In addition to their effects on
macroeconomic performance, budget deficits have a more direct implication for
the future: the resulting government debt may force the government to raise
taxes when the debt comes true. These future taxes reduce household incomes in
two ways- directly through the tax payments and indirectly through the dead
weight loss that arises as taxes distort incentive. Alternatively, if taxes do
not rise, the government may be forced to out transfer payments or other
spending to free up funds to pay the debt. A rise in taxes or a fall in
spending pays off a country’s debt. The effect of these depends on both policy
choices and luck. One surprising fact is that the government may never need to
raise taxes or cut spending at all. Instead, it can simply roll over its debt:
it can pay off interest and maturing debt by issuing new debt. At first, this
policy might appear unsustainable, because the level of debt increases forever
at the rate of interest. Yet as long as the rate
of GDP growth is higher than
the interest rates the rate of debt to GDP falls over time. With the debt
shrinking relative to the size of the economy, the government can roll over the
debt forever even as its absolute size grows. That is, the economy can grow its
way out of the debt.
Government raises taxes to ensure
that the debt income ratio does not explode. One natural safe policy is to
raise taxes enough to stabilize the real value to the debt. As long as economic
growth does not stop entirely, this policy will ensure that the debt is an
upper bound on the future tax burden arising from past budget deficits.
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