With the Deficit Super Committee’s deadline to engineer $1.5 trillion in deficit reduction over the next decade, approaching this week, we thought it fitting to share some related faculty research on the impacts of raising the U.S. Debt Limit, featured in the Fall 2011 edition of B. Magazine.
There are three primary short-term impacts of the increase in the U.S. debt ceiling. First, government continued without interruption to the U.S. economy, which could not afford a government shutdown. Second, in the present economy, the alternatives (reduce spending, increase taxes) would have had a greater negative economic impact. Reducing government spending or increasing taxes under duress in the short term would be very poor public policy and would have had a dramatic negative economic impact. Third, there was an unintended and unexpected impact: with the Standard and Poorís downgrade, which was due to the political circus in Washington, U.S. government bonds should have been perceived by the market as having greater risk, resulting in higher priced bonds. Because of a worldwide investor “flight to quality,” the opposite occurred, and bonds rallied. More risk, lower returns? Go figure. Some believe there would have been a greater downgrade if the debt level was not increased.
The long term impact is obvious: we have to pay for this some way in the future. There are three options: inflation, economic growth and government deficit reduction (decrease spending, increase taxes). The real problem is that Washington has not shown significant conviction toward the third alternative (Greece, anyone?), and strategically the markets will react negatively (in the long term). The message to the world has been underwhelming. The annual U.S. government deficits exceed one trillion dollars: even the Supercommittee of Congress is directed to cut the deficit by only $100 billion or so each year. So, the first two alternatives – inflation and economic growth – are the likely long-term scenarios. Let’s pray for the latter.
In the short term, raising the debt limit means that our leaders do not have to make immediate choices of which employees and vendors get paid before others, even though we are running more than $1 trillion dollars in annual deficits. As a result, all employees (as well as office paper vendors, etc.) in all of the areas of government have the same priority for their checks as our soldiers in combat. So the short-term impact of raising the limit is that it encourages people, no matter who they are, to continue to do business with the U.S. government because there is zero risk of late payment, let alone non-payment. The long-term impacts are not so favorable. In the post-WWII era, the United States has experimented with many different marginal income tax rates, including rates of more than 70 and 80 percent. What has been found is that no matter how high the rates, the amount of federal tax revenue collected seems to always converge back to a range of about 18 to 20 percent of the GDP. In other words, beyond a certain point, people change behaviors to limit taxes, and when rates go down they tend to report more taxable income. But either way, the revenue eventually converges to within a few points of 20 percent of the GDP. Conceptually this means that just about all of our annual spending above 20 percent of the GDP since WWII was paid for with borrowed funds. In the past, our creditors tolerated this because they had the expectation that this was not a permanent condition. Today, however, they are getting concerned about persistent spending above this threshold. So if extra tax revenue is not generated through economic growth, the long term will see additional downgrades and warnings about the U.S. government’s credit rating, eventually leading to increased borrowing costs and slower future growth for everyone.
David Vang, Ph.D., professor of finance