May 2019 Q1 e.
Public debt is an important source of revenue for a government to finance public spending where taxation capacity may be limited, or when the alternative would be to print money and compromise macroeconomic stability. There are however, negative consequences of high public debt on the economy.
Required:
Evaluate FOUR (4) of such negative consequences of public debt on the economy of Ghana. (4 marks)
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- The Tax Burden
When the government borrows money from its own citizens, it has to pay interest on such debt. Interest is paid by imposing tax on people. If people are required to pay more taxes simply because the government has to pay interest on debt, there is likely to be adverse effects on incentives to work and to save. It may be a happy coincidence if the same individual were tax-payer and a bond-holder at the same time.
But even in this case one cannot avoid the distorting effects on incentives that are inescapably present in the case of any taxes. If the government imposes additional tax on Mr. X to pay him interest, he might work less and save less. Either of the outcome — or both — must be reckoned a distortion from efficiency and well-being. Moreover, if most bondholders are rich people and most tax-payers are people of modest means repaying the debt money redistributes income (welfare) from the poor to the rich. - Higher Interest Rates
The government depends on investors’ continuous purchase of Government of Ghana long-term bonds to fund its spending. If the bond market gets nervous about the excessive borrowing of the government as a result of the high default risk and the demand for the government’s bonds falls, their price also declines as a result.
The fall in the price will cause the yield on the bond to rise. This means the nation pays more in interest for every cedi borrowed. When the government borrows more from the domestic market through sale of treasury bills it increases the interest rates paid on them and this risk-free interest rate forms the basis for borrowing cost. - Stifling Economic Growth
If the government borrows money from the people by selling bonds, there is diversion of society’s limited capital from the productive private to unproductive public sector. The shortage of capital in the private sector will push up the rate of interest.
In fact, while selling bonds, the government competes for borrowed funds in financial markets, driving up interest rates for all borrowers. With the large deficits of recent years, many economists have been concerned in the competition for funds; also higher interest rates have discouraged borrowing for private investment, an effect known as crowding out.
This, in its turn, will lead to fall in the rate of growth of the economy. So, decline in living standards is inevitable. This seems to be the most serious consequence of a large public debt. As Paul Samuelson has put it: “Perhaps the most serious consequence of a large public debt is that it displaces capital from the nation’s stock of wealth. As a result, the pace of economic growth slows and future living standards will decline.” - Negative effect on long term investment
Raising taxes or ramping up inflation to deal with the debt both have a negative impact on investors’ willingness to invest. High levels of public debt also call into question whether the debt will be repaid in full. That can lead to a higher risk premium, and that’s associated with higher long-term real interest rates, which in turn has negative implications for investment as well as for consumption of durables and other interest-sensitive sectors, such as housing. - Public Debt reduces society’s consumption possibilities
When a country borrows money from other countries (or foreigners) an external debt is created. It owes its all to others. When a country borrows money from others it has to pay interest on such debt along with the principal. This payment is to be made in foreign exchange (or in gold). If the debtor nation does not have sufficient stock of foreign exchange (accumulated in the past) it will be forced to export its goods to the creditor nation. To be able to export goods a debtor nation has to generate sufficient exportable surplus by curtailing its domestic consumption.
Thus, an external debt reduces society’s consumption possibilities since it involves a net subtraction from the resources available to people in the debtor nation to meet their current consumption needs. - Public Debt and Growth
By diverting society’s limited capital from productive private to unproductive public sector public debt acts as a growth-retarding factor. Thus an economy grows much faster without public debt than with debt.
When we consider all the effects of government debt on the economy, we observe that a large public debt can be detrimental to long-run economic growth. What is more serious is that an increase in external debt lowers national income and raises the proportion of GNP that has to be set aside every year for servicing the external debt.
This seems to be the most important point about the long-run impact of huge amount of public debt on economic growth. To conclude with Paul Samuelson and W. D. Nordhaus: “A large government debt tends to reduce a nation’s growth in potential output because it displaces private capital, increases the inefficiency from taxation, and forces a nation to service the external portion of the debt.” (4 points well explained for 4 marks)