Freeman

ARTICLE

Politics, Economics, and the Destructiveness of Deficits

JANUARY 01, 1991 by DWIGHT R. LEE, CYNTHIA D. LEE

Are chronic budget deficits a threat to the economy? The general public believes that budget deficits are something to fear, but economists are not so sure, and Congress doesn’t seem to care.

It is difficult to argue that either Congress or economists are wrong, given their respective concerns, even though the public is justified in its worry over the economic consequences of persistent Federal deficits. The public’s concern is real, but it’s an unfocused background concern that fails to translate into significant political pressure. So why should the concern over deficits by members of Congress go beyond rhetoric when they can spend the Federal budget into one large deficit after another and still look forward to re-election rates in excess of 98 percent?

Economists don’t have to worry about being reelected, but they are worried about making obviously foolish predictions, and they have noticed that the huge budget deficits of the 1980s have precipitated none of the adverse consequences predicted by deficit doomsdayers. Economists are concerned with explaining the effect of budget deficits on such economic variables as interest rates, inflation, and the savings rate. These variables have not responded to large deficits as predicted by standard macro-economic models, and economists have been busy developing alternative models explaining why they haven’t. A major conclusion of these models is that budget deficits are almost completely neutral in their effect on the economy. An increasing number of economists have concluded that deficits have little effect, either positive or negative, on the economy, and see public concern over deficit spending as unfounded.

While economic analysis can provide useful insights, it is always risky to dismiss the concerns of the public. The public may not have a sophisticated understanding of economic analysis, but this is not necessarily a liability. Sophistication in the analysis of narrow economic relationships can divert attention from broader features of the political economy that are more relevant to our economic prospects. In particular, budget deficits may reflect flaws in the political decision-making process that are a threat to economic performance quite apart from any direct economic impact of the deficits themselves.

In this essay we discuss briefly the argument that budget deficits are unlikely to have the adverse economic effects commonly attributed to them. It is pointed out, however, that the theoretical basis for the view that deficits are benign is hard to reconcile with the undeniable fiscal impulses of politicians. And given these impulses, the greater the political latitude to rely on deficit financing the greater will be the level of government spending. Even if deficits do not, for example, noticeably crowd out investment directly through interest-rate increases, the political opportunity afforded by deficit spending can facilitate the expansion of public sector activity, which necessarily crowds out private sector activity. The consequences of substituting the less productive public sector for the more productive private sector may not register immediately in statistical measures of key economic variables. But the long-run economic consequences of such a substitution are no less destructive because they go unnoticed by econometric studies and the myopic political process.

Do Deficits Matter?

What is the effect on the economy of an increase in deficit spending? The best known answer to this question is given by the standard Keynesian model which predicts that increasing the deficit will increase aggregate consumption demand, thereby reducing the total savings in the economy and increasing the real interest rate. With a higher interest rate there will be a reduction in investment, and the deficit spending will have crowded out some productive capital.

Harvard economist Robert Barro has attacked the standard Keynesian view by arguing that, under what he believes are plausible conditions, it makes no difference whether government spending is financed by taxing or by borrowing.[1] The argument begins with a proposition that dates back to the early 19th century, when it was put forth by the English economist David Ricardo. Ricardo argued that if government financed, for example, an additional $100 of spending by borrowing, then, instead of being responsible for $100 in tax payments immediately, taxpayers would be responsible for $100 plus accumulated interest at a later date. But the present value of the $100 plus interest later is equal to $100 now, so the taxpayer who expects to be paying taxes later will find deficit financing no less costly than tax financing. The taxpayer will be indifferent as to whether bor rowing or taxing is used to finance government spending.

If borrowing versus taxing is a matter of indifference to taxpayers, then it is also a matter of indifference as far as important economic variables such as the interest rate and investment are concerned. Assume that government increases the budget deficit by reducing taxes without reducing spending. Taxpayers will recognize that even though they experienced an increase in current disposable income, they have also experienced an equivalent increase in the present value of their future tax obligations. Because they are no better or worse off, there is no reason for them to increase current consumption and so the entire tax reduction will be saved. Consumption and saving therefore will not be affected by the increased deficit; both private and public consumption remain the same, and the increased public debt will be exactly offset by increased private saving. This being the case, increasing the deficit, with government spending held constant, will not reduce long-run economic productivity by exerting upward pressure on the interest rate and crowding out private investment.

