*2.2.1. Measuring the fiscal sustainability of the welfare state*

In the previous study, the fiscal sustainability of the welfare state has been replaced by the level of the primary balance or the national debt level. However, the financial condition of the state cannot be exclusively evaluated using either values, because it means that even if deficit occurs, state can recover fiscal balance without default [53–55]. Moreover, the financial problems of the welfare state are not problems that can be solved through the technicalities that control the level of public expenditures or tax revenues. This is, in the end, a matter of politics [8]. Therefore, in order to gain a comprehensive understanding of fiscal sustainability, it should be conceptualized and measured in accordance with the economic structure and institutional capacity of the state.

excessively high levels of debt may make it difficult to offset debt accumulation, because the marginal response of the primary balance to public debt is lower [60] and adjustment effort

How Does a Welfare State achieves Fiscal Sustainability? A Study of the Impact of Tax Equity

http://dx.doi.org/10.5772/intechopen.72527

Next, the dashed line shows the effective interest rate schedule, given the interest rate-GDP growth rate differential multiplied by the debt ratio. At low levels of debt, the interest rate is the risk-free rate, by assuming that output growth is independent of the public debt or the interest rate, so this schedule is simply a straight line with a slope determined by the risk-free interest rate-growth rate differential. When there is an unexpected economic shock, there is a stronger likelihood that public debt will accumulate, which means the debt reaches the debt limit, the interest rate is rapidly increased because of risk premiums. In this case, creditors may be reluctant to buy public bonds because of concerns about the potential for the country to declare bankruptcy. To secure public finances, countries should be willing to raise the interest rate through the application of risk premiums because of the increased default risk. This is

̂ and d¯.

conditional stable point. There is positive relationship between the primary balance and the public debt, so if a shock raises the debt level above this point, then the primary balance in subsequent periods will offset the higher interest payments and the debt ratio returns to its long-run average. However, the upper intersection (d¯) cannot guarantee fiscal sustainability. If the debt exceeds this point, then it will rise forever, because the primary surplus will never be enough to offset the growing debt. This point represents the public debt limit, which is the critical point of debt led by the historical fiscal response without special action of the government [56]. If there is no fiscal space and a debt limit, current fiscal stance does not take the ability to afford the debt burden. That is, country is not always facing a fiscal crisis, but it is difficult to ensure the fiscal sustainability unless significant change of current fiscal stance [56]. At this point, in this study, I examine fiscal sustainability in the welfare state by calculating the fiscal space of the welfare state like Ostry et al. [56] and Ghosh et al. [57]. However, I have included some additional considerations for measuring fiscal sustainability in the welfare state. First, I select variables to estimate the fiscal reaction function based on theory and previous studies. I excluded some similar variables (openness, inflation, oil prices, and nonoil commodity prices) and replaced them with more appropriate variables to avoid multicollinearity problems. In addition, I include public welfare spending instead of total public expenditure in examining the fiscal sustainability of the welfare state. Second, the interest rate is estimated by the vector autoregressive (VAR 1) model based on Polito and Wickens [62, 63] to avoid the problems caused by arbitrary regulations as well as to reflect the endogenous relationship between debt and interest rate.

Although the composition of the national finance has recently been pointed out as a determinant of fiscal sustainability [6, 27], empirical research has lacked reflection them. In the previous study, total public spending and total tax burden level were mostly considered, focusing on identifying whether spending cutoff strategies and tax expansion strategies are more effective to ensure fiscal sustainability [56, 64]. It is true that those were difficult to suggest specific policy measures to enhance the fiscal sustainability of the welfare state. Related to this, this

study focuses on tax structure as a determinant of fiscal sustainability of welfare state.

) defines the

103

peters out as tax increases or spending cuts become politically infeasible [61].

Between these two lines, there are several intersections. The lower intersection (d<sup>∗</sup>

represented by the solid rising curve between d̂

*2.2.2. Determinants of fiscal sustainability of welfare states*

Related to this, the research of Ostry et al. [56] and Ghosh et al. [57] is useful. Their research reflects the context in which public finance is embedded [58]. Changes in financial conditions do not always cause financial crises in the welfare state. We must consider the political, economic, and social contexts that might lead to a financial crisis.<sup>2</sup> They define the fiscal space as the gap between the debt limit and current debt level implied by the country's historical fiscal adjustment for understanding fiscal sustainability like **Figure 1** [56, 57].

