Public Finance in Democratic Process: Fiscal Institutions and Individual Choice

James M. Buchanan.
Buchanan, James M.
(1919- )
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Indianapolis, IN: Liberty Fund, Inc.
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Foreword by Geoffrey Brennan.
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Chapter 18Fiscal Policy Constitutionally Considered



To this point, all problems concerning the possible utilization of fiscal instruments to accomplish macro-economic objectives have been deliberately neglected. Any claim that the approach is a general one must include some reference to its ability to handle these problems. Can a normative "theory of fiscal policy" be derived from an individual choice calculus? Will an individual, at the moment when he is confronted with defining a fiscal constitution, authorize his government to employ the budget as a stabilizing, growth-inducing instrument?


Will an individual prefer that the aggregate income of the community in which he lives rise at some steady rate (or remain stable) or that it fluctuate around some long-term growth path? If he can predict his own income prospects with certainty, he need not be directly concerned with fluctuations in aggregate community income, although he may be indirectly concerned through tax-base externality. He will, however, be directly interested in aggregate income growth if his own income prospects are expected to correspond with those of the community in general. Here he will clearly prefer steady growth to unpredictable fluctuations. He may also prefer income stability to wholly predictable fluctuations if resort to the capital market is costly and private spending needs are relatively more stable than income. As the analysis of Chapter 15 indicated, the individual should select tax instruments which will mitigate the impact of his own fluctuating income prospects. Tax institutions that contain significant built-in revenue flexibility will tend to be selected. If, however, fluctuations in personal incomes are general over the whole community and not offsetting among separate persons and groups, the built-in flexibility of the tax structure will cause revenues of the government to decline sharply during periods of cyclical downswing. More appropriately stated, if aggregate community income does not grow at its average rate, governmental revenues will fall short of their projected levels, even if they do not decline absolutely. If the rule of in-period budget-balance is strictly enforced, public services supply will be curtailed during such periods, and, of course, expanded sharply during booms, neglecting possible in-period tax-rate adjustments.


The question is whether or not the individual will choose to allow specific relaxation of the rule of in-period budget-balance in order to facilitate a steadier flow of public service supply over time. It seems evident that he will do so. Note, however, that this departure from in-period balance is justified solely on the grounds that it will facilitate a smoothing out of public spending over time. We have not yet examined the individual's choice calculus when he recognizes that, by allowing some departure from in-period budgetary-balance, aggregate community income over time may actually be increased. Fluctuations may not take place around some long-term growth path, but, instead, may represent a "bouncing down" on occasion from a long-term growth path considered properly as a ceiling. It is this latter purpose of unbalanced budgets that the Keynesian and post-Keynesian discussion of fiscal policy is all about. It also seems clear that the individual, who is presumed here to be contemplating the design or constitution of the financial structure of his government, will tend to prefer features for this structure that will promise the highest level of community real income over time, other things equal. His motivation is found directly in the fact that his own income prospects are related, probabilistically, to aggregate community income.

Fiscal Policy in a Closed National Economy


The next question is that of determining what structural features of a budgetary policy will best accomplish this. It is necessary to make additional clarifying assumptions at this point. Assume that the individual, whose constitutional choice process we are examining, lives in an isolated, fully closed economy, with only one governmental unit. Fluctuations in aggregate money income are anticipated to occur because of changes in the demand for circulating media, and these are expected to be translated quickly into fluctuations in real income and employment on the downside because of acknowledged rigidities in the wage-price structure. Assume further that the supply of money is not directly controlled by the government, despite its money-creating powers, but is, instead, allowed to adjust passively to demands via the mechanism of a banking system. The government may, however, add directly to or subtract from the supply of money by an exercise of its money-creating power.


