By W A Wijewardena –

Dr. W.A Wijewardena

Budget maximisation by governments

American economist William A. Niskanen, writing to the American Economic Review in 1968 presented a model in which the governments and government agencies have incentives to enlarge their budgets. He called this the budget maximising behaviour of bureaus – spending units in the governments – to enhance the personal benefits for themselves rather than for the citizens. This model, further developed by him, was published later in 1971 in book form under the title “Bureaucracy and Representative Government” and in 1973 as a Hobart Paperback edition under the title “Bureaucracy: Servant or Master?”.

Principal-agent problem in budgeting

The gist of Niskanen’s arguments is as follows. The governments provide services to people through spending units – called bureaus – operated by public servants known as bureaucrats. There are three parties involved in this game, bureaucrats, politicians, and the people. People demand public services and politicians as holders of the public purse agree to supply them. They have the power to tax the people to finance such public services. Hence, eventually it is the people who bear the cost. Accordingly, in this model, people are the principals and politicians and bureaucrats are the agents. In any contract, agent is required to meet the goals of the principal. That rule applies in this case too. Thus, politicians and bureaucrats are to meet the goals of the people and not their personal goals.

But what the experience shows is that bureaucrats work toward the attainment of their own personal goals instead of meeting the goals of the people. In economics, this is known as the principal-agent problem. But the bureaucrats maximise their budget or the total expenditure involved in the supply of the expected public service. Though Niskanen has not mentioned it, in countries like Sri Lanka, both politicians and bureaucrats work collusively to enhance the budget to serve their own interests. The people have no power to control it and hence, the augmented budgets are forced upon them by the two categories that work for their own personal interests. Hence, the total Government expenditure in the budget is much more than the true cost of providing various public services.

Public monopolies are not so virtuous

Niskanen in this model challenges the traditional view that public monopolies are better than private monopolies because the former can be controlled by the people. But since they have no power to do so and both politicians and bureaucrats work collusively against them, it becomes just a fiction rather than a fact. Hence, he suggests that public monopolies should be broken by getting the competitive private service providers to work along with them. It would establish benchmarks to assess the performance of the public monopolies. Niskanen concludes that most bureaus are too large, use too much capital, grow too fast, and exploit the people who supply funds for running those bureaus. The absence of good governance within the public sector makes the matters too complicated. If the budget of the government is enlarged due to the unchecked corrupt practices, that burden too is passed on to the people.

Burden of budgets

What this means is that the Government expenditure rises above the levels which it should be under the competitive conditions. This poses a serious problem for the bearing of the burden by the people who are the sponsors of numerous public services. The general belief by people is that it is only the taxes that they pay – either direct or indirect – that constitutes their burden. Taxes are a burden because those who pay them are left with a lesser amount for their own welfare, current or future consumption, on one side, and the ability to make more money in the future through income generating investments, on the other. If the public services are produced by minimising the budget, the people will get back what they have sacrificed. But if the budget is maximised by the two agents, politicians and bureaucrats, the people will have to pay more. Hence, even if the budget is fully funded by taxes, it is an unnecessary burden being borne by people.

Taxes only one source

Taxes constitute the only source of financing the budgets if they are balanced budgets. That is because in balanced budgets the total expenditure of the budget is equal to the total revenue. But if the budget runs a deficit, that is, the total expenditure is more than the total revenue, there are two other important sources of financing the budgets. One is borrowing from the domestic or foreign, or a combination of both. The other is the money printing power of modern states.

Burden of foreign debt

When a country makes a foreign borrowing, resources are transferred from the rest of the world to the country concerned increasing its total welfare levels. Foreign borrowings delivered in the form of foreign exchange helps a country to finance investments if the domestic savings are not sufficient, increase consumption through a higher inflow of imports, and build a buffer stock of foreign assets to meet unforeseen negative external shocks such as increases in the prices of essential raw materials. But when the foreign loans are repaid, there is a corresponding resource outflow from the country. It reverses the original welfare gains by forcing the citizens to sacrifice the current consumption or investments unless the country has gained capacity to repay those loans through increased foreign exchange earnings. If that capacity has not been increased, as in the present case in Sri Lanka, foreign borrowings constitute a burden for the people. This is true if the foreign borrowings have been used for current consumption or for wasteful projects or for destructive wars.

Domestic debt not mere redistribution of assets

Domestic borrowing by the governments have been viewed for long by economists as a mere redistribution of assets involving no burden at the national level. When the government borrows domestically, it issues bonds. The lenders to the government will convert their cash assets to bond assets. When those bonds are repaid, the people will reconvert the bond assets back to cash assets. Hence, it is an instance of people owing to themselves. As a result, it was long held by economists that domestic borrowings do not constitute a burden to the people.

