Question

The possibility of capital flight is likely to be greater at higher levels of government debt because there is a greater:

A) potential for tax smoothing policies to be eliminated.
B) probability that a balanced budget will be adopted by the government.
C) temptation to default on the debt.
D) likelihood that the government will begin issuing indexed bonds.

Answer 1

The possibility of capital flight intensifies with higher government debt due to the increased risk of default or inflationary measures, which can lead to investor unease and prompt the withdrawal of investments.

Step-by-step explanation:

The likelihood of capital flight is higher at elevated levels of government debt primarily due to an increased temptation to default on the debt. As government debt levels rise relative to GDP, investors may fear the implementation of inflationary measures or debt default, making investment in government bonds riskier. Capital flight becomes more probable as investors seek to protect their investments from potential losses caused by government actions such as excessive inflation or default.

Increasing government deficits and the associated interest payments can crowd out domestic investment, hinder economic growth, and lead to higher interest rates. The ensuing financial pressure could prompt the government to either cut spending or raise taxes, actions which are likely to be politically difficult and have negative effects on the economy. High amounts of short-term portfolio investment in government bonds could trigger substantial capital outflows if any indication of an inability to repay debt or a potential exchange rate decline emerges.