Fiscal Consolidation

Desirable Fiscal Consolidation

The reduction of a fiscal deficit is not the final target of fiscal reform. The final target of fiscal consolidation is to reform the content of a government budget efficiently and equitably. Nevertheless, it is important to reduce the excessive burden on future generations. In order to realize successful fiscal consolidation, it is necessary to reduce government spending, increase taxes, and reduce the new issuance of public debt.

In this section, we investigate how the government may reduce fiscal spending and fiscal privileges, and increase taxes, in a political economy. See the advanced study of Chap. 12, Appendix, for a more formal analysis of fiscal consolidation in a political economy.

In reality, many interest groups such as labor unions, management unions, agricultural groups, lawyers, and medical doctors conduct various political activities to seek group-specific benefits, tax-related privileges, and specific public works. The accumulated fiscal deficit may be regarded as the outcome of these privileges. If so, successful fiscal consolidation means that the government has to reduce these fiscal privileges. In other words, fiscal consolidation requires interest groups to assist with an improvement in the fiscal situation by accepting a reduction of fiscal privileges.

For simplicity, imagine that fiscal privileges occur only in the net tax burden for each interest group. Benefits may be regarded as a negative tax burden. Group- specific public works, which benefit only a small number of regions, could also be regarded as privileges for specific interest groups. However, the government provides nationwide public goods that provide benefits across the nation, such as the fundamental services of administrative works, national defense, and diplomacy. Thus, total public spending is the sum of nationwide public goods and fiscal privileges.

In what way would each interest group be willing to accept reductions in fiscal privileges? It is interesting to investigate this issue in a political economy (see Chap. 12). For simplicity, we assume that this issue is determined by comparing private benefits and the cost of reductions.

The private benefit of accepting a reduction of privileges is an increase in nationwide public goods that are available through a reduction in privileges. This is the positive effect of fiscal consolidation. Since each interest group is a member of a nation, it may receive the benefit of fiscal consolidation to some extent.

An improvement of the fiscal situation may raise the provision of nationwide public goods, which should benefit each interest group. However, the reduction of a group’s own fiscal privileges is harmful. It may reduce the group’s utility directly or may reduce disposable income, thereby reducing the group’s utility indirectly.

Thus, the best scenario for each interest group is that fiscal consolidation is attained by reducing the privileges of other interest groups. Then, a group may enjoy the benefit of fiscal consolidation without sacrificing its own fiscal privileges. Since nationwide public goods have positive externalities, any interest group may enjoy the benefit. This is a typical example of free riding because the government cannot enforce the willingness-to-pay principle. Without strong political leadership from the government, each interest group has an incentive for free riding; thus, fiscal consolidation attempts are easily delayed.

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