The Wrong Line in the Sand

by Matt Mitchell on January 13, 2011

in Tax and Budget

There are many in policy circles these days who believe that newly-empowered House Republicans – especially those that were elected with Tea Party backing – ought to draw a line in the sand on raising the debt ceiling. This is the wrong line in the sand. Excessive debt is indeed bad. But it is a symptom of the disease, not the disease itself. To treat the real disease, I believe we need to get serious about addressing the spending problem.  

What is Wrong With Debt?

It used to be that Republicans focused almost-exclusively on taxes instead of on their root cause: spending. This, of course, biased policy in favor of huge deficits. When deficits are large but manageable, they drive up interest rates and crowd-out private investment. And when deficits are large and unmanageable, they can up-end a country’s entire economy.

Economists Carmen Reinhart and Kenneth Rogoff examined the implications of debt in 44 countries over a 200 year period. They found that in economically-advanced countries, when debt-to-GDP ratios moved from around 30 percent of GDP to 90 percent or more, economic growth rates tended to halve. Now the US isn’t a typical country and investors may be willing to let our government get away with debt-to-GDP ratios that are higher than 90 percent.

But certainly they are not going to let us get away with debt-to-GDP ratios of 200+ percent (which is what the CBO projects for 2035), let alone 300+ percent (2047) or 800 percent (2078).

At some point, the federal government will have accumulated too much debt for investors to feel comfortable lending at current rates. At that point, they will demand higher interest rates which will undermine economic growth.

In a best-case scenario, we will join the list of countries that have seen excessive debt severely hamper their economic growth rates. In a worst-case-scenario, the increased interest-cost will further add to the government tab, consuming the whole budget and causing the whole edifice to collapse under its own weight.   

What is Wrong with Taxes?

Now you might think we ought to draw a line in the sand and not borrow anymore. The problem is that if we refuse to raise the debt limit, it might cause the government to default on its existing debt, hastening the day when investors will lose confidence in the full faith and credit of the government.

An even more-likely scenario is that a refusal to raise the debt limit will trigger a massive tax increase. Some critics, of course, have blithely suggested that a tax increase is just what we need. The problem here is that taxes can also inflict great economic harm. Economists Christina and David Romer examined over 60 years of U.S. data to understand the impact of taxes on GDP. They carefully disentangled the tax-effect from other effects, and concluded that a tax increase of 1 percent of GDP lowers real GDP by almost 3 percent.

The CBO projects that if we were to meet our current long-term spending promises without more borrowing, all taxes would need to roughly double. If the Romers’ estimate is anywhere near accurate, a doubling of all tax rates would trigger one of the worst economic contractions in US history.  

So what should we do? I’d say the first thing we need to do is focus on spending. Its two symptoms — excessive debt and excessive taxation — are both economically damaging. Only by focusing on the disease can we avoid both symptoms.

Spending is where the line should be drawn.

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