No difference between debt financing and tax financing 

But in early 19th century, the English economist David Ricardo disputed this theory. Suppose the Government has financed its expenditure by borrowing domestically so that the people will have to pay less taxes in the current period. Thus, the burden of tax payments is eased. However, at the time of repaying the bonds, the people are required to pay more taxes to provide funding for the bond repayments. Hence, it is simply a postponement of the current tax liability to the future generations which economists have termed as ‘intertemporal burden bearing’. As such, Ricardo’s position was that there was no difference between the bond financing and tax financing. Hence, it is known as Ricardian equivalence.

Huge profits in money printing

During Ricardo’s time, there was no money printing as a method of financing budget deficits as a routine matter. It was used in exceptional circumstance like waging a war against another country. Hence, Ricardo did not look at money printing as a burden to be borne by the people. Money printing became a mode of budget financing after the Governments started issuing paper currency of which the cost of printing was less than the face value of the note concerned. For instance, if the printing cost of a 5,000-rupee note is Rs. 20, for every note issued by the Government generated a super profit of Rs. 4,980 called seigniorage by economists. Since there was no visible burden involved, it was also believed that financing the budget deficits did not impose any burden to citizens.

In fact, it is this logic which is being presented by those who advocate Keynesianism as a policy guide for governments to run budget deficits. Hence, today, when the Governments use this source to finance the budgets, if it is used excessively over the real growth in the economy, it will lead to the imposition of a new type of tax called the inflation tax. Money is needed to allow the growing volume of transactions in an economy supported by the real growth. For instance, if the real growth is 5% and the money supply growth is 5%, it will not cause inflation since the new money is needed to have a smooth flow of transactions in the country. But if it is done excessively over the real growth, it will lead to inflation which is a method of transferring resources from the citizens to the Government.

Inflation tax 

How the inflation tax operates can be explained by a simple example as follows. Suppose the Government gets the central bank to print a 5,000-rupee note and uses it to buy the services of a teacher for one month. The teacher sacrifices her real labour for this 5,000-rupee note but the Government sacrifices only the printing cost, say Rs. 20, in real terms. Hence, it is an unequal exchange in which the teacher makes a bigger real sacrifice than the real sacrifice made by the Government. But why should the teacher agree to this unequal exchange? That is because she is told by the Government that with this 5,000-rupee note she can command a basket of real goods from the market.

For simplicity, let’s assume that there is only one real good and that real good is milk food. If a kilogram of milk food costs Rs. 5,000, this teacher exchanges one month’s real labour not for a piece of paper but for a kilogram of milk food. But if the Government has given these 5,000-rupee notes to others also – which is the case always – they also go to the market to buy milk food raising their price to say Rs. 10,000 a kilo. Now the teacher can buy only half a kilo of milk food for her 5,000-rupee note. The other half of a kilo she has lost is a tax she has paid to the Government. Since it arises from inflation, it is known as inflation tax.

CCPI and elevated cost of living

Let’s take an example to illustrate this point. In terms of the new series of the Colombo Consumers’ Price Index or CCPI, in January 2021 when the CCPI was 100, it cost a family of 3.8 members Rs. 91,880 to buy the basket of real goods and services involved. In January 2024 when CCPI has increased to 200.6, the family should spend Rs. 184,311 to buy the same basket of real goods and services. That has increased the cost of living by 100%. If a family has the same income level as in January 2021, it amounts to cutting their real purchasing power by a half. This is an inflation tax which Sri Lankans have been paying over the period.

Burden of gross expenditure

Hence, it is not the current tax burden only that people should worry about. It is the total Government expenditure, known as the gross expenditure, about which they should be worried. If the Government expenditure level is high and it is financed by taxing people, borrowing from both domestic and foreign sources, and printing money leading to inflation, people are forced to bear a burden. Hence, higher the Government expenditure, greater the burden being borne by people.

For instance, the Budget 2024 envisages to raise Rs. 3.8 trillion by way of taxes and another Rs. 307 billion as other incomes. But the total Government expenditure that includes the repayment of both domestic and foreign debt as well has been estimated at Rs. 11.7 trillion or 35% of estimated GDP. It has generated a gross financing requirement of Rs. 7.4 trillion or 22% of GDP. Since the new Central Bank Act has prohibited the direct money printing to finance the budget, the entirety of the gross financing requirements should be financed by borrowing from the domestic and foreign sources and from commercial banks.

The last item is money creation and, therefore, it leads to an inflation tax imposed on citizens.

Cut the gross expenditure and not the budget deficits

Thus, it is the total Government expenditure that should worry citizens instead of the mere tax payments. The total expenditure of the Government, known as gross government expenditure, is made up of the recurrent or consumption expenditure, expenditure incurred for building the country’s capital stock, and money used for repaying the maturing Government debt.

Financing that expenditure, whether it is done through taxes, borrowings, or money printing, or a combination of all the three, is a burden to the people. Taxes force them to bear the burden today, borrowings tomorrow, and inflation today as well as the future.

Hence, the unwarranted increase in the Government expenditure is a worrisome matter for the people of a country.

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com