Taxes Plus Borrowing Equals the Total Cost of Government
Besides the misdirection of reemployed workers and industries from government deficit spending that sets the stage for some needed future correction and rebalancing of the economy, does it matter if the government funds some portion of its spending through borrowing? The Nobel economist Milton Friedman (1912-2006) argued that at the end of the day, the answer was, “No.” What matters is the total quantity of the society’s resources the government siphons off, regardless of whether it is done through taxes or deficits.
Said Friedman, “Keep your eye on one thing and one thing only, how much government is spending, because that’s the true tax. . . . If you’re not paying for it in the form of explicit taxes, you’re paying for it indirectly in the form of inflation or in the form of borrowing. The thing you should keep your eye on is what government spends, and the real problem is to hold down government spending as a fraction of your income, and if you do that, you can stop worrying about the debt.”
If the government taxes the citizenry, the dollars collected and the real resources those dollars have buying power over in the marketplace are transferred from private-sector hands to the hands of Uncle Sam, who then decides what they will be used for.
But this is no less the case when the government borrows dollars in financial markets to cover part of its expenses in excess of collected taxes. Instead of a private borrower borrowing those dollars and using the real resources those dollars can buy in the marketplace for investment, capital formation, or other purposes, the government borrows them and uses the real resources that can be bought with them for its own politically oriented goals and ends.
Either way, the total amount of the income and resources of the society transferred out of private hands and into the hands of the government is represented by the total spending by that government, even if part has been taxed and part has been borrowed.
Friedman once asked the question: Which is preferable, a situation under which the government taxes and spends $800 billion with a balanced budget, or a situation in which it taxes $400 billion and borrows $100 billion for a total of spending of $500 billion, with a budget deficit?
In terms of the total extraction of wealth and income from the members of society by government, clearly its siphoning off $500 billion is preferable to it taking and using $800 billion of the resources and products produced through the peaceful and productive efforts of the citizen-taxpayers, Friedman reasoned.
America’s Former Balanced Budget Rule and Its Benefits
Although it is true that whether the government taxes or borrows the taxpayer-citizens are poorer by that total amount, it is nonetheless the case that government following a balanced budget rule versus a budget deficit expedient has a huge political difference on the institutional ease or difficulty of government growing over time.
Nobel Prize economist James M. Buchanan (1919-2013) and Richard Wagner pointed out in Democracy in Deficit (1977) that during the first 150 years of the United States, the federal government followed what the writers refer to as an “unwritten fiscal constitution.” There is nothing in the U.S. Constitution that requires the government to balance its budget annually. Such a balanced budget “rule” for managing the government’s spending and taxing was considered a way to ensure transparency and greater responsibility in the financial affairs of government.
It was argued that a balanced budget made it easier and clearer for the citizen and the taxpayer to compare the “costs” and “benefits” from government spending activities. Since each dollar spent by the government required a dollar collected in taxes to pay for whatever the government was doing, the citizen and taxpayer could make a more reasonable judgment whether they considered any government spending proposal to be “worth it” in terms of what had to be given up to gain the supposed benefit from it.
The tradeoff was explicit and clear: any additional dollar of government spending on some program or activity required an additional dollar of taxes, and therefore the “cost” of one dollar less in the taxpayer’s pocket to spend on some desired private-sector use instead. Or if taxes were not to be increased to pay for a new or expanded government program, the supporter of this increased spending had to explain what other existing government program or activity would have to be reduced or eliminated to transfer the funds to pay for the new proposed spending.
There was an exception to this balanced budget rule, and that was a “national emergency” such as a war, when government might need a large amount of extra funds more quickly than they could be raised through higher taxes. But it was also argued that once the national emergency had passed, the government was expected to manage its finances to run budget surpluses, taking in more than it spent each year. The surplus was to be used to pay off the accumulated debt as quickly as possible to relieve current and future taxpayers from an unnecessary and undesirable burden.
This was the fiscal rule and pattern followed by the U.S. government throughout the 19th century and into the 20th century until the Great Depression in the 1930s.
Keynesian Call: Budget Deficits to ‘Stimulate’ the Economy
Starting with the 1930s, this unwritten fiscal constitution was permanently overturned as part of the Keynesian revolution, an economic movement based on the ideas of the British economist John Maynard Keynes. It was argued that the government should not balance its budget on a yearly basis. Instead, the government should balance its budget “over the business cycle.” Government should run budget deficits in “bad” years (recession or depression) and run budget surpluses in “good” years (periods of “full employment” and rising gross domestic product).
This new “rule” of a balanced budget over the business cycle became a generally accepted idea for fiscal policy among economists and government policymakers. However, there has been one major problem with this alternative conception of the role and method of managing government spending and taxing: During the 75 years since the end of the Second World War in 1945, the U.S. government has run budget deficits in 63 of those years and had budget surpluses in only 12 years.
In other words, as Buchanan and Wagner put it, we live in a seemingly perpetual “democracy in deficit.”
The Fiscal Illusion of Giving Voters Something for Nothing
With the elimination of the tacit balanced budget “rule” as the guide for fiscal policy, it has been possible for politicians to create the economic illusion that it is possible to give voters “something for nothing”—a “free lunch.”
Politicians have been able to offer more and more government spending to special-interest groups to obtain campaign contributions and votes in the attempt to be elected and reelected to political office. They can offer benefits in the present in the form of new or additional government spending, but they no longer have to explain where all the money will come from to pay for it. The “costs” of that deficit spending are to be paid for by some unknown future taxpayers in some amount that can be put off discussing until that “some time” in the future.
Thus, politicians can supply benefits in the present—“now”—to targeted groups whose votes are wanted on Election Day, and avoid answering how the money will be paid back (with interest) because that can be delayed until the future, years ahead, when someone else will hold political office and will have to deal with the problem.
