Thinking about Long-Term Debt

The pandemic and its legislative response exacerbated an already dire budget outlook. The 2020 federal deficit was already projected to exceed $1 trillion before lawmakers added $2 trillion in new borrowing to fund COVID-19 economic relief packages. The consequences for the long-term budget from this spending is significant. Last year, the Congressional Budget Office projected federal debt held by the public to rise from 79 percent of GDP in 2019 to 144 percent in thirty years. Just over a year later, however, debt now exceeds 100 percent of GDP and is projected to grow to 195 percent by 2050.

While COVID-19 and the related response by Congress increased the nation’s debt levels, the future debt will still be driven by massive future spending increases. Over the next thirty years, federal spending is projected to rise from 21 percent of GDP to 31.2 percent. Meanwhile, taxes will only rise from 16.3 percent to 18.6 percent of GDP. The result will be growing deficits that exceed 10 percent of the nation’s economy.

As we noted in last year’s Policy Insights edition on the debt, the increased spending is driven by a mere handful of government programs, specifically: Medicare, Medicaid, and Social Security. In 2019, those programs accounted for just over half of government programmatic spending. By 2050, they will account for more than two-thirds. In the video below, economist John Cogan explains why these programs are expanding:

Increases in the federal debt might not concern you too much right now. Interest rates are near all-time lows, so paying for the borrowing is relatively inexpensive today. But over the long term, out-of-control debt threatens to destabilize the economy and destroy future economic opportunities.

Economist John Cochrane discusses the possible consequences of the higher federal debt in his blog the Grumpy Economist. He notes that as debt rises, the United States is more at risk of a debt crisis where lenders to the federal government become unwilling to finance the debt. The risks may seem small now—investors are currently eager to buy US Treasury Bonds—but Cochrane explains how this might change in the future:

At this point, the US has, say, 150% debt to GDP. It needs to borrow another $5–$10 trillion, or get people to hold that much more newly printed money, to bail out once again, and pay everyone’s bills for a while. It will need another $10 trillion or so to roll over maturity debt. At some point bond investors see the end coming, as they did for Greece, and refuse. Not only must the US then inflate or default, but the firehose of debt relief, bailout, and stimulus that everyone expects is absent, together with our capacity for military or public health spending to meet the shock that sparks the crisis. 

Even beyond a debt crisis, rising deficits will have economic consequences. Government borrowing requires that someone lend money. It might come from foreign buyers of the debt or from the Federal Reserve. Or, it might come from investors who would have otherwise invested in someone’s business or invention. Economists call this “crowding out.” It happens where money is lent to the federal government that would have been directed to entrepreneurs to create or expand their business. The result is less private investment, which will ultimately reduce economic growth. 

Economist Michael Boskin examines the economic effects of the debt in his paper “Are Large Deficits and Debt Dangerous?” He explains that “to the extent deficits decrease national saving and crowd out investment, incomes, especially wages, will be lower than they would have been in the future.”

For many the answer to all this debt is obvious: we should raise tax rates. But there are good reasons to think that increasing revenue in this fashion is not a panacea to our debt crisis.

First, the size of the problem means that we would need substantial rate hikes. How much? The America Off Balance Budget Calculator estimates that we would need to raise taxes by more than 16 percent just to keep federal debt at or below 100 percent of GDP. If you tried to raise all that revenue by only raising taxes on high-income taxpayers, you would need much larger rate increases that would push marginal income tax rates far beyond 50 percent.

Tax increases may help reduce debt levels, but increasing tax rates would have significant side effects. The video below explains how high tax rates give individuals fewer reasons to work, save, and invest. The economic effects from these tax increases can be great. Economist Michael Boskin has estimated that an additional dollar of revenue from high tax rates “costs the economy about $1.40.”

And even beyond the effect on the economy, the higher tax rates won’t necessarily deliver the revenue need to improve our budget picture. As Joshua Rauh covers in the above op-ed, California has tried this strategy in the past, and several California lawmakers appear eager to try it again. Rauh shows, however, that this strategy isn’t guaranteed to raise much revenue. High taxes lead people to change their behavior in ways that reduce taxable income. Rauh has noted that past California tax hikes have encouraged high-income Californians to flee the state or alter their income flows to avoid the high taxes.