In such conditions as these, the rational individual should recognize that the government's budget provides one instrument that might be utilized directly to insure against downswings in community income. Some departure from the strict rule of in-period budget-balance is suggested, despite the effects of in-period fiscal choice that this departure might also be predicted to produce. (These effects have been discussed in Chapter 8.) The individual may, therefore, authorize or "vote for" the authorization for the government to create deficits deliberately during periods of threatened retardation in aggregate community income growth. In these conditions, deficit creation may be among the set of fiscal institutions judged to be efficient by the individual citizen.


Deficits, if they are allowed to occur, must be financed, and the mere authorization of deficit creation does not imply anything at all about the manner of financing them. Nevertheless, the rational response of the individual here seems clear. He will authorize the government to create money in order to cover deficits in its current budget accounts during periods of real income slack. Money creation by government along with the injection of the newly created money into the economy via the fiscal process seems indicated. If the deficit-creating, deficit-financing institutions are successful in accomplishing the objective sought, community income will grow at a steady rate.*97 This growth in itself will require that net additions be made to aggregate purchasing power over time if final product prices are to remain stable; hence, a net budget deficit over time becomes desirable.*98


Note that nothing in the analysis here suggests that public debt issue be authorized as a means of financing budget deficits. Public debt is a different fiscal institution from money, despite the unexplainable and near-inconceivable refusal of many sophisticated economists to recognize the distinction. By definition, an issue of public debt must involve a transfer of current purchasing power (liquidity) from the lender (a member of the public who purchases the securities) to the borrower (the government) in exchange for which the borrower obligates itself to pay an interest charge during subsequent time periods. An operation of this sort is obviously undesirable when the purpose of the budget deficit is to increase the total flow of spending in the economy. Hence, the rationally chosen institutional structure will contain no provision that would allow the financing of budget deficits by debt issue, under the conditions postulated.

Fiscal Policy in a Wholly Open Economy: The Case of the Local Governmental Unit


The conclusions reached above hold only in the wholly closed economy. To the extent that an economy is open, different conditions prevail and the whole analysis requires re-examination. By an "open economy" here we mean that citizens are free to purchase and to sell goods and services with citizens of other jurisdictions, and, beyond this, are free to transfer both labor and capital resources freely among separate jurisdictions. Real-world national economies normally represent some combination of the closed and open models. We shall return to discuss these mixed models at a later point. The extreme example of an open economy is that of the local community in a larger national economy. Here not only does freedom of trade and of resource mobility exist; also, the local governmental unit does not normally possess the constitutional power to create money. It will be helpful to examine the individual's choice process when he attempts to select an optimal fiscal constitution for the local governmental unit. Will he find it desirable to include institutions that will produce a positive fiscal policy for the local governmental unit? Will provisions be made for allowing budget deficits to be created and financed during periods when the state or the municipality is characterized by relatively low levels of aggregate income?


Somewhat surprisingly, this question seems rarely to have been raised. There has been considerable discussion concerning the role of state-local governments in macro-economic policy.*99 This discussion has been concentrated on measuring the actual impact of state-local fiscal structures on the flow of national spending over past periods. There has been almost no discussion of the normative principles which "should" guide state-local decision-makers. Inferentially, the textbook or standard attitude seems to have been as follows: It would be desirable if state-local units should "co-operate" with the national government in furthering the "national interest" by explicitly adopting counter-cyclical policies. Few scholars have asked the question: What should state-local units do in this respect in furtherance of their own interests?*100 To rephrase this same question so that it fits our own frame of reference: Will the individual want to include in the fiscal constitution of his local governmental unit some provisions for a positive fiscal policy?


The answer is not so simple here as that derived with respect to the closed economy; the institutions available to the chooser are different in the two cases. For the local government, the financing of budget deficits must involve borrowing, the creation of public debt. The unit has no recourse to money creation. The fiscal structure that was shown to be optimal for the closed national economy cannot, therefore, be applied for the local unit. Will a policy of deficit creation, with deficits to be financed by debt issue, prove efficient?


