You Can't Tax Your Way Out of a Debt Crisis

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On April 22, something happened that should serve as a warning to those who believe that "austerity" (especially tax increases) is the way out of a sovereign debt crisis. That day, Portugal announced significant tax increases, including imposing a 20% tax on capital gains. Their goal was to reassure lenders and reduce their borrowing costs. Instead, the exact opposite happened. The day that the tax increases were announced, interest rates on Portuguese bonds increased.

Although what happened is a shock to the conventional wisdom, this is exactly what you would expect if you realize that what the markets actually lend against is the nation's future tax revenue. What matters is the relationship between the amount of the debt and the estimated present value of future government revenues, discounted at the rate of interest on the bonds.

The present value methodology makes it possible to calculate a country's debt capacity, as a percentage of current GDP. Let's take the U.S. as an example. The Social Security Trustees assume that from here "to the infinite horizon", the U.S. economy will grow at a real average annual rate of about 2.0%, and that the Federal government will pay a real interest rate of 2.9% on its debt. Further assuming that Federal revenues will average 18% of GDP and that the government can devote 5% of its revenues to debt service, the maximum "debt capacity" of the Federal government would be 93% of GDP. In other words, lenders would be confident that the U.S. government would be able to service debt equal to about 93% of GDP.

Right now, the U.S. government's "debt held by the public" is $8.4 trillion. This is about 58% of current GDP, which is $14.6 trillion/year. Accordingly, right now, Federal indebtedness is only about 62% of our estimated debt capacity.

So, why are the markets worried about the Federal debt? One reason that the markets are getting worried is that the debt is rising rapidly and is projected to continue rising rapidly. Another reason is that, in addition to its explicit debt, the U.S. has unfunded liabilities in its Social Security and Medicare programs that have a present value of about $100 trillion-about twelve times our current bonded indebtedness.

However, the biggest reason that the financial markets are concerned about the U.S. fiscal situation is the same reason that they reacted negatively to Portugal's announcements on April 22. Big deficits create the impetus to do something stupid-namely, raise taxes.

Why are tax increases a stupid response to deficits? Because the debt capacity of a nation is exquisitely sensitive to its rate of economic growth, and tax increases reduce economic growth. When Portugal announced the tax increases on April 22, the markets calculated that they were actually reducing the country's debt capacity, and they demanded a higher interest rate to compensate for the increased risk of default.

Using the U.S. as an example, increasing the Federal Government's "tax take" to 20% of GDP from 18% of GDP (say, by letting the 2001 and 2003 tax cuts expire) would increase the nation's debt capacity to 103% of GDP. However, if these massive tax increases reduced GDP growth by just 0.11 percentage points, debt capacity would not increase at all. The Federal government would be back to where it started from, and the rest of the nation would be worse off.

If you do the math, it is clear that the only way out of a debt crisis is to cut taxes in order to increase economic growth. As an example, let's take the case where we eliminate the corporate income tax, thereby reducing the Federal "tax take" to 16% of GDP. It would take only a 0.11 percentage point increase in economic growth (to 2.11%) to "pay for" this enormous tax cut, and only an additional 0.2 percentage points of growth (to 2.20%) to raise U.S. debt capacity to 103% of GDP.

Now, eliminating the corporate income tax would produce a seismic shift in the economy. Investment and employment would skyrocket. Let's look at a case where the result was to increase long-term economic growth by 1.0 percentage points, to 3.0% (which is still lower than the U.S. average over the past 100 years).

At an average real economic growth rate of 3.0% annually, the debt capacity of the U.S. government becomes infinite. This is simply what happens when the GDP growth rate exceeds the interest rate. Note that this is true at a "tax take" of 16% of GDP, but it is also true at a "tax take" of 10%. Any percentage of infinity is infinity.

It is clear from the mathematics of Federal finances that the only important economic goal is to get our long-term economic growth rate up over 3.0%. Eliminating the corporate income tax is the surest way to do this. In calendar year 2009, the corporate income tax brought in only about $135 billion in revenue. For only 17% of the cost of the hopeless, useless, "Stimulus" bill, we could have had the economy back on track and most unemployed people back to work by now.

I would urge the Republicans running for Congress this year to campaign on pro-growth tax cuts. If you think that "we can't afford them", do the math.


Louis Woodhill (, an engineer and software entrepreneur, and a RealClearMarkets contributor.  


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