How much should we borrow?

A commenter directed me to a Noah Smith post that begins as follows:

One of the most important questions in macroeconomics is one that economists have curiously chosen not to study. That question is: “How much can the government safely borrow?”

In my view, this is the wrong question.  The right question is: How much should the government borrow?

The term “safely” is quite vague.  Safe from what?  From default?  From hyperinflation?  From future tax rates that are punishingly high?

In contrast, we have a great deal of research on the optimal level of public borrowing.  In a 1979 JPE paper, Robert Barro argues that the budget deficit should fluctuate in such a way as the minimize the long run deadweight cost of taxation.  Here is the abstract:

A public debt theory is constructed in which the Ricardian invariance theorem is valid as a first-order proposition but where the dependence of excess burden on the timing of taxation implies an optimal time path of debt issue. A central proposition is that deficits are varied in order to maintain expected constancy in tax rates. This behavior implies a positive effect on debt issue of temporary increases in government spending (as in wartime) a countercyclical response of debt to temporary income movements, and a one-to-one effect of expected inflation on nominal debt growth. Debt issue would be invariant with the outstanding debt-income ratio and, except for a minor effect, with the level of government spending. Hypotheses are tested on U.S. data since World War 1. Results are basically in accord with the theory. It also turns out that a small set of explanatory variables can account for the principal movements in interest-bearing federal debt since the 1920s.

Can we safely borrow as much as we are currently borrowing?  I’d say yes.  Should we be borrowing as much as we are currently borrowing?  I’d say no.  After all, I don’t think anyone in their right mind expects a “constancy in tax rates” in the coming decades.  Tax rates are going to increase.

PS.  If you don’t believe that tax rates are set to increase, consider today’s news:

House Republicans voted to allow their members to request dedicated-spending projects, known as earmarks, following that same move by Democrats, in a positive sign for President Joe Biden’s hopes for a bipartisan infrastructure bill.

So remind me, which one is the party that favors small government?


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Guest Contribution: “Republicans oppose deficits only when Democrats hold the White House”

Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy  School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate. High among the many priorities of newly-inaugurated US President Joe Biden are the challenges of an economy that appeared to […]

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Charles Barkley Articulates the Benefit Principle

There are various versions of the benefit principle of taxation. One is the James Buchanan/Knut Wicksell version, which says that to get unanimous agreement for a government expenditure, you need to have people pay an amount in taxes that is less than the benefit they perceive.

That’s not what former NBA player Charles Barkley articulates but nevertheless he does state a reasonable version of the benefit principle.

Barkley said yesterday that NBA, NFL, and NHL players should get the vaccine right away because of the huge taxes they pay. He stated:

As much taxes as these players pay, they deserve some preferential treatment.

When Kenny Smith challenges him by saying “the amount of money you make” and then trails off but is clearly about to say that one’s income shouldn’t be a consideration in when one gets the vaccine. But Barkley stays on message saying, “I said taxes; I didn’t say the amount of money you make.” Kenny’s making the point that those are highly connected but Charles is right to keep it focused on his point. This is something that taxpayers paid for, players in those three leagues pay a lot of tax per person, and, therefore, they should bet preferential treatment.

There are two other reasons to give them preferential treatment.

First, as my Hoover colleague John Cochrane emphasizes, it’s important to get the vaccine early to those who would be superspreaders. The players are virtually all young and many of them have active social lives. So, simply from the externality viewpoint, they should get preferential treatment.

Second, and I think this is a weaker argument, various state governments have dictated the various things we can’t do together. One of the ways left is TV. We hear every day about this or that game that is postponed because of players having tested positive. My own Golden State Warriors won’t be playing tonight against the Phoenix Suns because of “ongoing contact tracing” of the Suns. More games; more entertainment; lower loss from the lockdowns.

Finally, note that if vaccines were allowed to be sold on the market, almost all players would have them by now and, of course, so would other people now in the queue. The slowness of the queue is due to government.

HT2 Tyler Cowen.


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Joe Stiglitz on Taxing Interest

This is another in my continuing series of excerpts from Joseph E. Stiglitz’s excellent 1988 textbook, Economics of the Public Sector. I’ve previously posted about this textbook here and here.

