact, increase the
availability of loanable funds to investors through several channels; for example, if
total output is not raised, inflation may increase the share of profits, thereby raising
corporate saving in the form of retained earnings.

While crowding out in its strong form is applied to current account budget
deficits, deficit financing of government capital expenditure is also viewed negatively in
many structural adjustment programmes. Here the crowding out argument in its
simplest form is that if there is full crowding out the public investment simply replaces
private investment with no net effect on capital accumulation. Even if we were to accept
the extreme liberal position that public goods arguments do not justify public sector

16 The modem use of the concept is attributable to E.P. Howrey and S.H.Hymans "The Measurement
and Determination of Loanable Funds Saving" Brookings Papers on Economic Activity:3,655-705
(1978)

16 This is consistent with the failure of econometric studies to find significant cost of capital
coefficients in LDC investment functions.


9

capital expenditure in advanced capitalist societies, such an argument could not apply to
fragmented ldc economies since indivisibilities and fragmented capital markets combine
to ensure that some projects with a positive present value could simply not be
undertaken by the private sector.

If the government undertakes them and finances them by non monetary debt,
would the resulting interest and availability effects reduce private investment? If we
treat public and private capital as distinct factors of production, entering an aggregate
production function of the type used by Eaton and Gersovitz17, an increase in public
capital raises the marginal product of private capital. It can therefore partially or fully
offset any decline in present values resulting from a tightening of loanable funds
markets18. In such a model public investment may more than offset the loanable funds
effect on private investment of public borrowing.

Finally, an orthodox argument very different from crowding out models has
also been advanced as a rationale for fiscal orthodoxy. Blejer and Cheasty, developing
an argument of Tanzi, argue that the state should budget for a surplus over all
expenditure in order to act "as some sort of a proxy for the financial market"19. It
should use this surplus to allocate "competitive and nonconcessionary" credit to private
investment.

The fragmentation of less developed economies, specifically the absence of
developed capital markets, is advanced as the rationale for this strategy but within the
orthodox framework it is not a sustainable argument. The policy is intended to ensure
the efficient allocation of capital within the economy in the absence of capital markets
and therefore offers non concessionary credit, but the fragmentation and absence of
capital markets makes the concept inoperative since no market rate exists to provide a
standard. Moreover, the strategy would perpetuate and worsen such fragmentation.

Within an orthodox framework, the development of mechanisms to achieve an
efficient allocation of capital would, in fact, be stimulated by deficit financing instead of
budget surpluses, for a growing stock of public debt is necessary for the growth of

17 J. Eaton and M.Gersovitz "Country Risk and the Organization of International Capital Transfer" in
G. Calvo et al (eds) Debt, Stabilization and Development Oxford, Basil Blackwell, 1989

18 M.I.Blejer and M.S.Khan "Government Policy and Private Investment in Developing Countries"
IMF Staff Papers Vol 31 pp 379-403, June 1984

19 M.I.Blejer and A. Cheasty "Fiscal Policy and Mobilization of Savings for Growth" in M.LBlejer
and K.Chu, Fiscal Policy, Stabilization and Growth Washington DC, International Monetary Fund,
1989; V.Tanzi, "Fiscal Policy, Keynesian Economics and the Mobilization of Savings in Developing
Countries" World Development, Vol 4, pp 907-917 (Nov-Dec 1976)


10

capital markets. The flow of funds into capital markets from alternative uses such as
self financing is stimulated by the ability of capital markets to offer superior
combinations of risk and return; any innovation that increases the efficiency of market
portfolios in that sense increases the incentive to switch funds from alternative uses to
the capital market. Assume state debt in the national currency is default risk free and has
a positive fixed interest rate while all other assets on the capital market are primary
bonds or equities of the private sector with stochastic default characteristics that yield
positive expected value and positive variance. Investors holding portfolios of private
securities can obtain lower risk with a given expected value than they could by holding
an individual asset; holding the market portfolio they can reduce risk to the market level
determined by the variance/covariance of the individual assets. But the introduction of a
riskless asset which they can hold in combination with such portfolios enables
investors to attain higher levels of utility, therefore increasing the inflow of funds from
other uses. The existence of state debt, therefore, assists the development of capital
markets; and increases in the scale of capital markets require expansion of the stock of
such debt to meet the demand for it in the expanding aggregate portfolio20.

