19.3 The Traditional View of Government Debt

Imagine that you are an economist working for the Congressional Budget Office (CBO). You receive a letter from the chair of the Senate Budget Committee:

Dear CBO Economist:

Congress is about to consider the president’s request to cut all taxes by 20 percent. Before deciding whether to endorse the request, my committee would like your analysis. We see little hope of reducing government spending, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country?

Sincerely,
Committee Chair

Before responding to the senator, you open your favorite economics textbook—this one, of course—to see what the models predict for such a change in fiscal policy.

To analyze the long-run effects of this policy change, you turn to the models in Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, and Chapter 9. The model in Chapter 3 shows that a tax cut stimulates consumer spending and reduces national saving. The reduction in saving raises the interest rate, which crowds out investment. The Solow growth model introduced in Chapter 8 shows that lower investment eventually leads to a lower steady-state capital stock and a lower level of output. Because we concluded in Chapter 9 that the U.S. economy has less capital than in the Golden Rule steady state (the steady state with maximum consumption), the fall in steady-state capital means lower consumption and reduced economic well-being.

To analyze the short-run effects of the policy change, you turn to the ISLM model in Chapter 11 and Chapter 12. This model shows that a tax cut stimulates consumer spending, which implies an expansionary shift in the IS curve. If there is no change in monetary policy, the shift in the IS curve leads to an expansionary shift in the aggregate demand curve. In the short run, when prices are sticky, the expansion in aggregate demand leads to higher output and lower unemployment. Over time, as prices adjust, the economy returns to the natural level of output, and the higher aggregate demand results in a higher price level.

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To see how international trade affects your analysis, you turn to the open-economy models in Chapter 6 and Chapter 13. The model in Chapter 6 shows that when national saving falls, people start financing investment by borrowing from abroad, causing a trade deficit. Although the inflow of capital from abroad mitigates the effect of the fiscal-policy change on U.S. capital accumulation, the United States becomes indebted to foreign countries. The fiscal-policy change also causes the dollar to appreciate, which makes foreign goods cheaper in the United States and domestic goods more expensive abroad. The Mundell–Fleming model in Chapter 13 shows that the appreciation of the dollar and the resulting fall in net exports reduce the short-run expansionary impact of the fiscal change on output and employment.

With all these models in mind, you draft a response:

Dear Senator:

A tax cut financed by government borrowing would have many effects on the economy. The immediate impact of the tax cut would be to stimulate consumer spending. Higher consumer spending affects the economy in both the short run and the long run.

In the short run, higher consumer spending would raise the demand for goods and services and thus raise output and employment. Interest rates would also rise, however, as investors competed for a smaller flow of saving. Higher interest rates would discourage investment and would encourage capital to flow in from abroad. The dollar would rise in value against foreign currencies, and U.S. firms would become less competitive in world markets.

In the long run, the smaller national saving resulting from the tax cut would mean a smaller capital stock and a greater foreign debt. Therefore, the output of the nation would be smaller, and a greater share of that output would be owed to foreigners.

The overall effect of the tax cut on economic well-being is hard to judge. Current generations would benefit from higher consumption and higher employment, although inflation would likely be higher as well. Future generations would bear much of the burden of today’s budget deficits: they would be born into a nation with a smaller capital stock and a larger foreign debt.

Your faithful servant,
CBO Economist

The senator replies:

Dear CBO Economist:

Thank you for your letter. It made sense to me. But yesterday my committee heard testimony from a prominent economist who called herself a “Ricardian” and who reached quite a different conclusion. She said that a tax cut by itself would not stimulate consumer spending. She concluded that the budget deficit would therefore not have all the effects you listed. What’s going on here?

Sincerely,
Committee Chair

After studying the next section, you write back to the senator, explaining in detail the debate over Ricardian equivalence.

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FYI

Taxes and Incentives

Throughout this book we have summarized the tax system with a single variable, T. In our models, the policy instrument is the level of taxation that the government chooses; we have ignored the issue of how the government raises this tax revenue. In practice, however, taxes are not lump-sum payments but are levied on some type of economic activity. The U.S. federal government raises some revenue by taxing personal income (46 percent of tax revenue in 2014), some by taxing payrolls (34 percent), some by taxing corporate profits (11 percent), and some from other sources (6 percent).

Courses in public finance spend much time studying the pros and cons of alternative types of taxes. One lesson emphasized in such courses is that taxes affect incentives. When people are taxed on their labor earnings, they have less incentive to work hard. When people are taxed on the income from owning capital, they have less incentive to save and invest in capital. As a result, when taxes change, incentives change, and this can have macroeconomic effects. If lower tax rates encourage increased work and investment, the aggregate supply of goods and services increases.

Some economists, called supply-siders, believe that the incentive effects of taxes are large. Some supply-siders go so far as to suggest that tax cuts can be self-financing: a cut in tax rates induces such a large increase in aggregate supply that tax revenue increases, despite the fall in tax rates. Although all economists agree that taxes affect incentives and that incentives affect aggregate supply to some degree, most believe that the incentive effects are not large enough to make tax cuts self-financing in most circumstances.

In recent years, there has been much debate about how to reform the tax system to reduce the disincentives that impede the economy from reaching its full potential. A proposal endorsed by many economists is to move from the current income tax system toward a consumption tax. Compared to an income tax, a consumption tax would provide more incentives for saving, investment, and capital accumulation. One way of taxing consumption would be to expand the availability of tax-advantaged saving accounts, such as individual retirement accounts and 401(k) plans, which exempt saving from taxation until that saving is later withdrawn and spent. Another way of taxing consumption would be to adopt a value-added tax, a tax on consumption paid by producers rather than consumers, now used by many European countries to raise government revenue.1