My late Nobel-laureate colleague James Buchanan made many important contributions. Among the most significant is his proof, first offered in 1958, that Adam Smith and other classical economists were correct to argue that government projects that are funded with debt are ultimately paid for by the future citizens whose taxes must be raised (or whose government benefits must be reduced) to get the funds necessary for repayment. (Randy Holcombe and I explain further here.) With deficit financing, today’s citizens-taxpayers impose costs on tomorrow’s citizens-taxpayers.
It’s possible, of course, that today’s citizens-taxpayers can use deficit financing also to bestow benefits on tomorrow’s citizens-taxpayers. If, for example, government borrows money today to build a hydroelectric dam that will operate successfully for decades, tomorrow’s citizens-taxpayers get not only the liability of having to pay for this dam but also an asset in the form of the dam’s capacity to generate electricity. But even if citizens-taxpayers tomorrow unanimously agree that the value to them of the dam is higher than is the amount of taxes they must pay for the dam, the inescapable reality is that these future citizens-taxpayers are the individuals who pay for the dam. The dam is not free, and no means of fancy financing or accounting shenanigans can make it so.
Yet those of us who today explain that deficit-financed government projects are paid for by tomorrow’s citizens-taxpayers too often lose sight of a real burden that deficit financing does often impose on today’s citizens-taxpayers. This burden is excessive growth of government that harms the current generation.
When Buchanan explained the dangers of deficit financing, he almost always assumed that all members of the current generation are united in their interests to live at the expense of future generations, and that the current generation pursues those interests knowledgeably. For example, the current generation of citizens-taxpayers might unanimously welcome a $50 billion increase in defense spending if it is paid for with borrowed funds – that is, paid for by future generations – but not if this spending must be financed out of current tax receipts. Because deficit financing is possible, however, the government uses this method of financing to expand the defense budget by $50 billion. Today’s citizens-taxpayers purchase, and enjoy, an excessive amount of national defense only because they get to pass the bill onto their children and grandchildren. In this example, deficit financing imposes no burdens on anyone in the current generation.
But examples such as this one mask an important feature of reality. Because today’s citizens-taxpayers are quite diverse in their interests, preferences, understandings, and economic positions, government projects undertaken today and funded with debt can impose real burdens on at least some of today’s citizens-taxpayers. This conclusion holds even though it remains true that the full burden of paying for such projects falls only on tomorrow’s citizens-taxpayers.
Suppose, for example, that a majority of today’s citizens-taxpayers in America conclude that it’s a good idea to nationalize the steel industry. Further suppose that a Supreme Court ruling prohibits government from simply seizing steel mills; the Court rules that if government wants to acquire steel mills it must pay market prices for these firms. Finally suppose that upon learning that the market price is $500 billion, Americans today are unwilling to have their taxes raised by this amount for this purpose. If deficit financing were unavailable, the steel industry would remain in private hands.
Deficit financing, however, is available. By borrowing the $500 billion to purchase steel firms, government enables that subset of Americans who support nationalization of the steel industry to achieve their policy goal without having to pay for it. The entire $500 billion will be repaid in the future by citizens-taxpayers not yet born.
But there is nevertheless a burden that emerges in the current period from this deficit-financed policy move – namely, the inefficiencies that immediately arise from the nationalization. The amount of resources consumed to produce each ton of steel rises inefficiently because government bureaucrats have fewer incentives than do private owners to ensure that mills operate efficiently. The costs of this excessive consumption of resources by government-owned steel mills ripple throughout the economy in the form of diminished outputs and higher prices of countless other goods and services.
In this example, nearly all Americans – and even some non-Americans – today suffer an immediate (and ongoing) burden as a consequence of this deficit-financed policy. Some Americans who are so ideologically enamored with the notion of industry nationalization might be content to bear this burden, while many other Americans might remain unaware that the higher prices they experience throughout the economy are a direct result of the nationalization. But the fact remains that, in this example, deficit financing imposes a real burden on the current generation despite the fact that full responsibility for repaying the loan falls only on future generations.
This example of a nationalized steel industry is, of course, hypothetical. But its lessons apply in the real world. For instance, to the extent that government subsidies of farmers and of aircraft producers are funded with borrowed money, similar burdens are created immediately: Resources are diverted from efficient to inefficient uses, causing even today’s citizens-taxpayers to suffer as a result of deficit-financed government programs.
Deficit financing – by enabling people today to free-ride on people tomorrow – allows government to expand its size and reach beyond that which would be obtained if government were required to fund all of its current expenses out of current revenues, with no opportunity for deficit financing. In short, deficit financing paves a path for the unwarranted and wasteful expansion of government activity. Only someone who is convinced that government will undertake only economically worthwhile projects regardless of the means of financing – or someone who doesn’t understand economics – can look favorably upon deficit financing by government.
This article, A Current Burden of Deficit Financing, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.