Thursday, May 28, 2009

Why the national debt is just as costly if we don't pay it off. Or even more so.

As the national debt surges I've seen many comments in blogs and discussions to the effect of: "So what? It's not as if we ever have to pay it off. We can just roll it over forever ..."

Unfortunately, any increase in the debt costs taxpayers the exact same amount in taxes whether the debt is paid off or rolled over forever. There is no free lunch in not paying off the debt.

A numerical example can make this clear. Say the government wants to spend an extra $1 billion. It can do so either by spending $1 billion of tax revenue or by borrowing $1 billion and adding that much to the national debt. If it spends...

[] $1 billion of tax revenue, the cost in taxes is $1 billion, simply enough.

[] $1 billion of borrowed money, it must finance the debt that results by paying interest on it. If the debt is rolled over forever, so only interest will ever paid on it, the total amount of the future interest payments when discounted to present value must exactly equal the amount of the debt. And that interest is paid from taxes. So the tax cost of the interest equals the amount of the debt ... $1 billion.

For instance, say the interest rate on government bonds is 5%. If the government borrows $1 billion, the interest paid on it annually will be $50 million, funded from taxes ... and $50 million to be paid annually forever, when discounted to present value using a 5% interest rate, equals exactly $1 billion. (Obviously the amount bond is sold for must exactly equal all the future cash flow to be received on it at current market interest rates, or one of the parties would be losing money on the deal and not go through with it.)

Thus, $1 billion in government spending costs $1 billion in taxes. Period. Borrowing to pay for the spending does not reduce the tax cost at all, it only delays when the taxes will be paid.

And this gets us to Milton Friedman's dictum: "spending equals taxes", to spend is to tax. If the government spends money, it will collect that amount of taxes to pay for the spending, either directly up front or as interest to be paid on the debt that results, because it has no other choice. (Other than raising funds by selling off the national parks and other assets, or declaring national bankrutpcy and defaulting on its debt.)

It follows that ....

[] Tax cuts are not tax cuts unless they are accompanied by matching spending cuts -- otherwise they are merely tax deferrals, taxes are just pushed into the future with interest added. (How Bush and the Republicans increased our future taxes.)

[] Spending increases financed with debt instead of current tax increases are tax increases, with the taxes to arrive at a future date. (How Obama and the Democrats are increasing our future taxes.)

Indeed, there is one way in which debt finance of a given amount, such as $1 billion, when the debt is rolled over forever, can be viewed as costing more in taxes than paying the same amount with a lump-sum payment of taxes up front.

This is because the present value of the future taxes incurred on the borrowing remains at the borrowed amount forever, no matter how much in taxes has already been paid on it.

Say that today the government pays $1 billion on some expenditure that will benefit you. You know that the tax cost of interest paid into the future forever on $1 billion is the same as $1 billion paid currently, when looking forward from today, so you are indifferent between the two options and go along happily enough when the government decides to add the $1 billion to the national debt.

But 30 years from now, in the year 2039, you notice that the tax cost to be incurred into the future for this long-forgotten expenditure is still the full $1 billion, even after you've paid your share of 30 years worth of tax payments on it. And your now-grown children look at you and ask, "We owe $1 billion of taxes for what?"

Because of the roll-over-the-debt-forever policy, the people of the future have to pay enough in taxes to pay for all their own government expenditures and the ones of the past as well.

So the next time you see people say, "The debt's not so bad because we never have to pay it off, we can just roll it over", tell them that rolling it over won't save even a penny of tax ... at best.