Change of Government
When a change of government is likely, the role of public debt is important. Namely, public debt is a stock variable and cannot be changed in the short run. If a new government gains office, the existing stock of public debt cannot be reduced at once. In a revolutionary change of government, the new government may declare a default of public debt, although in reality this is unlikely to occur.
If there is a possibility of a change of government, the current ruling party has an incentive to manipulate public debt strategically in order to influence the future fiscal policy conducted by the opposing party. This is because taxes and spending are flow variables, which can be freely controlled by the ruling party. However, public debt is a stock variable that limits the freedom of fiscal management to some extent. Past fiscal measures can affect future fiscal policy in terms of the redemption of public debt.
When the government changes, different policies are conducted with respect to the evaluation of government spending. For example, imagine changes between the Democrat Party and Republican Party in the US and the Labour Party and Conservative Party in the UK. If the current right-wing ruling party is likely to be replaced by the opposing left-wing party, which prefers bigger government spending, how is current fiscal policy affected?
Imagine that the current government wants less spending than the future government. The current government, once the future change of government is a possibility, has an incentive to conduct further excessive fiscal measures such as tax cut and accumulate a greater fiscal deficit. By so doing, the future government is forced to reduce public spending to some extent because the significant public debt produces great pressure to conduct fiscal consolidation.
When the initial fiscal situation is bad, any government has to take certain measures with regard to fiscal consolidation. The government may introduce fiscal constraint against raising public spending. Thus, a conservative government has an incentive to expand the fiscal deficit if a change of government is likely to occur in the near future. This explains why in the 1980s, the Republican government in the US increased the fiscal deficit by reducing taxes.
Figure 12.9 explains this outcome. The current government has two choices, issuing a high level of debt, DH, or a low level of debt, DL. If it issues DH, the future government has to reduce its spending. G declines significantly. If it issues DL, the future government does not have to reduce its spending significantly. G does not decline by much. Hence, if the current government seeks small government, it prefers to issue DH now.
Fig. 12.9 Change of government