# 18. General government purchase of goods and services, balanced budget

The experiments above have demonstrated that the public budget could either end up in deficit or in surplus depending on the effect on public revenues or expenditures. This happens because there is no fiscal reaction function in ADAM that can be activated in order to keep the public budget in balance. The following two experiments show the effects of a demand shock and a supply shock, respectively, when the public budget is kept in balance in the long term through a change in the income tax rates. Table 18 presents the effect of a permanent increase in government purchases of goods, financed by higher income taxes. The public purchase of goods and services is increased by 1000 million, in 2005 prices. The central government income tax rates are permanently raised by 1.1 percent and the capital tax is temporarily raised by a lump sum of 0.17 percent of GDP in the first year only. (See experiment) Table 18. The effect of a permanent increase in public spending, balanced budget
|  | 1. yr | 2. yr | 3. yr | 4. yr | 5. yr | 10. yr | 15. yr | 20. yr | 25. yr | 30. yr
|  | Million 2005-kr.
Priv. consumption | fCp | -446 | -826 | -1091 | -1341 | -1508 | -1767 | -1861 | -1949 | -2006 | -2049
Pub. consumption | fCo | 1167 | 1185 | 1202 | 1220 | 1239 | 1340 | 1448 | 1565 | 1690 | 1824
Investment | fI | 178 | 121 | -331 | -589 | -703 | -677 | -449 | -319 | -276 | -262
Export | fE | -36 | -51 | -57 | -56 | -50 | 79 | 251 | 314 | 245 | 97
Import | fM | 313 | 160 | -126 | -299 | -363 | -243 | -50 | 53 | 88 | 92
GDP | fY | 574 | 294 | -107 | -413 | -600 | -717 | -502 | -384 | -375 | -416
|  | 1000 Persons
Employment | Q | 0,57 | 0,57 | 0,27 | -0,06 | -0,32 | -0,51 | -0,03 | 0,25 | 0,29 | 0,22
Unemployment | Ul | -0,30 | -0,28 | -0,12 | 0,04 | 0,17 | 0,25 | 0,01 | -0,12 | -0,14 | -0,11
|  | Percent of GDP
Pub. budget balance | Tfn_o/Y | 0,24 | 0,02 | 0,01 | -0,01 | -0,02 | -0,02 | -0,01 | 0,00 | 0,00 | 0,00
Priv. saving surplus | Tfn_hc/Y | -0,26 | -0,04 | 0,00 | 0,02 | 0,04 | 0,04 | 0,02 | 0,01 | 0,01 | 0,01
Balance of payments | Enl/Y | -0,02 | -0,01 | 0,00 | 0,02 | 0,02 | 0,02 | 0,02 | 0,02 | 0,01 | 0,01
Foreign receivables | Wnnb_e/Y | -0,05 | -0,06 | -0,04 | 0,00 | 0,03 | 0,15 | 0,21 | 0,24 | 0,26 | 0,26
Bond debt | Wbd_os_z/Y | -0,23 | -0,24 | -0,24 | -0,22 | -0,19 | -0,05 | 0,02 | 0,02 | 0,00 | -0,02
|  | Percent
Capital intensity | fKn/fX | -0,07 | -0,05 | -0,04 | -0,03 | -0,03 | -0,08 | -0,12 | -0,13 | -0,13 | -0,13
Labour intensity | hq/fX | -0,05 | -0,04 | -0,03 | -0,02 | -0,02 | -0,03 | -0,02 | -0,02 | -0,02 | -0,02
User cost | uim | 0,00 | 0,01 | 0,01 | 0,01 | 0,00 | -0,01 | -0,02 | -0,02 | -0,01 | 0,00
Wage | lna | 0,01 | 0,02 | 0,02 | 0,02 | 0,02 | -0,03 | -0,05 | -0,04 | -0,02 | 0,01
Consumption price | pcp | 0,00 | 0,01 | 0,01 | 0,01 | 0,01 | -0,02 | -0,03 | -0,03 | -0,02 | -0,01
Terms of trade | bpe | 0,00 | 0,00 | 0,01 | 0,01 | 0,00 | -0,01 | -0,01 | -0,01 | 0,00 | 0,00
|  | Percentage-point
Consumption ratio | bcp | 0,04 | 0,01 | -0,01 | -0,02 | -0,04 | -0,05 | -0,04 | -0,04 | -0,04 | -0,03
Wage share | byw | -0,01 | 0,00 | 0,01 | 0,01 | 0,01 | 0,00 | 0,00 | 0,01 | 0,02 | 0,02
(See details) In contrast to the unfinanced experiment in section 1, the long-term effect on government debt is now zero. There are two opposing effects - expansionary and contractionary effects. The former is due to the increase in public expenditures that increases domestic demand, production and employment. The contractionary effect is due to the increase in income tax rates which reduces disposable income and there by private consumption. In the very short term the expansionary effects are stronger so production and employment expand. Investments also expand reflecting the increase in business investments in machinery and buildings. The overall positive effect in year 1 occurs because private consumption reacts to the tax increase with a delay. In the following year, the tax increase reduces consumption as disposable income falls. As a result, employment falls. With a financed public purchase, it takes only 4 years for the initial increase in employment to disappear and it takes almost the same number of years for employment to return to the baseline. The fall in private consumption reduces the demand for housing, and investment in housing and house prices fall. In the long run, private consumption and investment fall due to the permanent fall in disposable income. Investments also fall permanently due to the fall in residential investment. The effect on unemployment oscillates before reaching equilibrium reflecting the fluctuation in the housing market and labor market. In general, with an unfinanced increase in public purchase it is exports that fall and make room for the public purchase of goods and services. With a tax-financed public purchase increase, it is the private domestic demand that falls to make room for the public purchase of goods and services. The public budget can be financed in various ways, and the outcome depends on the choice of financing instrument. Actually, the outcome of the unfinanced shock in section 1 is equivalent to the outcome of an increase in public purchase financed by reduced public transfers to abroad. Public transfer vis-a-vis the foreign sector has no impact on the private sector in ADAM. Figure 18. The effect of a permanent increase in public spending, balanced budget