Fiscal sustainability, or public finance sustainability, is the ability of a government to sustain its current spending, tax and other policies in the long run without threatening government solvency or defaulting on some of its liabilities or promised expenditures. There is no consensus among economists on a precise operational definition for fiscal sustainability, rather different studies use their own, often similar, definitions. Many countries and research institutes have published reports which assess the sustainability of fiscal policies based on long-run projections of country's public finances (see for example, and ). These assessments attempt to determine whether an adjustment to current fiscal policies that is required to reconcile projected revenues with projected expenditures. The size of the required adjustment is given with measures such as the Fiscal gap.
Government's inter-temporal budget constraint
There is no consensus among economists about the correct criterion/definition to be used for fiscal sustainability. The most commonly used criterion is the government's inter-temporal budget constraint or inter-temporal equilibrium condition:
where is the stock of public debt, is the interest rate of public debt and is the primary balance (negative of primary deficit or government revenues minus government expenditures excluding interest expenditure).
The government's inter-temporal budget constraint states that the initial debt level should be equal to the present value of future surpluses. That is, the government debt must be backed by expected future cash flows.
Many economists have voiced grave concerns over using inter-temporal budget constraint as a de facto definition or criterion for fiscal sustainability. Also, it has been shown that under plausible assumptions the inter-temporal budget constraint is in fact not the correct criterion for sustainability.
Indicators of fiscal sustainability
There are many different indicators of fiscal sustainability. The indicators measure the fiscal adjustment required to bring public finances back to sustainable track. Specifics of the indicator depend on the operational definition of fiscal sustainability and the underlying economic modelling framework employed in a study. Some of the most commonly used indicators are so-called tax gaps. For example, the infinite horizon tax gap, or S2 sustainability indicator in European Commission phraseology is defined as:
where is the debt-to-GDP ratio, is the interest rate of government debt, is the growth rate of the economy and is the primary balance to GDP ratio.
The infinite horizon tax gap gives the adjustment required to satisfy the inter-temporal budget constraint in terms of a permanent one-time change to projected path of primary balance to GDP ratios. Thus, if ITGAP = 5%, primary balance must be greater than projected by 5% of GDP for each future year. This could be achieved by permanently raising taxes or cutting expenditures 5% of GDP. For derivations and more information, see for example, or.
- Government debt
- Government budget deficit
- Fiscal policy
- Government spending
- Government budget
- Public finance
- Generational accounting
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