Of course, as recognized by both Ricardo and Barro, complete indifference between taxation and government debt requires that everyone alive when government increases its debt be responsible for all of the future tax increases that servicing the debt requires. But many people realize that they will no longer be alive when the future taxes required by current deficit spending come due. Why won’t these people treat the deficit as a real reduction in their tax burden (with a corresponding increase in the tax burden of future generations), and respond by saving less and spending more?

Barro confronts this question by arguing that most people will be reluctant to increase their consumption when debt is substituted for current taxation even if they know that they will not be alive to pay the higher future taxes required by the debt. According to Barro, this reluctance is based on the obvious fact that people are concerned with the well-being of their children beyond their own lifetimes. This concern is reflected in the investment parents make during their lifetimes in their children’s human capital and the bequests they make to their children. Given this bequest motive, Barro argues that parents will recognize that substituting debt for taxes in the financing of government expenditures will reduce the well-being of their offspring by increasing their future taxes. In other words, parents will realize that the value of the taxes they will avoid because of increased reliance on deficit financing will represent a reduction in the value of their bequest to their offspring. The natural response to this is for parents to increase their bequests, and therefore their saving, by an amount equal to the tax burden that is passed from them to their children because of the increased deficit. The substitution of debt for taxation therefore leaves total saving in the economy unchanged with no crowding out of private investment and no reduction in the long-run productivity of the economy.

Barro recognizes that bequest adjustments will not offset completely the effects of deficit spending, but he argues that these adjustments are more complete than most people would expect. But Barro ultimately rests his case on what he sees as empirical support for the economic neutrality of deficit spending, with this support consisting of sophisticated econometric studies that find little connection between budget deficits and interest rates.

No amount of empirical testing will ever provide conclusive support either for or against the Barro thesis. Aggregate economic data are always of questionable accuracy, and empirical techniques are always less powerful and robust than would be desirable. Fortunately, additional evidence can be brought to bear on the relevance of Barro’s proposition to fiscal policy without having to rely on economic data and sophisticated econometric techniques. This evidence comes from the dearly observed behavior of politicians and it suggests caution in accepting the Barro position. Furthermore, this behavior suggests that we be concerned about budget deficits for reasons not addressed either by Barro or by economists in general.

The Political Cost of Deficits

If the cost to the taxpayer is the same whether government spending is financed through taxes or deficits, then politicians should be indifferent as to the mix of these two means of financing. The evidence is clear that they are not. Why, for example, are politicians so reluctant to respond to the public’s general disapproval of large deficits (a disapproval that is hard to square with the idea that debt and taxation have equivalent effects on the well-being of both current and future taxpayers) by simply financing all government expenditures with taxation? The proposition that deficits are economically neutral is simply inconsistent with the obvious reluctance of politicians to reduce deficit spending significantly.

The attractiveness of persistent budget deficits to politicians suggests strongly that current taxpayers do not believe that the future taxes they will have to pay because of additional government debt are as costly to them as the current taxes that the debt replaced. If this is the case, then over some range politicians will find it is less costly politically to finance spending through debt than through taxation. This suggests that the existing combination of debt and taxation prevails because it is the combination that allows existing spending levels to be financed at the least political cost. This being the case, it is clear that politicians will be reluctant to reduce deficit spending unless the political cost of deficit financing is increased. Also clear is that any increase in the public’s tolerance of deficit spending will lower the political cost of government spending and, therefore, motivate both larger deficits and greater spending. Can anyone doubt seriously that government spending would increase if increased public tolerance of deficits lowered the political cost of further expanding deficit spending?

There is no obvious direct measure of the marginal political cost of deficits, so it is difficult to imagine a direct test of the proposition that a decrease in that cost will increase government spending. But a testable implication of such a response to a reduction in the marginal political cost of deficit spending is that an increase in the ratio of deficit financing to tax financing will be associated with an increase in government spending as a percentage of the Gross National Product (GNP). The budget experience of the federal government is consistent with this implication. Yearly Federal budget data from 1960 to 1988 show that when the ratio of deficit to non-deficit financing (almost all of which is tax revenue) increased by 1 percent, government spending as a percentage of GNP increased by .087 percent. There can be little doubt that the political cost of deficit financing has been reduced by the political embrace of a simplistic version of Keynesian policy prescriptions, an embrace which began with the 1960 election of John F. Kennedy and lasted, though with reduced enthusiasm, into the 1980s. There can be even less doubt that the decrease in the political cost of deficit financing, whether caused by Keynesian economics or not, is largely responsible for the increase in the relative size of the federal government since 1960 (from 18.2 percent of GNP in 1960 to 22.3 percent of GNP in 1988).