Thus an income tax that taxes interest can be viewed as a differential commodity tax in which future consumption is taxed more heavily than current consumption. The question of whether it is desirable to tax interest income is then equivalent to the question of whether it is desirable to tax future consumption at higher rates than current consumption.

Just as, with a well-designed income tax, there may be little to be gained by adding differential commodity taxation, so too there is little to be gained from taxing consumption at different dates at different rates. This means, in effect, that interest income should be exempt from taxation. An income tax that exempts interest income is, of course, equivalent to a wage tax, and we showed in Chapter 17 that a wage tax was equivalent to a consumption tax (in the absence of bequests. This suggests that it may be optimal to have a consumption tax.

That’s very tight reasoning on Stiglitz’s part.

Even though I hate taxes, I love analyzing the economics of taxation.

Co-blogger Scott Sumner is, I believe, an advocate of consumption taxes. If you’ve read me closely over the years, you’ll know that I’m not. I’ve been very critical of a VAT, for example, which comes close to a consumption tax.

So why am I not a fan? Because the analysis of a VAT that finds a VAT to be superior, on efficiency grounds, to other taxes, holds constant something that empirical evidence says should not be held constant: the amount of revenue raised. Because VATs tend to be less visible, they lead to less political resistance and result in a much larger amount of government tax revenue and government spending. Because so much of government spending is inefficient–how much do you value, relative to cost, the occupation of Iraq and Afghanistan or defending wealthy Germany or the middle-speed train in California’s central valley or agricultural subsidies?–the inefficiencies from higher government spending probably outweigh the inefficiency of a less-efficient form of collecting government revenue.



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Fiscal Policies for a Transformed World

By Vitor Gaspar and Gita Gopinath The ongoing COVID-19 pandemic has already prompted an unprecedented fiscal policy response of close to $11 trillion worldwide. But with confirmed cases and fatalities still rising fast, policymakers will have to keep the public health response their No. 1 priority while retaining supportive and flexible fiscal policies and preparing […]

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What does it mean to say a debt is “unsustainable”?

I often warn against countries running up excessively large public debts. Some people interpret my worry as a prediction of a future financial crisis, perhaps including default and/or very high inflation. They point out that countries such as Japan have run large deficits for many decades, with interest rates on long-term bonds remaining near zero. So are these worries overblown?

For developed countries with their own currency my actual fear is not outright default, or even hyperinflation. Rather I fear that an excessively large public debt will eventually force painful changes in fiscal policy, such as benefit cuts or more likely large tax increases. The most efficient fiscal policy is one that smooths tax rates over time, as high taxes are a drag on the economy.  Furthermore, the effect of tax increases is not linear. A doubling of the tax rate will lead to a roughly fourfold increase in the deadweight loss, without even doubling tax revenue.

By the mid-1990s, Japan’s budget deficits were on an unsustainable path while the US budget deficits were still on a more sustainable path.  At this time, Japan had a 3% national sales tax whereas the US had no national sales tax.  Both countries had overall tax burdens that were below average for developed countries.

In 1997, Japan raised its national sales tax to 5%.  In 2014 they raised the tax to 8%.  In 2019 they raised the tax to 10%.  These increases were intended to address the debt problem.  Meanwhile the US continued to have no national sales tax.  Thus the very thing I was worried about did actually occur in Japan.  Furthermore, more tax increases are almost certainly on the way.  Unfortunately, the US budget deficit situation also became unsustainable during the late 2010s, due to a highly expansionary fiscal policy.  Thus the US is likely to be forced to raise taxes (or cut benefits) in future years.

To summarize, it is true that Japan is likely to be able to avoid default on their public debt.  But this does not mean that those who warned the deficits were unsustainable were wrong.  Indeed, Japan was forced to repeatedly raise taxes precisely because the path of the public debt was unsustainable without future tax increases.

PS. The FRED data site shows net debt for Japan (blue line) and gross debt for the US (both as shares of GDP.)  So the actual gap is even larger than it appears:



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