The amount of debt interest a government needs to pay depends on two factors:

• The amount of outstanding debt.
• The interest rate on government bonds.

Higher bond yields will increase the cost of future borrowing.

Note: There are quite a few different ways of measuring government debt / financial liabilities, therefore you may come across slightly different statistics for debt interest payments as a % of GDP. I have indicated source of data where possible.

Debt interest payments as a % of GDP / Tax revenue give a reasonable guide to how manageable the government’s debt situation is. For example, Japan has a national debt of over 220% of GDP, yet net debt interest payments are forecast to be only 1.4% of GDP in 2013. Italy by contrast is facing a higher interest burden, with over 5% of GDP going on net debt interest payments.

It is worth noting that in the case of UK and US, net interest payments are not exceptionally high as a % of GDP.

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• The fiscal multiplier looks at how much an initial change in injections affects real GDP.  For example, if increased government spending of £1bn causes overall GDP to rise by £1.5bn, the multiplier effect is 1.5
• If £1bn worth of tax rises causes real GDP to fall by £0.5bn, the multiplier effect is (0.5)

Since 2009, countries in the Eurozone (and others such as the UK) have pursued deflationary fiscal policy – reducing spending and increasing taxes to reduce their budget deficits.

These austerity measures have led to sharp falls in the rate of economic growth, suggesting the negative multiplier effect is larger than may be expected in usual situations.

As a rule of thumb, the IMF expect a fiscal multiplier of 0.5. This means if you tighten fiscal policy by 1%, you can expect a fall in the rate of GDP growth by 0.5%.

For example, the UK has tightened its cyclically adjusted budget balance by 3.8%, and (Real GDP % growth – trend) fell by 3.9%. This suggests a fiscal multiplier of 1.0.

However, in other countries such as Ireland and Spain, the fiscal tightening led to a bigger fall in GDP giving a fiscal multiplier of over 2.0. This suggests in the current climate of the Eurozone, fiscal tightening comes at a big cost.

 What Determines Size of Fiscal Multipliers?

There have been cases where countries, e.g. Canada 1990s, can pursue fiscal tightening with relatively limited impact on Real GDP. This is because they can:

1. Pursue expansionary monetary policy; e.g. cutting interest rates to provide a monetary stimulus. (i.e people have higher taxes, but have lower mortgage payments so overall there is no change in spending)
2. Depreciation in the exchange rate. If a country pursues fiscal tightening but monetary loosening there is likely to be a depreciation in the exchange rate. This makes exports cheaper, and imports more expensive. This helps to boost domestic demand.
3. External Demand.  It is usually easier to tighten fiscal policy if neighbouring countries are growing strongly. Export demand can help overcome the fall in government spending.
4. Situation of the economy. If there is spare capacity, then fiscal tightening is likely to cause a bigger negative multiplier effect. This is because the shock of falling demand is harder to absorb. If the economy is growing strongly, fiscal tightening may help reduce inflation and be easier to absorb.
5. Confidence. If austerity measures improves confidence in future public finances, people may continue to spend. But, it is more likely austerity worsens confidence because of headline concerns over jobs and spending cuts.

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Readers Question: What should the government do to improve the American standard of living?

How could the President + Congress, make the biggest difference to improving American standards of living in the long run?

These are a few policies which I feel would improve US living standards.

1. Reduce Unemployment. The rise in US unemployment is one of biggest social and economic problems the US faces. A key factor is the sharp rise in unemployment since the start of the recession in 2008.

This graph shows unemployment, plus ‘partial’ unemployment – workers facing part time work rather than full time job.

The US unemployment rate would have been worse without some federal fiscal expansion and the partial monetary expansion we have seen. In this regards, the US are doing better than say the Eurozone. However, there is still a need for stronger US economic growth to enable a more sustained reduction in unemployment. This requires a combination of expansionary fiscal and monetary policy to maintain the weak economic recovery. If the US recovery is sustained, that will leave them in a much better position to deal with their long term debt.

2. Tax on investment income.

Currently tax on investment income is taxed at a lower rate than income. It means that millionaires who receive their income through dividends and capital gains, pay a lower average tax rate than people on much lower incomes. Increasing tax on wealthy would help improve tax revenues and also create greater equality in society. (See also: why is US investment income taxed less than income? – business insider). Recently, President Obama  developed the “Buffet Rule,” (named after billionaire investor Warren Buffet), which says rich people shouldn’t pay taxes at a lower rate than ordinary workers. Obama has stated that people making more than $1 million should pay at least 30 percent of their income in taxes. I would go further and increase the marginal tax to 40% for incomes over $1 million.

3. Tax on Gasoline

source: tax

US tax on gasoline is substantially less than in Europe. In the US, the average tax on gasoline is 48.9 cents per gallon for gas. By contrast in the UK, tax is over 70p.

Higher petrol tax help US living standards through various means:

• Raise revenue to help deal with budget deficit
• Raise revenue which can be spent on improving America’s infrastructure (roads/railroads). These are ‘public goods’ which are underprovided in a free market and need to be paid for out of general taxation. Better infrastructure would help improve the supply side of the economy.
• Reduce foreign dependency on oil. In 2008, the US spent $430 billion on importing oil from other countries. Higher gasoline tax would encourage people to use oil more conservatively. It would also encourage the purchase of more fuel efficient cars (e.g. fewer SUVs – more hybrid cars). Higher oil prices would also encourage firms to develop alternative energy sources.
• By reducing the consumption of oil, it would make a contribution to decreasing America’s CO2 emissions.
• Higher petrol tax may encourage Americans to cycle and walk rather than drive anywhere – this would help improve health standards.

4. Universal Health Care – Free at the point of use

The US spends 15% of its GDP on health care and this is rising because of an ageing population and improvement in medical science creating more expensive treatments. At the moment there is a patchy system of private insurance. This system encourages more expensive treatment, but still not everyone is guaranteed. If you look at European universal health care systems, there is a lower total % of GDP spent on health care, however there is better universal health care coverage.  Universal health care free at the point of use would cut out private health insurers. It could lead to lower wage costs as firms and workers can pay less than they currently do.

Health Care in US and UK

US health care costs were 7% of GDP in 1970. UK was 4% of GDP in 1970 (Runaway health care costs)

More on US vs British health care

In terms of the US long run budget deficit, the growing demand for health care spending (through Medicare and Medicaid) are one of the strongest demands on US federal spending. Dealing with this growth in health care spending is a key factor to ensuring sustainability in US public finances.

5. Improve Public Health

Related to health care is the issue of obesity and the growing diseases of affluence. In the United States, obesity has overtaken tobacco as the biggest killer of people. 16% of all deaths in the US (400,000 a year) are attributed to obesity. [1] Obesity and poor public health are a key factor in reducing living standards.

Rather than spending money on treatment of diseases, (which the current model promotes) there needs to be greater focus on improving health and preventing related health problems. The government could promote a healthier, less obese, population by:

• Taxing sugary / fatty foods.
• Regulation of the food industry to reduce portion size e.t.c.
• Ending the subsidies of corn starch which has encouraged growth of high sugar foods. (billions in tax subsidies to junk industry)
• Encouraging cycling and pedestrians in city centres – giving less priority to motor cars.

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