Debt and Taxes I
There might be such a thing as a free lunch.
There will soon be a Democrat in the White House and Republicans will soon rediscover their hatred of deficits (which were no problem when they were cutting taxes on firms and rich individuals). We are going to read a lot of arguments about irresponsibly burdening our children with debt (which ignore the fact that they will also inherit most of the bonds). We will be reminded that sooner or later we will have to pay.
I am not sure if Milton Friedman will be quoted saying “to spend is to tax”. There will be arguments about how deficit spending creates the illusion of wealth (as consumer/investors we forget that we owe the money as well as owning the bonds just as citizens we forget that we are (most of) the creditors as well as the owners of the indebted Federal Government). There will be arguments about how we can pay now or pay later and it will be more costly if we pay later.
All of this is based on the assumption that the Federal Government’s intertemporal budget constraint is binding. Arguments that you can’t get more now without having less later are arguments about a binding budget constraint. The argument that an increase in spending must be financed by increased taxes in the present or in the future of the same present value is the argument that the intertemporal budget constraint is binding (in fact it is a better explanation of the concept than “the intertemporal budget constraint is binding” the two statements are equivalent and “increased spending … increased taxes …” is written in plain English).
It is true that in standard models, the intertemporal budget constraint is binding (this is called the transversality condition just to type more big words). This is a condition for *optimality* — an aspect of the solution to an intertemporal optimization problem. It is not a given or an assumption about the problem agents face. This is embarrassingly simple. In standard models, you can’t get something for nothing, because if you were in a situation in which you could get something for nothing, then you made a mistake not getting it, and it is assumed that you didn’t make a mistake.
When discussing fiscal policy, Friedman et al assumed that it is optimal while criticizing it as suboptimal. This is a plain contradiction and simple error. All of the discussion of fiscal policy which is used to rule out more deficit spending now assumes that policy is optimal which rules out any change by assumption.
This is not a quibble. The condition for a binding intertemporal budget constraint is that r>n that the interest rate the Treasury must pay is greater than the trend growth of GDP. if r<n then debt can be rolled over forever with new bonds sold to pay interest and principle on the old bonds. The debt to GDP ratio shrinks to zero if r<n and debt is rolled over. This is how the USA handled World War II debt. The US did not pay it off by running primary surpluses. The USA rolled the debt over until it was small and then elected Reagan and began the modern era of huge deficits.
The relevant r in the inequality is the interest rate the Treasury pays on it’s debt. This is always much lower than many other interest rates and has historically usually been very very low. It is now exceedingly low, and it has been extremely low since 2008. It was also very low until the 70s and, when corrected for inflation, remained very low until Reagan and Volcker began working with each other.
This is well known to economists. A masterful explanation and empirical demonstration was given as an American Economic Association Presidential address by OJ Blanchard in 2019 . Read it if you doubt my claims (also if you don’t — it is very good).
For a while after 2008, it was assumed that this was temporary and things would return to normal (normal meaning as they were from 1980 to 2000 but never were before 1980 nor have been after 2000). Many economists now agree that this is the new normal (same as the old normal and different from the situation of extremely loose fiscal policy combined with extremely tight monetary policy).
Importantly this is *not* entirely a forecast. The yield on 30 year inflation indexed bonds is currently -0.24% — the US Federal Government can borrow for 30 years paying a negative real interest rate. Pessimists think that the trend of real GDP growth has fallen to 2% a year (from 3% historically). But it is definitely growth not shrinking.
It is true that investors might change their minds and interest rates might shoot up. If the US financed it’s spending with 30 inflation indexed bonds, this would not be a problem for the Treasury for 30 years. Investors who bought the bonds would lose money, but the Treasury would still have to pay the same coupons and face value. There is even a discussion of introducing extremely long duration bonds — 50 year bonds to lock in interest rates longer or even consols (bonds which last forever and pay a constant interest rate — obviously a multiple of the CPI because the old 19th century nominal consols are silly collectors’ items now))..
But basically the main hugely important point is that there is every reason to think that the US Federal Government can get something for nothing, because it has a slack intertemporal budget constraint.
Failing to take advantage of that would be failing to solve an intertemporal optimization problem. It is one of the few (very difficult) ways to fail my Macroeconomics course.
