Government Deficits and Debt in a Federal Economy

Ronald David Kneebone, McMaster University

Abstract

In federal states such as Canada and the U.S., non-federal governments control a sizable fraction of total government revenues and expenditures. Despite this, the literature on the macroeconomic effect of government deficits and debt deals virtually exclusively with unitary states. Similarly, the literature which examines issues pertaining to non-federal governments ignores the issue of the effect their choosing to deficit finance might have on macroeconomic stability. This thesis represents an effort to bring together these two strands of research. The results indicate that many conclusions of the existing literature on the macroeconomic effect of government deficits and debt are either completely overturned or significantly modified when one considers a federal-rather than a unitary state. In particular, we find that the condition(s) which must be satisfied for macroeconomic stability are made significantly more stringent when non-federal governments choose to deficit finance disturbances to their budget positions. We also find that the success of federal debt management policies are greatly influenced by the decision of non-federal governments to deficit finance. In conclusion then, we find that two issues which have played a prominent role in recent policy debates- whether government deficit financing must, eventually lead to large tax increases (or expenditure cuts), and the magnitude of deficit reductions necessary to maintain manageable levels of debt- are both highly sensitive to decisions made not only at the federal government level but also at the non-federal level.