Consider once again the setting in which this question is put. The individual anticipates that the income of the local community may fluctuate over time, and that his own income prospects are directly related to the levels of community income, although somewhat less so than in the previous model. If his needs for both private and public goods are expected to be more uniform over time than this income, he will tend to approve both tax devices that contain some built-in revenue flexibility and also some authorization for public debt issue. These institutions combined will facilitate a smoothing out of both private and public consumption over time.


This does not, however, get at the central question. Will a positive fiscal policy—that is to say, one that is designed to raise income levels of the community during periods of depression—seem desirable as an adjunct of local government fiscal structures? To get at this, we must inquire concerning the predicted effects of deficit creation and deficit financing in periods of locally depressed activity. Aggregate income in the community is presumed to have fallen. A budget deficit has emerged as revenues from approved tax institutions have shrunk and as spending rates have been maintained or increased. To finance the deficit, the local governmental unit has created and sold public debt instruments on the capital market. Can this combination of events be expected to generate a real income increase in the local community? The answer is clearly affirmative, and for a reason that may appear paradoxical to some scholars. The flow of spending in the local community will increase because the government here borrows funds on the national capital market. If this unit is small relative to the size of the total economy, the interest rate is not modified. The debt created is external to the local community; no funds are drawn away from either local consumption or investment spending. If, through some quirk, funds have been drawn from local sources, that is, if the debt is internal, there would be little, if any, income-creating effects of the combined operation. This seems almost to reverse the implied conclusions of much orthodox theory; the elementary textbook discussion of fiscal policy is likely to suggest or to infer that deficit financing is to be recommended as income-generating only if internal public debt is used as the financing device. By contrast, the model here suggests that deficit financing through public debt issue is efficient only to the extent that external debt is created.*101


The combined operation tends to attract capital funds from the whole economy; these funds are expended locally by the governmental unit in purchasing public goods and services. Aggregate community income rises; unemployment is reduced. Real income of the local community over time is increased. A heritage of public debt will exist after the initial period, and this will impose a net burden of servicing this debt on taxpayers in all subsequent periods. The question becomes that of determining whether or not the current-period increase in income is sufficient to outweigh in present value the discounted value of the future tax obligations.


Consider first an extreme case in which the local community purchases the public goods supplied to local citizens exclusively from external sources. Pure examples of this sort are difficult to imagine, but one could think of a local community supplying educational services to its children by sending them bodily to other communities for schooling, paying the other communities for these services. In this case, there would be no local income multiplier effect. However, since the public services themselves represent additions to real income, the combined operation is still desirable, provided only that the decision to supply the services is an efficient one. The present value of future taxes required to service the debt that financed the services should just be equal, in some objectively quantifiable sense, to the current value of the services that are supplied. But, of course, the combined operation here would do nothing to increase local income and employment outside the particular benefit stream.


In almost all cases, there will be a local multiplier effect. The community will only in rare circumstances purchase resource inputs exclusively from external sources. Normally, in supplying local public goods and services local citizens will be employed, local inputs will be purchased. To the extent that this takes place, some of the debt-financed spending by the local government will remain in the community and private spending in subsequent periods will increase. When this occurs, the combined deficit creation-debt financing operation will clearly be extramarginal. The present value of the future taxes required to service the debt obligation may fall far short of the current value of the public service benefits plus the current net additions to local income. A positive fiscal policy seems clearly to be desirable for the local governmental unit when its operations are viewed ex ante, even though this unit does not possess money-creating powers.


To this point, we have assumed that income in the local community declines without specifying what happens elsewhere in the national economy. It is perhaps evident that the analysis above holds without reservation in those situations where national aggregate income remains constant or increases at some steady rate while local community incomes vary. Suppose, however, that the over-all level of national income falls below desired levels uniformly in all areas of the economy. Will it then be desirable for a single local governmental unit to follow a positive fiscal policy? If the national government takes no action of its own to bring over-all national income to desired levels, there is no basis upon which a single local unit can predict the trend or growth path of national income over time. Faced with depression in its own area that is known to be matched by similar conditions elsewhere, should the local unit carry out fiscal policy?


