Since When Does Government Have a Money Tree?

Someone, at some point, needs to pay for government spending.

Just because some politicians and advocates assume there’s a money tree for this purpose doesn’t make it so. Nor is it helpful for either side in the debate to talk in generalities, whether with reassurances that “the rich will pay,” on one hand, or with vague warnings that “higher taxes and larger deficits hurt the economy,” on the other.

In March 2020, Congress appropriately responded to the Covid-19 emergency by throwing fiscal caution to the wind. But extraordinary measures were supposed to be temporary. Instead, many Democratic leaders got a taste of bigger government, and seem to like it. And measures like checks to households have proved very popular with voters.

The result? President Joe Biden signed a recklessly large stimulus that needlessly continues many lockdown-era measures. He is following that up with a push for over $2 trillion on infrastructure, in-home care for the elderly and disabled, and subsidies to the manufacturing sector. He will soon propose trillions more for programs to benefit workers and families. Many in his party are pressuring him to go even further — for example, to cancel a large share of student loan debt.

Biden would raise taxes on corporations to pay for a portion of his infrastructure proposals, and will call for increases on individuals to cover some of his proposed benefits for families.

But corporate tax increases aren’t a free lunch. Sure, the owners of capital will bear most of the burden of the corporate tax, but workers will pay a price as well through lower wages. If U.S. competitiveness decreases as a result, our children and grandchildren will also pay through slower productivity growth and lower incomes.

Higher income taxes on individuals reduce incentives to save and invest. Less investment will reduce productivity growth, which in turn will lower wages across the board.

Programs like Biden’s child allowance — which will send a monthly check to the majority of parents — can be thought of as transferring money from childless adults to adults with kids. Taxpayers without children pay.

A new working paper released by the nonpartisan Congressional Budget Office studied the longer-term effects of financing a large and permanent expansion of government spending through higher taxes. Using a progressive income tax, a $1 trillion increase in spending reduces the level of GDP by 5% and after-tax wages by 10%, after 10 years. A $2 trillion spending boost reduces wages by 20% and GDP by 10%. CBO’s analysis does not include the economic benefits of the spending, but isolating the effects of the higher tax burden needed to finance it is illuminating.

Larger deficits also aren’t a free lunch. Even at today’s low interest rates, government debt reduces private-sector investment by putting upward pressure on interest rates. A recent CBO working paper estimates that rates rise by 2 to 3 basis points for every 1 percentage point increase in the ratio of debt to GDP. Less investment leads to lower wages.

The U.S. could borrow to cover spending today and increase taxes in the future to pay down the debt. But raising income taxes — in this case, on future generations — has the drawbacks I previously discussed. Alternatively, the government could allow for higher inflation to reduce the debt burden. But inflation operates as a tax by reducing the purchasing power of savings, hurting those on fixed incomes.

It is commonly argued that because the safe interest rate is below the economic growth rate, we can climb out of the red, because the debt burden grows more slowly than the economy.

There is something to this theoretical curiosity, but it omits real-world factors. For one, the return on private capital can be much higher than the rate on government bonds. Second, the interest rate on government debt might increase as the size of the debt grows, so the ability of the U.S. to grow its way out of debt shouldn’t be thought of as a lasting feature of the economy. Most importantly, the actual amount of borrowing is much larger than the gap between the government’s borrowing rate and GDP growth.

In 2020, the government spent $345 billion in serving the debt. The CBO expects that to grow to around $800 billion in 2031. Debt service crowds out other spending priorities. Some of the burden for it is borne by people who would have benefited from government programs that were never enacted because of high debt-servicing costs.

Large deficits also threaten the ability of the U.S. to respond to disasters. All of society might pay the costs of borrowing if the U.S. soon faces another crisis and finds it difficult to run adequate deficits.

Deficits are not always bad. They can be used to finance investments that enhance productivity, reducing their costs, or that make society better off. In 2020, the U.S. borrowed 15% of GDP, which was appropriate given the pandemic. As with many economists, my views on the dangers of deficits have softened in recent years.

Likewise, tax increases are often necessary to finance programs with large economic and social benefits. In addition, U.S. tax revenue is too low, which contributes to larger deficits.

But the costs of financing government spending should always be front and center. When they aren’t, cost-benefit tests simply become benefit tests. Politicians, remember: There is no money tree.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Michael R. Strain is a Bloomberg Opinion columnist. He is director of economic policy studies and Arthur F. Burns Scholar in Political Economy at the American Enterprise Institute. He is the author of “The American Dream Is Not Dead: (But Populism Could Kill It).”

©2021 Bloomberg L.P.

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