Governments are running out of headroom on debt

23 Jan 18

The US shows countries are running the risk of increasing their debt to levels where they will not be able to borrow anymore, warns the University of London’s Professor Michael Ben-Gad.

The recent changes to US federal income tax (Tax Cuts and Jobs Act, December 2017) will lower effective tax rates on asset income, bringing them closer to their optimal rate, while at the same time increasing federal debt by about 1 trillion dollars over the course of the next ten years.

Back in July, the US Congressional Budget Office (CBO) already predicted that driven by rising spending on social security and Medicare, publicly held debt would reach 91.2% of GDP in 2027 and 150% by 2047.

Yet prior to its passage nearly all opposition to the bill focused on its distributive impact and not on its negative impact on the country’s future fiscal stability.

My recently published research suggests an explanation for the unusual alacrity with which the US public and its elective representatives have so far greeted the unprecedented rise (in peacetime) in the debt burden since the early 1980’s.

The rise in immigration, when combined with falling birthrates incentivises a reliance on deficit finance to fund current expenditures on both government consumption and transfer payments even if shifting the tax burden to the future violates the standard precepts of public finance that favour smoothing tax rates over time to minimise the overall dead weight loss.

Consider that upon arrival, each new immigrant inherits a share of the public infrastructure the economy has previously accumulated, along with a share of the outstanding national debt to be financed with the help of their future tax payments.

In the past when there were fewer immigrants and natives had more children to inherit the debt, voters might have objected to burdening their future selves, or their children, with the economic cost associated with higher tax rates.

Now these considerations are outweighed by the incentive to use deficit finance to shift some of the overall burden of taxes toward the large number of immigrants who are yet to arrive.

During the 1970s, the rate of net migration to the United States averaged 1.9 per thousand.

It rose to 2.8 during the 1980s, to 4.3 during the 1990s, before receding to 3.2 per thousand.

Yet the impact of immigration on the future composition of the population is also a function of the fertility rates among native women in the United States, which dropped below replacement by the early 1970s.

The foreign-born share of the population rose from 4.7% in 1970 to 13.9% in 2015, and it is predicted to reach 17.7% by 2065.

By then the US population is projected to grow from 324 million to 441 million, with nearly the entire increase comprised of future immigrants or their descendants.

It is they who will share the cost of financing a debt largely incurred before their families arrived in the US.

Since its inception the United States has allowed its debt burden to climb during wartime, only to reduce it during the subsequent decades of peacetime.

Between the US entry into World War II at the end of 1941 and the year the war ended in 1945, the US Federal Government debt as a ratio of GDP climbed from 43.3% to 112.7%.

From then on, every year but three, the debt to GDP ratio declined as the US government retired its wartime debt, until the end of 1974, when it reached a postwar low of 24.6%. During the remaining years of that decade, the debt burden was relatively stable.

The year 1981, when President Ronald Reagan took office and initiated the last significant round of tax cuts, was a turning point.

In every one of the subsequent 13 years, the percentage of debt to GDP rose, until it had nearly doubled to 49.5% at the end of 1993.

During the late 1990’s it declined, dropping to 33.3% of GDP as a consequence of the tech bubble, but has since more than doubled.

This seems to be the direction of travel not only for the United States, but for much of Europe.

As people anticipate the continued immigration flows, their willingness to pay taxes or restrict transfer spending to curb the growth of debt, or to finance public investment that benefits future generations will continue to deteriorate.

Debt will carry on growing until governments are unable to borrow anymore.

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