Suppose that the central government adheres strictly to a rule of in-period budget-balance, and that it undertakes no positive monetary policy. Income throughout the economy falls as a result of hoarding, and this affects all local communities uniformly. Consider then the plight of the single local government. Assume that no other community is observed to undertake fiscal policy action. What will happen if the one local unit, on its own, tries to carry out positive fiscal policy? Income in the community is below desired levels; and revenues from existing tax institutions are below those needed to finance public spending. In order to maintain public-goods supplies, the local unit issues public debt. This debt will be purchased and the funds supplied by the banking system at existing rates of interest. The local community's behavior here adds a net increment to the spending stream in the economy, and, for the national economy as a whole, the full income multiplier will operate. But, for the local unit, leakages to other communities can be predicted. However, some local multiplier effect will remain, as suggested above. The fiscal policy action remains rational within certain limits.


As income in the single community rises, resources from external sources will tend to flow differentially to the area, quite apart from the ordinary leakages. These resources will compete with local resources for employment, and an unduly high level of unemployment may remain. Should the community, still acting alone, continue to add to its spending rate through deficit creation financed by debt? Beyond some point, there will be little current real income to be gained from expanding local public-goods supply. However, if local income gains are sufficient, continued deficit creation is suggested, provided only that the resources which flow into the local area are somehow brought into the local tax base. In other words, if the local income generated as a result of the operation can be made the base for future tax obligations embodied in the debt that is issued, there is no reason why the single local community should not continue to carry out the fiscal policy so long as net increments to local income exceed the current value of future taxes made necessary by servicing and amortizing the debt.

Fiscal Policy for the Private Citizen


If the analysis of normative fiscal policy for the single governmental unit in a wholly open economy is accepted, similar conclusions should follow for the individual since his "economy" is, par excellence, wholly open. In making his earning-saving-spending plans over time, should the single person or family act so as to conduct "positive fiscal policy"?


It seems evident that he should do so. If his own income declines while the income of the whole community remains steady, he should, of course, borrow in order to stabilize spending. If this borrowing-spending generates any "private multiplier" effects on his own income, this provides an extramarginal incentive for such behavior. The difference between the individual and the local government arises solely out of the fact that the latter, being the larger, is more likely to enjoy some local multiplier effects. The point to be emphasized here is that, conceptually, there is no difference at all in the principles of rational behavior. The individual who lays out his own optimal spending-saving plans over time, and the individual who tries to lay down, constitutionally, the optimal spending-saving plans for his local governmental unit are one and the same, and behavior in each case is informed by the same criteria.

Fiscal Policy for a National Government in a Partially Open Economy


National governments possess money-creating power. This essentially distinguishes them from local governments. But they may operate in an international economic order that is substantially open, especially in that trade can move freely across national boundaries and that capital is highly mobile as among different nations. The model to be used in deriving a logic of fiscal policy from individual choices here must be some combination of the wholly closed and the wholly open economy models that have been examined above.


Since national governments do possess powers of money creation, some assumptions must be made concerning the institutions that relate national currencies one to the other. It will be helpful to consider the models under each of two assumptions, freely fluctuating exchange rates and fixed exchange rates.


National Fiscal Policy Under Fixed Exchange Rates in an Open International Economic Order.  In specifying the conditions of this model, we may follow Mundell in assuming that the mobility of capital is such that interest rates among separate countries tend to be equalized.*102 Let us also assume that the country is small relative to the world economy.


Suppose now that a decline in the level of spending in the national economy is anticipated. Assume that the standard Keynesian conditions are present. Wages, and prices, are rigid against downward pressures. It will be useful to trace the effects of three possible sets of governmental actions designed to prevent the decline in national real income.


