FINANCING GOVERNMENT SPENDING

I. METHODS OF FINANCING

Every government must find the revenue to finance its spending plans. The Ministry of Finance in Taiwan is responsible for obtaining the funds to finance spending by the central government in the ROC. There are five basic ways in which the government on Taiwan can finance its spending. Let's consider each of these ways.

First, the most common and most important source of funding for government is taxation. However, the design of the tax system is very complicated and involves many considerations. Taxes can directly affect the behavior of individuals and companies, so it is not clear which types of taxes are the best to use. In general, economists look for taxes having the least distortionary effect on the economy. What this means is that such taxes should not cause the demand and supply of goods and services to be greatly disrupted. For example a tax on food may cause consumers to alter their desired eating styles, while it may cause suppliers to experience undue economic hardship. Taxing interest payments may cause households to save less than they would normally, and this could hurt the economy's long run growth and productivity. In addition to taxes there are other forms of fees that are paid such as tariffs, user fees, rents on public land, licensing fees, etc. Finally, taxes should be chosen so that they can be efficiently and fairly collected. Some taxes cause individuals to evade taxes. These individuals operate in the underground economy, and this is very unfair for others who pay their taxes.

The second source of funding comes from bond sales. Here the government issues bonds, or fixed income securities, to individuals and banks, and obtains credit for a certain period of time. Bond sales in the ROC have become more and more important, due to the implementation of the Six Year National Development Plan. Bonds have both interest payments and principal payments. A seven year bond which is issued will mature in seven years. During this time, each year, interest payments will be made. At the end of the seven years, the principal will be paid off. Newly issued bonds are sold in the primary bond market by investment bankers or underwriters. After a bond has been sold in the primary market, the holder can sell it to another person in the secondary market if he needs the cash. The price of bonds will vary inversely with the market rate of interest. Therefore, we say that any increase in interest rates will depress bonds prices. And, any decrease in bond prices will be associated with increases in interest rates.

The third source of funding the government has is by issuing money. Here the central bank can buy government bonds and create money for the government to use. This method is not used very often because it is considered inflationary. But, technically, any increase in the money supply must originate with the government, so that the new money represents funds which it can use. The simplest way to see this is with currency. Suppose that the government buys paper for $1 NT and then uses the paper to print a $100 NT bill. The profit that the government gets is therefore $99 NT and this is called seniorage. More complicated examples are possible, and are often discussed by economists.

The fourth way that the government can obtain funds is from the profits earned by the state run enterprises. When the Taiwan Power Company makes a profit, or the China Petroleum Corporation has net earnings, this money returns to the state coffers. Taiwan currently has about 100 state run industries. Some of these are owned by the central government, some by the provincial government, and some by municipal governments. Recently, there has been a movement in Taiwan to privatize these large state run firms, which leads us to the last source of government funding.

The final means of financing government is a short run method. This involves the sale of government assets to the private sector or to foreigners. If the government has land, then it can sell this land to the private sector and obtain money for its own disbursement. It is estimated that the state run firm Taiwan Sugar Company owns 8-10% of the arable land in Taiwan. If this land were to be sold, the government could obtain a huge amount of funds. The recent sale of China Steel common stock to private interests also garnered a considerable sum to the central government. However, after the government owned asset is sold to the private sector, the government loses any future income which the asset would produce. It is this reason that we say this method is only valid in the short run.

II. WHICH METHOD OF FINANCING IS THE BEST?

As we have seen there are five sources of income to which the government has recourse. Whichis the best source to use? This question is not easy to answer, and will depend on the circumstances. It also involves a political judgment, since different segments of the economy will be hurt depending on which method is chosen.

Suppose that we only used taxes to finance government spending. This is sometimes called a balanced budget rule of fiscal policy. Although it sounds very good, it has numerous problems. For example, if the government does not issue bonds, then investors or savers in the economy will not have an important, risk free place to invest their money. One can invest in the stock market, and one can invest in land and property, but these all carry substantial risk. Furthermore, banks hold many government bonds and would have greater risk if these bonds were not available. The interest on bank accounts which savers could hold would have to be much lower than presently exist. Also, households would have to pay much higher taxes, and certainly they would oppose this idea.

Next, suppose that only bonds were used and taxes were completely eliminated. In this case, a very large amount of bonds would have to be issued. This would lower bond prices and drive up interest rates in the economy. Companies which needed to borrow funds would find it impossible, because the government is "crowding out" their demand. The government would find that each year the principal and interest payments on the debt outstanding would increase, leading to even more bond sales. The system would not take long to break down.

Finally, suppose that the government used only the printing of money to finance its expenditures. This is what happened in Mainland China from 1945-1949. The result was an extremely high rate of inflation, which economists call hyperinflation. The ever rising supply of money was not matched by an equally rising supply of goods. This caused the prices of goods to skyrocket. Clearly, this is not a reasonable way to finance government spending.

We see that each method by itself is undesirable, but with the proper mixture of sources, government can have a stable supply of revenue to finance its spending. The proper choice or mixture of resources is a complicated issue, and economists will continue to debate the issue in the future.

Discussion Questions:

1. Which of the five methods of public finance is most important in Taiwan?

2. Are government deficits a bad thing? Why or why not?

3. Is privatization a very good policy in Taiwan?

4. What causes interest rates to rise in Taiwan?

5. Give some examples of Taiwan's underground economy.

6. Should Taiwan raise taxes and lower its budget deficits.

7. Should the money supply in Taiwan be kept constant?