The Economic Cost of Deficits

The connection between deficit spending and the relative size of government suggests a cost associated with deficits that is easily overlooked by standard investigations of the economic effect of deficits. The expansion in government that is facilitated in a regime of chronic budget deficits reduces economic productivity and growth. To argue that government expansion reduces economic growth is not to deny that over some range government is a source of improved economic performance. A few government activities are necessary to establish an economic order that promotes productive specialization and exchange. But it also has to be recognized that organized interests persistently exert pressure in favor of expanding the scope of government activity beyond productive limits. These interests are often quite successful owing to the fact that the cost of expanding government is typically diffused over a dispersed and unorganized public, which lowers the political cost of this expansion below the social cost. The result is that governments at all levels have expanded well into the range where, at the margin, they are reducing our economic wealth.

Recent cross-national studies of the relationship between the relative size of government (as measured by government expenditures as a percentage of Gross Domestic Product) and economic growth provide a quantitative dimension to the negative marginal impact of government. One such study of 115 countries by economist Gerald Scully found that a 1 percent increase in government expenditures (as a percentage of GNP) reduced average annual economic growth by one-tenth of a percent.[2]

Using Scully’s estimate of the connection between government size and economic growth and our earlier estimate of the connection between the ratio of deficit spending to taxation and government size, it is possible to make a ball-park estimate of the cost, in terms of forgone GNP, associated with increased deficit spending: If the ratio of deficits to tax revenue doubled from 10 to 20 percent (at the Federal level this ratio averaged about 3 percent during the 1960s, while from 1980 through 1988 it averaged 22.5 percent) then ourearlier estimate predicts that government spending as a percentage of GNP will grow by 8.7 percent. This means that if government spending began at 20 percent of GNP it would have increased to 21.74 percent of GNP, which according to Scully’s estimate would reduce economic growth by .174 percent. With a GNP in the U.S. of approximately $5 trillion, this reduction in growth is approximately $8.7 billion per year. This may appear to be a relatively modest amount as government budget numbers go, but with the figure increasing each year with economic growth, and accumulating over time, this deficit-related cost is of genuine significance.

While reasonable people can disagree over the magnitudes involved, it is hard to deny that the easier it is to engage in deficit spending, the lower the political cost of increasing government spending. Equally hard to deny is that the increased spending that will result, other things being equal, transfers resources out of the productive private sector and into the far less productive public sector. The clear conclusion is that there is a cost associated with deficit spending that is not the direct economic result of deficits themselves.

By attempting to determine the direct effects increased deficits have on such economic variables as interest rates and savings, economists have been ignoring what may be far more important consequences of deficit spending. Even if deficits have little direct economic effect, they can still be economically costly. It is not the deficits per se that are the problem, but rather the political environment that is created when politicians face little resistance to relying on deficit financing. The move to such an environment increases the control politi cians have over productive resources, reduces the responsibility imposed on them in exercising that control, and, as a consequence, diminishes the productivity of our economy.

1.   Robert J. Barro, “Are Government Bonds Net Wealth?” Journal of Political Economy, Vol. 81 (1974), pp. 1095-1117.

2.   Gerald W. Scully, “The Size of the State, Economic Growth and the Efficient Utilization of National Resources,” Public Choice, 63, (1989), pp. 149-64. Scully’s findings are supported by similar studies. For example, see Daniel Landau, “Government Expenditures and Economic Growth: A Cross-Country Study,” Southern Economic Journal (January 1983), pp. 782-92; and Michael L. Marlow, “Private Sector Shrinkage and the Growth of Industrialized Economies,” Public Choice, 49 (1986), pp. 143-54.

ASSOCIATED ISSUE

January 1991

ABOUT

DWIGHT R. LEE

Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.

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