That argument from orthodox theory suggests that government deficits, even
debt financing of dissaving, can assist policies aiming at sustained growth through
efficient accumulation of capital and therefore runs counter to the conventional wisdom
on fiscal orthodoxy. Its conclusion on capital market growth can include growth of
financial intermediaries. A historical example of such a role for state debt is Britain
where public sector debt was a significant basis for stock market development in the
nineteenth century and had a major influence on the growth of the modem banking
system21. It rests on a concept of state debt as risk free which, although often treated
as axiomatic, requires further consideration and I suggest one perspective in the next
section.

4 Growth, Distribution and Planning

In the previous sections I have argued that orthodox theory does not provide
robust arguments to support fiscal orthodoxy; however, that does not mean that deficit

20 Proofs of the propositions that investors with diminishing marginal von Neumann-Morgenstem
utility (risk averters) are able to maximise utility by holding diversified portfolios of risky assets with
a risk free asset are due to W.F.Sharpe Portfolio Theory and Capital Markets New York, McGraw-
Hill, 1970 and J.Tobin, "The Theory of Portfolio Selection" in F.H.Hahn and F.P.R. Brechling (eds),
The Theory of Interest Rates, London, Macmillan, 1965. In the present discussion, default risk is
defined as risk of default on interest payments.

21 B.Fine and L.Harris The Peculiarities of the British Economy, London, Lawrence and Wishart, 1985


11

financing is desirable. If a country has socialist objectives instead of those considered
so far, and if we model the economy on Kaleckian assumptions, deficit financing will
have clear negative effects.

Let us define "socialist objectives" as growth with redistribution and planning
and give them the weakest interpretation in order to generalise the argument. Let growth
have the same meaning as in the former, structural adjustment model; it is defined by
the accumulation of capital, for that is assumed to be a precondition for growth of per
capita output. By redistribution, I shall mean redistribution from profits to wages but
this objective is to be interpreted weakly as a constraint: policies which reduce the wage
share at any given level of output are to be avoided. Planning means state actions to
achieve a different allocation of resources from that which would be reached by
competitive markets. That is a weak definition of planning which could embrace a range
from moderate strategies of price intervention alone to central planning of material
balances.

The main new postulate in addition to the assumption of fragmentation is that
workers have a higher (constant) average propensity to consume than capitalists. I shall
adopt the extreme assumption that workers' marginal and average propensity to save is
zero, so they receive only wages. Such a model provides several theoretical bases for a
development strategy combining a dirigeist state with fiscal orthodoxy: the first set of
problems introduced by fiscal deficits concerns inconsistencies between growth and
distribution, while a second set concerns the effect of deficits on planning.

Fiscal deficits may cause incompatibility between the growth objective and the
redistribution goal (constraint) both directly through their financing and indirectly
through subsequent interest payments. Directly, fiscal deficits representing public
sector dissaving must be financed by an increase in private sector saving if they are not
to prejudice the growth objective by reducing total accumulation. But the assumption of
differential propensities to consume means that at any level of output higher private
sector saving can only be achieved by redistribution from labour to capital, which
would violate the redistribution constraint. Indirectly, the debt issued to finance public
sector deficits generates interest payments which are transfer payments of a regressive
character if, as a result of our saving assumption, capitalists hold a disproportionate
share of public debt. If those interest payments are financed by taxation (instead of
from the yield of public sector physical capital) they will violate the redistribution
constraint unless the tax system is sufficiently progressive. In any case, however they
are financed, they themselves represent a severely regressive transfer payment.


1 2

The question of taxation to finance interest payments relates to the assumption
made in the previous section that government debt in its own currency is default risk
free. That is frequently taken as axiomatic; otherwise it is explained by the state's
compulsory powers of taxation but the implications of those compulsory powers are
unexplored. If those powers are not weakened by political constraints - if there is no
"fiscal crisis of the state" - they can guarantee risk free debt servicing but that must have
distributional implications.

Distributional effects can be examined in a simple model with one technique of
production such that wage and profit revenues are related along a linear wage - profit
frontier, y=wL+rK. Taxation falls either on wage revenue or on profits and has to
produce a predetermined revenue equal to interest payments on the existing stock of
(perpetual) government debt, iB. Interest payments by firms on their own debt are not
riskless because their own return on physical capital is stochastic. For the same reason,
with a given tax structure, wage revenue and tax receipts from profit taxation are
stochastic. However, to guarantee interest payments the state requires total tax revenue
to be certain, and this can only be approached by diversifying the sources of tax
revenue. In this simple model, the negative correlation between wage and profit
revenues enables the government to reduce the variance of total tax revenue to zero by
applying a unified proportional tax to wage and profit income. Consequently, the
expected value of workers' net income is reduced by the debt-tax regime while that of
capitalists' is raised22. This model illustrates one mechanism by which interest
payments can violate the distribution constraint.