Caveat after the jump
So far I have acted as if the US Federal Government is an agent which wants to consume. However, it is merely an instrument we use to serve our interests and we have different interests. A safe interest rate less than the rate of growth of GDP implies that increasing debt by giving everyone money ($600,$2000,$1400 whatever) is like a windfall — people get something and no one has to pay – ever.
However, increased public debt also has side effects. In particular, unless the economy is in a liquidity trap with interest rates at the zero lower bound, it crowds out private investment. This is not necessarily a cost. A necessary condition for optimal levels private investment is r>n. if r<n, then less capital can be better for everyone.
However, the r in that equation is the return on privately owned capital not the interest rate paid by the Treasury. That return is much higher than the safe interest rate. In fact, Blanchard describes two effects — a windfall which is good if the safe rate rf is less than the growth rate and another effect on welfare which is good only if the risky rate (expected return on privately owned capital) is less than n.
With Barbara Annichiarico, Brad DeLong, and I are working on this. It turns out that the second effect of debt is a transfer from workers to investors. Lower investment implies lower wages and a higher return on capital. This second effect can be cancelled by taxing capital income and subsidizing wages.
The combination of higher debt and a shift from taxing wages to taxing capital income can cause increased welfare (in the model for everyone so a Pareto improvement) so long as the safe interest rate is less than the rate of GDP growth.
The standard of efficiency in public economics is can we achieve a Pareto improvement with this reform and also some taxes and transfers to compensate those who are hurt by the reform.
Also I like imagining Republicans’ reaction to a proposal to increase debt and also tax labor income less and capital income more. It all follows from a very standard Macroeconomic model.
I am glad you are getting there. But a quicker route to where you are going would be reading some MMT economics. I don’t care how you get there or what you call it when you do. Save some time and toss that government ‘intertemporal budget constraint’ out the window right away.
What Barbara Annichiarico, Brad DeLong, and I are working on is this.
That is a mouth full right there of how to incorporate a level of direct income or services such as healthcare, etc.
We, the middle class, paid about one percent in a bank tax up through 2019, and we will likely pay over two percent in the upcoming years. The way it works is an armored car goes to our banks, picks up fees and excess rates, and takes them back to Treasury, just like a tax, exactly like a tax, it is a tax. They are called seigniorage taxes, they are currently over a percent but have not finished their rise. They are highly regressive and intelligent. So intelligent that our double entry accounting system will find any fool who believes otherwise and tax their bank account.
Retail branches for the fiats are closing at a record pace, mostly in rural areas and poow urban areas, hitting exactly the people on both sides by taking their S/L accounts and traping them. The massive transfer of wealth from poor people to the wealthy as we continue this delusion eventually results in default.
And, byt the way, we defaulted in 1972, and in 1932 and we will do it again. We will have a sudden default, harming us all, if we keep up the nonsense about this debt being inflated away,. That regressive tax the progressives impose causes deflation, and we are facing about a hundred years of painful deflation due to this bogus story about inflating away he debt.
Do you believe in TIP? Well I have news folks, TIPs is bogus because the Fed has about a 500 billion in TIPs holdings, making that estimate bogus.
Do you believe the flow of funds from the Fed? I*t is bogus for now, velocities are fllatlined and it now takes three quarters, not on, to find flow of funds. Thus you banks are in crisis, at the moment. The small states are not agreeing to any of this nonsense, and the Senate is at a stop, while the House is more conservative now then before.
Run — we are trying to keep the model simple. Also it is the topic of debt and taxes II so not really explained yet.
Anonymous, the purchase of banking services is not a tax. Transfers from the Fed are a small part of the Federal budget. They are almost all due to the Fed bailing out the financial system by buying risky assets.
This is not like a tax at all. The Fed paid more than anyone else was willing to pay (so it was partly a gift to people who sold RMBS to the Fed especially back in 2009). The huge profit comes from the fact that the US Federal Government can bear huge amounts of risk (unlimited so long as r<n). The trade is profitable to both parties.
The only problem is that The Federal government did not buy more risky assets. This is not at all a tax — it would be a voluntary transaction beneficial to both parties and better than a windfall worth a trillion.