1. The government may create a budget deficit (or allow one to emerge) and finance this deficit with the creation of new money. Aggregate spending is maintained at the desired level. Interest rates do not move upward or downward; hence, there is no net change in international capital flows. Prices remain steady; there is no change in the international balance of payments. It seems clear that this set of policy instruments, which is the same as those previously shown to be efficient for the wholly closed economy, remains the efficient set under this partially open model.


2. The government may attempt to accomplish the same purposes through orthodox "monetary policy," defined as the use of open-market weapons. In an attempt to stimulate internal demand, the monetary authority purchases securities. Interest rates will tend to fall; capital flows out of the country. A balance-of-payments deficit emerges, and the monetary authority may find it necessary to sell foreign exchange to restore this balance. This, in turn, offsets the initial purchase of domestic securities. Monetary policy under these conditions tends to be self-defeating.


3. Now suppose that the government, inadvisedly, decides to create a deficit, as under the first alternative, but to finance this deficit, not with money creation, but with public debt issue. Here the results are identical with those treated with respect to the fiscal policy operations of the local governmental unit in the wholly open economy. The only difference between these two cases is that the much larger national economy can expect a higher local income multiplier to be operative; potential leakages will be largely internalized. Through selling debt instruments in this model, the national government is effectively borrowing on the world capital market. It is adding directly to the national spending stream without creating new money directly. The operation becomes, in effect, equivalent to external borrowing.


If the first alternative is not possible, this third alternative may, of course, be recommended. However, when the first alternative is available, as it should be in all cases where the governmental unit does possess the power to create money, this third alternative is not efficient. It involves the creation of a future tax liability due to the necessity of servicing the debt that is created. This sort of liability simply does not exist under the first alternative since interest is not paid on money.


National Fiscal Policy Under Fluctuating Exchange Rates in an Open International Economic Order.  Using the same basic assumptions as before, let us now examine the same three policy combinations under a regime where exchange rates are allowed to fluctuate freely.


1. The government creates a budget deficit (or allows one to emerge) during periods of threatened declines in total spending; it finances this deficit with money creation. Aggregate spending is maintained at the desired level. No pressure is put on interest rates, and the price level does not change. There is no change in the exchange rate.


2. The government may try to accomplish the same objective with orthodox monetary policy. It directs the monetary authority to enter the open market and purchase securities. This action puts downward pressure on interest rates. Capital tends to flow out of the country; the exchange rate falls. This, in turn, generates an expansion in exports. Income and employment are maintained. This policy combination seems to be successful here whereas it was unsuccessful under a regime of fixed exchange rates.


3. Suppose now that the government creates a budget deficit and finances this deficit with the issue of public debt. The sale of securities tends to raise interest rates domestically; but this will attract capital into the country and upward pressure will be put on the exchange rate. This will, in turn, discourage exports and encourage imports. In the net, there may be little or no effect on domestic income and employment because, in equilibrium, the interest rate may not have changed and the money supply may not have increased. The fiscal policy action in this instance will fail to accomplish its desired purpose of shoring up domestic spending on goods and services.*103


Why does fiscal policy fail here? It does so because the exchange rate effectively isolates the domestic and the foreign capital markets, and prevents the flow of foreign capital to the country that takes place under the fixed-rate system, and which serves as a possible base for expansions in the domestic money supply. The increased spending flow generated here by the deficit-financed purchases of public goods and services is offset by the increased foreign drainage resulting from the shift in the exchange rate.


The most interesting, and seemingly most paradoxical, conclusion stemming from the analysis of the various models here is that the efficacy of debt-financed deficits in shoring up local income is greatly enhanced when the institutions are such as to make this debt external in its essential respects.



Under a regime of flexible, as well as fixed, exchange rates, the first alternative seems to be recommended. A positive fiscal policy that incorporates the possibility of generating budget deficits during periods when total spending threatens to fall below desired levels along with the provision that these deficits should be financed with money creation can emerge from the rational constitutional choice calculus of the individual. Similar adjustments may, of course, be included to allow for fiscal adjustments in the event of threatened or actual inflation. These have not been traced here.