In the more complex reality of development strategies the distributional effects
of government interest payments cannot be so neatly quartered, but the experience of
the past decade has shown that they are sufficiently large and, in a world of flexible
rates, so variable that they have a major, if unquantifiable distributional effect especially
in the context of stabilisation policies. For example, between 1980 and 1986 in sub-
Saharan Africa the ratio of government interest payments to GDP rose from 1.5 % to
4.3 % requiring cuts in other expenditure, tax rises or increases in the total budget
deficit relative to GDP and, therefore, having significant effects on distribution23.

22 Let iB be tax exempt interest payments and t (0 iB=t(wL + rK). With zero interest the expected value of capitalists' income is rK, while that of workers
is y-rK. The debt-tax regime leaves capitalists with expected value of net income at [(l-t)rK+iB]>rK
while workers' net income is [y-(l-t)rK-iB]
23 UNDP/World Bank, African Economic and Financial Data, 1989


1 3

The second type of negative effect fiscal deficits have on the objectives of this
socialist strategy is the problems they cause for planning. A major problem, identified
in Wuyts' study of Mozambique24 but more widespread than that, is that in a
fragmented economy, especially one with widespread and uneven excess demand for
goods, deficit financing leads to uneven accumulation of excess liquidity. These excess
balances enable entrepreneurs to obtain quasi rents by trading and producing in non-
competitive positions, achieving outcomes quite different from the state's plan. In other
words, the effect of deficit financing prejudices the objective of planning.

That phenomenon is different from two other, apparently similar propositions.

It is not the same as the critique of state policies based on the theory of a rent seeking
society25, for the latter postulates an alliance between the state and rent recipients while
the phenomenon discussed here is rent seeking which undermines the state's policies.
And it differs from the effects identified by Stephanie Griffith-Jones in the light of
Chile's experience under Allende26, for those concerned the effects of fiscal
imbalances on inflation and macroeconomic equilibrium whereas the effects identified
by Wuyts are problems in the allocation of resources at both micro and macro economic
levels. Moreover, if planning seeks to regulate the organisational form of enterprises
and techniques of production (as it does in land reform and rural development
programmes for example) the effect of fiscal imbalances goes further than
misallocation of resources through unplanned trade. The accumulation of quasi rents
leads to new "informal" production systems; their owners invest in new activities with a
different order of relations of production.

Finally, deficit financing can prejudice planning through effects which are at the
political end of the political economy spectrum, for it can undermine state autonomy, as
both distant and recent history testify. In an open economy, public sector deficits
financed with foreign saving increase the probability of government policy being
constrained and ultimately determined by foreign creditors or agencies. Such
diminution of sovereignty is not the consequence of foreign debt as such, for debt
growth at rates appropriate to the productivity of capital or foreign exchange earnings
can be sustainable and, in some models, even optimal. But the leverage produced by
foreign debt introduces a high degree of default risk to states' external finance when the
international economy is marked by high variabilty of interest rates, exchange rates and
commodity prices. Increased default risk, or the occurrence of virtual (if not formal)

24 M.Wuyts, Money .Planning and Socialist Transition, Aldershot, Gower, 1988.

25 A. Krueger, "The political economy of the rent-seeking society" American Economic Review Vol
LXIV (3) 291-303 (1974)

2^ S.Griffith-Jones The Role of Finance in the Transition to Socialism London, Pinter, 1981.


14

default, leads to loss of control over economic policy either because creditors require
supervision, in forms ranging from conditionality to technical assistance in
restructuring, or because the state itself recognises a need to reorder its objectives and
give debt reduction priority over all others - abandoning the objectives for which the
debt was incurred in the first place.

Even if fiscal deficits are financed from domestic rather than foreign savings,
their effect can be to reduce the state's freedom of action, placing an unanticipated
economic constraint on policies chosen through the political system. Domestic financial
institutions gain added power through their ability to determine the terms of refinancing
debt; in an open economy those terms are themselves related to international credit
terms, while in an economy with some de-linking the domestic institutions have the
alternative of investing in other sectors or reducing their intermediation by holding high
reserves.

Moreover, variable interest costs can put the state in a position of having large
unanticipated interest payments in its budget, thereby generating a fiscal crisis. Unless
the state borrows in order to pay interest (Minsky's case of Ponzi finance which is an
inherently unstable strategy), unanticipated interest costs force it to raise taxes or cut
other categories of spending and those actions can easily generate a crisis of political
legitimation. The alliance of classes or groups upon which the state's power rested is
disturbed by fiscal measures which hurt its different elements - withdrawal of food
subsidies hurts urban workers, cuts in health care undermine the support of many poor
groups, wage freezes hurt state employees, and tax increases are a threat to profits. The
result is a classic fiscal crisis of the state in which groups unwilling to accept tax
increases or expenditure cuts prevent the state having any economic strategy, effectively
nullifying its political authority27.