First, the solid line represents the behavior of the primary balance as a function of debt. It reflects the nonlinear relationship between the primary balance and the public debt. Specifically, the primary balance shows little response to rising debt at very low levels of debt. Fiscal policy makers do react to changes in the level of public debt unless the public debt is fairly high [59], so the increase in the primary balance appears negligible. However,

**Figure 1.** Determination of debt limit from Ostry et al. [56]: 8; Ghosh et al. [57]: F11.

<sup>2</sup> The Bohn test, which draws implications from the manner in which fiscal policy has responded to increases in public debt, is also considered the context-embedded public finance, and it has two limitations [56]. That does not address the nonlinear relationships between primary balance and public debt and does not consider endogenous relationship between interest rates and public debt.

excessively high levels of debt may make it difficult to offset debt accumulation, because the marginal response of the primary balance to public debt is lower [60] and adjustment effort peters out as tax increases or spending cuts become politically infeasible [61].

*2.2.1. Measuring the fiscal sustainability of the welfare state*

nomic, and social contexts that might lead to a financial crisis.<sup>2</sup>

adjustment for understanding fiscal sustainability like **Figure 1** [56, 57].

institutional capacity of the state.

102 Taxes and Taxation Trends

2

between interest rates and public debt.

In the previous study, the fiscal sustainability of the welfare state has been replaced by the level of the primary balance or the national debt level. However, the financial condition of the state cannot be exclusively evaluated using either values, because it means that even if deficit occurs, state can recover fiscal balance without default [53–55]. Moreover, the financial problems of the welfare state are not problems that can be solved through the technicalities that control the level of public expenditures or tax revenues. This is, in the end, a matter of politics [8]. Therefore, in order to gain a comprehensive understanding of fiscal sustainability, it should be conceptualized and measured in accordance with the economic structure and

Related to this, the research of Ostry et al. [56] and Ghosh et al. [57] is useful. Their research reflects the context in which public finance is embedded [58]. Changes in financial conditions do not always cause financial crises in the welfare state. We must consider the political, eco-

the gap between the debt limit and current debt level implied by the country's historical fiscal

First, the solid line represents the behavior of the primary balance as a function of debt. It reflects the nonlinear relationship between the primary balance and the public debt. Specifically, the primary balance shows little response to rising debt at very low levels of debt. Fiscal policy makers do react to changes in the level of public debt unless the public debt is fairly high [59], so the increase in the primary balance appears negligible. However,

The Bohn test, which draws implications from the manner in which fiscal policy has responded to increases in public debt, is also considered the context-embedded public finance, and it has two limitations [56]. That does not address the nonlinear relationships between primary balance and public debt and does not consider endogenous relationship

**Figure 1.** Determination of debt limit from Ostry et al. [56]: 8; Ghosh et al. [57]: F11.

They define the fiscal space as

Next, the dashed line shows the effective interest rate schedule, given the interest rate-GDP growth rate differential multiplied by the debt ratio. At low levels of debt, the interest rate is the risk-free rate, by assuming that output growth is independent of the public debt or the interest rate, so this schedule is simply a straight line with a slope determined by the risk-free interest rate-growth rate differential. When there is an unexpected economic shock, there is a stronger likelihood that public debt will accumulate, which means the debt reaches the debt limit, the interest rate is rapidly increased because of risk premiums. In this case, creditors may be reluctant to buy public bonds because of concerns about the potential for the country to declare bankruptcy. To secure public finances, countries should be willing to raise the interest rate through the application of risk premiums because of the increased default risk. This is represented by the solid rising curve between d̂ ̂ and d¯.

Between these two lines, there are several intersections. The lower intersection (d<sup>∗</sup> ) defines the conditional stable point. There is positive relationship between the primary balance and the public debt, so if a shock raises the debt level above this point, then the primary balance in subsequent periods will offset the higher interest payments and the debt ratio returns to its long-run average. However, the upper intersection (d¯) cannot guarantee fiscal sustainability. If the debt exceeds this point, then it will rise forever, because the primary surplus will never be enough to offset the growing debt. This point represents the public debt limit, which is the critical point of debt led by the historical fiscal response without special action of the government [56]. If there is no fiscal space and a debt limit, current fiscal stance does not take the ability to afford the debt burden. That is, country is not always facing a fiscal crisis, but it is difficult to ensure the fiscal sustainability unless significant change of current fiscal stance [56].

At this point, in this study, I examine fiscal sustainability in the welfare state by calculating the fiscal space of the welfare state like Ostry et al. [56] and Ghosh et al. [57]. However, I have included some additional considerations for measuring fiscal sustainability in the welfare state. First, I select variables to estimate the fiscal reaction function based on theory and previous studies. I excluded some similar variables (openness, inflation, oil prices, and nonoil commodity prices) and replaced them with more appropriate variables to avoid multicollinearity problems. In addition, I include public welfare spending instead of total public expenditure in examining the fiscal sustainability of the welfare state. Second, the interest rate is estimated by the vector autoregressive (VAR 1) model based on Polito and Wickens [62, 63] to avoid the problems caused by arbitrary regulations as well as to reflect the endogenous relationship between debt and interest rate.