It is not as if the danger from unrestrained government borrowing was never warned about before John Maynard Keynes (1883-1946) made deficit spending a “virtue” in the name of “stimulating” the economy in his famous book The General Theory of Employment, Interest, and Money (1936).
Long-Ago Warnings About Government Deficits and Debt
The famous Scottish philosopher, historian, and economist David Hume (1711-1776), for instance, expressed the danger in his essay “Of Public Credit” (1741), almost 280 years ago:
“It is very tempting to a minister [in the government] to employ such an expediency, as enables him to make a great figure during his administration, without overburdening the people with taxes, or exciting any immediate clamors against himself. The practice, therefore, of contracting debt will almost infallibly be abused, in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London, than to empower a statesman to draw bills [borrow money], in this manner, upon posterity.”
Almost 150 years ago, the American economist Dudley Baxter (1827-1875) very clearly contrasted the incentives at work on those running for and holding political office when the institutional rule is a balanced budget versus deficit spending and accumulating debt, in his book National Debts (1871):
“When money is raised by taxation within the year for which it is needed, the amount that can be raised is limited by the tax-enduring habits of the people and must be as small as possible in order not to provide discontent [among the voters]. By the same reason it must be spent economically, and made to go as far as possible.
“But when the money is raised by loans, it is limited only by the necessity of the interest [payment] not to be too large for the taxable endurance of the people, or provoking their discontent. Hence the limits of borrowing are about twenty times larger than the limits to taxation, and an amount that is monstrous as a tax, is (apparently) a very light burden as a loan. In consequence, borrowing is freed from the most powerful check that restrains taxation.…
“When a loan is obtained the reason for economical expenditure is equally wanting, and borrowed money is commonly expended with much greater profuseness, and even wastefulness, than would be the case with taxes.”
Keynesian economics has served as an additional and powerful rationale for politicians to do what they like to do: spend other people’s money. In the process, it pushed aside the warnings of those like Hume, Baxter, and countless other economists who understood clearly the dangers of unrestricted government authority to both tax and borrow.
The Moral Dimension of Government Debt Financing
There is an additional, moral dimension to the issue of government deficit spending and its resulting accumulation of debt. This was a theme especially addressed by the aforementioned James M. Buchanan.
Normally, when a private individual or enterprise undertakes debt financing of some portion of his current expenditures, the legal obligation to pay back the contracted principle and interest falls upon the borrower. If he defaults or passes away before repayment of all that had been borrowed, creditors have a lien on the borrower’s positively valued assets.
The “benefits” of having the use of a greater sum of money in the present than his own income would enable him to spend, imposes on the borrower the “cost” of an obligation to pay back the loan out of his future income and assets. The cost and the benefit are linked together within the same person.
It is not the same, Buchanan argued, with government deficit spending and repayment of accumulated debt:
“If I borrow $1,000 personally, I create a future obligation against myself or my estate in the present value of $1,000. Regardless of my usage of the funds, I cannot, by the act of borrowing, impose an external cost on others. Unless I leave positively valued assets against which my debts can be satisfied, my creditors cannot oblige my heirs to pay off their claims.
“By contrast, suppose I ‘vote for’ an issue of public debt in the amount of $1,000 per person. I may recognize that this debt embodies a future tax liability on some persons, but I need not reckon on the full $1,000 liability being assigned to me. If I leave no positively valued assets, the government’s creditors can still enforce claims on my progeny as members of the future-period taxpaying group.
“Further, the membership in the taxpaying group itself shifts over time. New entrants, and not only those who descend directly from those of us who make a borrowing-spending decision, are obligated to meet debt, interest and amortization charges.
“In sum, the institution of public debt introduces a unique problem that is usually absent with private debt; persons who are decision makers in one period are allowed to impose possible financial losses on persons in future generations. It follows that the institution [government] is liable to abuse this and overextend its borrowing practices. There are moral and ethical problems with government deficit financing that simply are not present with the private counterpart.”
Giving to Peter Today at the Expense of Paul Tomorrow
Government debt is a way to impose part of the cost of what special-interest-group voters and politicians want “today” on those who “tomorrow” will have to be taxed to pay back the borrowed money.
Even if a current recipient of such governmental deficit spending largesse is, himself, one of the future taxpayers, he very well may have received a greater benefit than his personal portion of the future tax burden. Suppose that he is a farmer, for instance, who receives “today” $100,000 from the government for not growing a crop. When “tomorrow” comes and taxes have to be raised to pay back that $100,000 to the creditors who lent that sum to the government, that particular farmer’s additional tax burden will be a small fraction of that total amount he earlier received from the government.
To continue with the same example, many farmers who may have benefited from agricultural price-support programs decades ago have passed away. The burden of paying back whatever portion of that farm price support spending that was originally financed by deficit spending now falls upon others who may not even have been born at the time the recipient received this special privilege from the government.
What is the ethical justification, James Buchanan asked, of a fiscal system under which incentives exist and come into play that enable the current generation of taxpayers and recipients of government programs to shift to future generations part of the burden to pay for them? Is that a culturally and economically healthy legacy to leave to our children and grandchildren?
No one in this election year even dares to raise the issue of the government’s massive deficit spending or the resulting accumulating national debt. It is not “politic” to tell voters that there are no free lunches, that if the government’s finances are to be ever gotten under control future spending will have to be reduced or even cut, or that taxes may have to be raised; or that a return to the “unwritten fiscal constitution” about which Buchanan and Wagner spoke has to be the goal for a limited and transparent government consistent with the establishment of a free society.
History is filled with examples of financial and economic disaster that has followed government fiscal recklessness. It can happen even here, in America.
[Originally posted on the American Institute for Economic Research (AIER) website.]