Government debt, GDP growth, and taxes, oh my!

Government debt sounds scary!  If debt is bad on an individual basis, shouldn’t we seek to eliminate debt?  And “you can’t spend your way out of debt!”  Except all of this is a pretty simplistic view.

In any monetary situation, we have to consider where the money comes from and goes.  At home, it (mostly) comes from your income.  In business, it’s (mostly) payments from your customers.  In government it’s (mostly) taxes from your citizens.  Where it goes is also important: at home, maybe food and rent or mortgage, in business to employees or to your investors or creditors, and government to various programs and to its creditors.  Lots of times, people associate government debt with personal debt: if personal debt is something you want to pay off entirely, shouldn’t we want to pay off government debt entirely?  And if so, how can we do that?

Measuring debt

First things first is how to measure debt.  Typically, it’s given as either an absolute number in order to terrify people (e.g. this) or as a % of the country’s GDP, or debt-to-GDP ratio.  Practically, the debt-to-GDP ratio is more inherently useful due to tax rates.  $1 billion in debt would be crazy for a single home and a lot for a business, but next to nothing for most nations because inherently their incoming income/payments/taxes are different orders of magnitude.  The current US debt-to-GDP ratio is around 104%.  The next question you should ask is “is 104% debt-to-GDP too high?  Is it low?  What would be a good number to get to?”

One way to approach answering that would be to look at the landscape of countries out there.  There are countries with higher ratios (as a few examples, Japan with 229%, Greece with 177%) some about the same (Belgium with 106%, and Singapore with 105%), some with a bit lower (UK with 89%, Canada with 91%, France with 96%), and some with a lot lower (Afghanistan with 6%, Russia with 18%, Nigeria with 12%, Mexico with 43%, and Australia with 37%).  In general, less developed nations keep lower debt-to-GDP ratios because their lenders don’t trust them with large debts and thus raise their rates if they try to increase their debt.  The debt rates for the US have been pretty low because both internal and external investors trust the US to repay the debt.

The US is in the upper quartile of debt-to-GDP ratios, but nowhere near Japan and nowhere near its historic high, and it also has a great history of repaying its debt, so maybe that’s not a terrible thing.  Still, if it’s possible to pay less on debt, that sounds intuitively like a good thing to do — though we should also acknowledge that intuition is often faulty.

Paying off debt

By cutting programs

One way to approach cutting back the 104% number and repaying faster is to look broadly at what you could spend things on if you weren’t paying (as much) interest.  By cutting back on existing government programs, you could pay off your debt, which would then lower your debt-to-GDP ratio.  This is fairly intuitive and one of the easier arguments to make.  However, the danger is that it often ignores what downstream impacts those programs you’re cutting may have on the GDP.  As a few examples, a higher skilled work force, e.g. through better education programs, can raise GDP in a semi-permanent fashion.  Improving the average citizen’s health can also do this.  Racial inequality has been shown to lead to declined GDP.  So when cutting programs in order to decrease debt, one should be careful of weighing what the long-term impacts of the programs are that you’re cutting.  These are hidden costs of cutting the program which may not show up for years, depending on the cycle and beneficiaries of the program.

By increasing taxes

Of course, nobody likes to hear the phrase “raise taxes” unless it’s on someone you don’t feel you’ll be affected by.  But this could have a positive impact on the net receivables of the US which they could then use to repay taxes.  Of course, the opposite of this is that people could move themselves or their businesses out of the US to avoid paying US taxes altogether, in favor of a different country’s tax scheme.

The net tax revenue as a % of the GDP in the US is just shy of 27%, so for every $1 billion you can get the economy to expand, the US government will have $270m to pay down debt.  Again looking at “peers”:

  • The UK is 34.4% net tax rate
  • Russia is 19.5%
  • Australia is 25.8%
  • Canada is 32.2%
  • Belgium is at 47.9%

The United states is pretty “average” here.  The OECD average is 34.8%, which puts the US below that, but above several less developed nations with lots of oil and other natural resources to export.

By increasing GDP

A third way to approach it is to take a completely different approach and look at how much you could grow your GDP:  if GDP grows faster than your debt as a result of your actions, your debt-to-GDP ratio shrinks.  Fundamentally this is an easy argument to make, but many people often miss the subsequent step: on how government spending could increase GDP.  What’s interesting is that this argument is also completely valid for two reasons.  First, simply because government spending is actually included as a piece of the GDP function (GDP = C + G + I + NX where C = consumer spending, G = government spending, I = investments, and NX = net exports), so increasing government spending directly affects GDP.  Second, government spending has to be spent on something: materials, contracts, etc, and that money ends up in business hands which ultimately ends up in a combination of investors and employees hands’.  Those businesses, investors and employees get taxed at some government rates and they use their leftover money to spend, invest, or save.

Generally, most everything done in the economy is taxed at some rate.  Various sales taxes tax consumption, there are personal and business taxes on incomes/revenues, taxes on imports, etc.  Thus, if the net volume and value of transactions that go on in an economy increase, the net taxes tend to increase as well, obviously dependent on what the various tax rates are.  Again, in the US, the net tax rates as a % of GDP are currently 26.9%.

By multipliers

In the last paragraph, I skipped over a secondary element of GDP going up, which lies in what GDP does and results in.

Before going further, I have to talk first about a Keynesian economics term called the marginal propensity to consume, or MPC.  That is, for every dollar I get, what % of if am I likely to spend (consume) vs save?  Currently, the numbers in the US are 20-40%, though it varies by age, wealth, and income as well as a number of other factors, including where the money gets spent.  This has an interesting multiplicative effect as a result of government spending.  I’ll walk through a hypothetical example.

Let’s say the government issues debt to spend $1 billion on a new project and for simplicity purposes, all of it goes to American companies/contractors.  And let’s say that we have a uniform MPC in our American economy of right in the middle at 0.30, or 30%.  Due to the wonder of mathematics, the $1b results in $1b * 1/(1-0.3) = $1b * 1/0.7 = $1.43 billion in total GDP, because people keep spending their money.  So if we start a $1 billion project and it has no value whatsoever, it’s likely to result in about a $1.43 billion increase to the GDP.  With a tax rate against GDP of 26.9%, $1.43b * .269 = $385 million in taxes, this means that the net tax burden from the project actually comes out to $1b – $385m = $615m.  And that’s with the project creating no value whatsoever.  If that project actually had a positive impact on the GDP because it was a good project, it could actually grow much larger.  If the $1 billion project has an (independent) positive impact on the economy to the tune of $615m in increased (independent) GDP, then it can actually be net positive.

Conclusion

It’s not clear at this point that the US is at an inherently bad debt situation.  However, with interest rates set to rise, it wouldn’t be bad to pay off some debt.  In any case, we should be careful of how and why we do so.  Cutting programs, raising taxes, and spending all have underlying costs to them, some of which may not be immediately obvious.  The impacts of any program need to be evaluated.  Statements like “we need to tighten our belt” without evaluating the medium, and long-term costs associated with the removal of the programs is a naive approach that can hurt our children’s generation.

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