It is important to note, to repeat, that the creation of public debt, as such, is never indicated for those governmental units that possess money-creating power as a part of the positive fiscal policy instruments under their control. It is clearly inefficient to create debt which requires a payment of future taxes when money can be issued without such service charges. Public debt should remain as a part of an over-all "fiscal constitution" of such governments only for issue during periods of high-level employment. For lower-level governments, as well as for private citizens, deficits must be financed by debt. In this case, a positive fiscal policy embodying debt issue may be efficient.

Notes for this chapter

Institutional rigidities in the economy may, of course, prevent the maintenance of both full employment and price-level stability along this growth path. Resolution of this conflict need not be discussed here. If inflation threatens, the policy institutions suggested are, of course, the reverse of those discussed.
The alternative institutional structure that might be designed to accomplish equivalent objectives is that one which allows strict adherence to in-period budget-balance, in the sense traditionally defined, and which then allows some governmentally created "monetary authority" to engage in "monetary policy." During periods of depressed community income, this authority would purchase, with new money, securities held by the public.

Careful examination reveals that this alternative structure is only superficially different from the first. Since the monetary authority must be a part of the government, its own "budget" should properly be conceived as a part of the government's budget. When this is accepted, the "monetary policy" differs from the "fiscal policy" alternative only in the fact that with the former, new money is used to purchase securities only, while in the latter, the new money is used to finance public-goods supply. Viewed in this light, the fiscal policy alternative seems relatively more efficient. Other considerations may, of course, modify this tentative conclusion. Notable among these might be some consideration for the burden of outstanding public debt. The monetary policy alternative allows for some retirement qua monetization of this debt over time whereas the fiscal policy alternative does not.

Although the list is by no means exhaustive, the following items may be noted: A. H. Hansen and H. Perloff, State and Local Finance in the National Economy (New York: Norton, 1944), especially Chapter 4; Mabel Newcomer, "State and Local Financing in Relation to Economic Fluctuations," National Tax Journal, VII (June, 1954), 97-109; Ansel M. Sharp, "The Counter-Cyclical Fiscal Role of State Governments During the Thirties," National Tax Journal, XI (June, 1958), 138-45; James A. Maxwell, "Counter-Cyclical Role of State and Local Governments," National Tax Journal, XI (November, 1958), 371-76; Morton A. Baratz and Helen T. Farr, "Is Municipal Finance Fiscally Perverse?" National Tax Journal, XII (September, 1959), 276-84.
This question is raised and discussed by Clarence Barber in his monograph "The Theory of Fiscal Policy as Applied to a Province," A Study Prepared for the Ontario Committee on Taxation (June, 1964), especially in Chapter 2. I am grateful to the Committee for allowing me to have access to this study. Barber's work stimulated my own interest in elaborating some of the models of this chapter, and appropriate acknowledgment should be made of this fact.
This has been recognized in a slightly different connection by Ronald I. McKinnon and Wallace E. Oates, "The Implications of International Economic Integration for Domestic Monetary, Fiscal, and Exchange Rate Policies," Memorandum No. 37, Research Center in Economic Growth, Stanford University (May, 1965).
The models discussed are essentially the same as those examined by R. A. Mundell in his provocative paper, "Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates," Canadian Journal of Economics and Political Science, XXIX (November, 1963), 475-95. See also the paper by McKinnon and Oates previously cited.
As noted, this analysis follows closely that presented by Mundell, "Capital Mobility," Canadian Journal of Economics and Political Science. He concludes that fiscal policy tends to be self-defeating in conditions of flexible exchange rates, and that monetary policy tends to be self-defeating under conditions of fixed rates. In effect, Mundell examines only alternatives II and III under each model, and he considers that fiscal policy must embody debt-financed deficits. As the analysis here indicates, if the first alternative is available, that of financing deficits with new money creation, this may be the most efficient policy combination under either fixed or flexible exchange rates.

End of Notes

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