Actual siegnorage is limited — that is obtained if the Fed issues high powered money paying 0.1% and buys *safe* interest bearing assets, which would be t-bills paying 0.09% (so the seignorage is negative — the Fed is giving (a small amount) public money to the banks by paying 0.1% and getting 0.09%). They money people pay to banks goes either to the costs of providing banking services or to banks’ profits. It does not, in fact, go to the Treasury.
The Fed pays the Treasury because it holds risky assets and issues safe assets. That is not seignorage. Seignorage was a relevant issue when T-bills paid significantly positive interest rates. It isn’t now. Also Fed profits are huge as profits go but tiny compared to the Federal budget (order of 1%).
This post was a good read. You gave me a lot of things to think about with r
The condition for a binding intertemporal budget constraint is that r>n that the interest rate the Treasury must pay is greater than the trend growth of GDP. if r
I am guessing the government could do the same with student loan debt much of which is simply penalties and interest on those penalties and interest on the whole of the two.
We are duking it out on giving the 8 million unemployed an extra $100 per pay period which does mean a lot when this could be put into play.
Not sure if I follow all of it and you have corrected Anonymous thoughts about banks, but his/her point about deflation is really like your analysis that the math only works when interest rates are lower than growth rates, and I believe that has to be a real interest rate. So if we are in a deflationary environment with little or no growth even a slightly negative nominal interest rate may be crippling. My point would be–and this is pure armchair empiricism because I am not an economist–is that the economy is only stimulated by deficit spending or tax reductions if it causes people to chase more goods and services and that means putting it in the hands of folks with higher marginal propensity to spend. If I can not afford an MRI and the government is not going to help me get it, then the hospital does not buy another machine, GE Medical or whoever shuts down one of its assembly lines and Mr. or Ms. investor’s return on capital gets reduced so maybe the investor puts their money into a liquidity trap or more likely invests in an emerging economy. End result is slower growth at least in this country and deflationary pressures both of which make debt a bigger issue. Do not know if that makes sense or not but if it does it sure would seem to indicate that cutting taxes for rich people and/or subsidizing big business is not sustainable in the long run while sending less well off people transfer payments whether as stimulus checks or in kind health care and education would allow deficits forever.
It is a good article and I was picked up on it right away. When you think about it, the issues are more than just income. Healthcare costs surpass what an average calculated income could pay sans the upper 5-10% in income. I just took a leap past what you were saying in surmising where an average citizen could be helped.
Your article kind of fits with what I am working on in healthcare. I have been working on the complexity of healthcare plans and what should a person choose given their health. For example, maybe you do not need the lowest deductible and perhaps a higher deductible would work. Krugman had difficulty choosing and it determined his choice of jobs as the story goes.
Somewhat, the same issue exists in Europe. It will take me a few more days, which have finally freed up after another bout with a disorder lasing weeks and came back with little warning.
Thank you for the return comment.
all this analysis is over my head, and to judge by the comments at least partially over everyone’s head (that is, they don’t agree with each other.
but it seems to me everyone overlooks “something.”
since all businesses and households engage in debt financing of
present needs, it seems to me that government doing the same thing cannot be “bad,” unless the money is wasted on foolish spending.
meanwhile, raising taxes now is the fastest way to reduce debt, but that seems to be off the table, or at least the table the deficit hawks eat off of. we ran up a pretty big debt to win the War, without dreadful consequences. If we believe that running up a big debt to finance “defense” will save the country from conquest, that might be a good reason to run a deficit and eventually accept the taxes to pay for it: as a child who will be saddled with that debt, i might think that i was benefited by it. or if it takes a deficit to see that some of today’s children are not raised in direst poverty… again, as a present child who will not die of starvation or homelessness, or not grow up in a country weakened by widespread poverty and consequent inability to raise an army to defend itself…i might conclude that i got some benefit from the debt that was incurred to prevent that.
a kid who’s family goes into debt to buy a house is not disadvantaged if dad dies leaving them “saddled” with the mortgage…or not disadvantaged by the house-with-mortgage, if disadvantaged by the death of dad or what the bank’s lawyers do to them next.
hell, even the bank is not disadvantaged, and if they did not have a predatory business model might find it advantageous to extend the loan until the kids can repay it.