5 Fiscal Orthodoxy and the Strong State

Proposals for fiscal orthodoxy with free enterprise and market forces
determining development dominate economic thinking although there is little historical
evidence in favour of them. There are reasons for thinking that a strong state rather than
free markets should drive development, and linking that with fiscal orthodoxy has its

27Throughout, I have been concerned with short run (non steady state) models. If we were to consider
long run equilibrium distributional effects would not operate in the manner proposed in this section. In
Pasinetti's steady state deficit financing does not change the rate of profit irrespective of the presence or
absence of Ricardian Equivalence (V.Denicolo and M.Matteuzi, Cambridge Journal of Economics,
September 1990). In a Marxian model where wages equal the value of labour power in the steady state,
taxation reduces capitalists' profit revenue but leaves wage revenue unchanged.


1 5

advocates. Certainly, the experience of India and South Korea suggests that it can have
significant successes and, looking forward, it is likely to inform strategy in post
apartheid South Africa. But what are the theoretical arguments for fiscal orthodoxy?

In this paper, I have discussed some of the main orthodox arguments against
deficit financing and shown their limitations for fragmented economies, but I have
argued that an alternative model does enable us to demonstrate the negative effects
fiscal deficits can have for "socialist" objectives of growth, distribution and planning.
The implication of those arguments is that, instead of fiscal orthodoxy being a desirable
complement to a strong state, it is a necessary foundation for it; the disadvantages of
deficit financing are that it prevents the state being able to achieve redistribution of
income and planned allocation of resources.

The implications can be illustrated in relation to the concrete example I posed at
the beginning; development strategies for post apartheid South Africa. It may be
concluded that since South Africa's transformation cannot be achieved without the state
having the leading role, it requires fiscal orthodoxy to ensure the state is sufficiently
strong for the task. Another step is required, however, before that conclusion can be
taken as a basis for policy. If deficit financing would hinder the state's pursuit of
development objectives, would not fiscal orthodoxy also create strategic problems for
other reasons? For example, in the absence of deficit financing how could the state
achieve an expansion of education and health care or subsidise prices of commodities to
alter the distribution of income and allocation of resources? In other words, would
fiscal orthodoxy mean abandoning dirigeisme; creating a state which is strong but
toothless, one which maintains its strength by doing nothing?

There have been successful examples of states combining fiscal orthodoxy with
interventionism; its feasibility depends on the methods used, requiring a strong tax
administration and the ability to raise private savings. First consider resource allocation.
Intervention in the price mechanism to achieve planning objectives has sometimes been
equated with uncontrolled subsidies, and therefore impossible under fiscal orthodoxy;
but, bearing in mind that relative prices are the object, intervention should combine
subsidies with taxes in order both to reduce the amount of subsidy needed for any
given change in relative price and to raise compensating revenues. Moreover, budget
control over such a system requires frequent reappraisal and adjustment to prevent the
institutionalisation of particular rates of subsidy (and tax) in changing circumstances.
Similar considerations apply to income distribution, for redistribution using subsidies


1 6

to income, goods, or services has to be financed by taxation if current account budget
balance is maintained.

Fiscal orthodoxy does not preclude deficit financing of public capital formation
but since that, too, can have a negative impact on development strategy it has to be
located within a financial strategy for the economy as a whole. To avoid the
disadvantages of foreign debt, the distributional implications of domestic debt, and
some of debt's negative implications for the state's authority, borrowing to finance state
investments requires a strategy to raise the saving rate of the private sector and, within
that, to raise the saving rate of wage earners, peasants, and low income groups.

Radical programmes can, therefore, be constructed without deficits on current
public spending and transfers and with deficit financing of public investment but their
extent depends upon tax capacity and administration and upon raising and mobilising
private saving. In a situation like South Africa's the difficulty stems from the urgency
with which transformation has to be achieved and the size of resource transfers
envisaged. A particular difficulty is financing the construction of a "welfare state" if
current spending and transfers are subject to a balance constraint; within the framework
envisaged here, however, that financing is possible by a mixture of tax and insurance-
principle contributions, and by borrowing to finance social investment (including
capitalised current spending) in "human resource" areas such as education.

Laurence Harris
London

December 1990





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