For Jim Buchanan

“We have a spending, not a revenue problem”, is an influential opinion in America. This is not intended to mean that raising any amount of revenue is not a problem. In fact, raising taxes is a problem. The intended meaning is that government spends too much, i.e. the development of spending is unsustainable, because there will not be enough revenues to pay for it. Also, that the needed, not the actual, spending could be covered by the already raised revenues, which is why revenues are not a problem. Finally, even if current spending, financed by debt, is not unsustainable, it is unjustifiable because the accumulated debt will have to be paid down by future generations, who of course have had no part in raising the debt that they will have to pay back. How true are these opinions?

The willingness to pay is a political matter. The median voter theorem predicts that the majority will go for increased taxes on the better-off, because the median voter income is below the average voter income. Clearly, the theorem cannot be applied straightforwardly to a representative democracy especially one with the division of power, but the general elections of 2012 seem to have come as close to the decision as realistically possible, so some willingness to pay clearly exists as long as the distribution of the tax burden is acceptable to the median voter, i.e. to the ordinary American.

From the fiscal point of view, public debt has to be paid down from taxes, so in that sense, that is a revenue problem, while fiscal deficits are more of a spending problem. Of course, fiscal surpluses needed to retire the accumulated public debt can come from lower spending as well as from increased taxes, but assuming that the needed, i.e. socially and politically desirable structure and level of public spending are determined, paying down public debt is a revenue problem. Choosing the time schedule of payments is, in part, what countercyclical fiscal policy is about.

Now, looked at it that way, fiscal policy is more of an accommodation, and therefore fiscal deficits and the public debt are driven by the business cycle. So, can fiscal policy be unsustainable? That depends on the growth of the economy and on the interest rate on the debt. If growth rate is above the interest rate permanently, public debt can be refinanced and will be sustainable. Assuming that the interest rate will in fact react to the unfolding of the business cycle, with higher rates being associated with booms and lower rates with busts, fiscal surpluses and the public debt should reflect the inter-temporal choices of the public or the electorate. It could prove unsustainable if at some point the willingness to pay breaks down.

The spending problem is that in these inter-temporal decisions future generations enter asymmetrically, that is as taxpayers for the inherited public debt they had not authorized in any way. Again, applying the median voter theorem under the important assumption that future generations will be wealthier than the current one (which means that increased public spending beyond that necessitated by the automatic multipliers will be directed to investments that do not crowd out private investments), spending today will be higher than the median voter of the future generation would have been willing to pay now, if there had been a possibility to take part in the current decision-making. This will be a spending problem, i.e. spending will be hard to cut, with or without Ricardo Equivalence.

This is the case even though – assuming that bills have to be paid, save for worthless paper or fiat money, which is nominally government’s liability, but can be transformed into trash at the end of times – the decision not to spend on public investments today and thus not carry over public debt over generations, is the same as the decision not to bequest anything to future generations. In other words, a decision not to build a road today so as not to leave a debt burden for children to pay is the same as leaving them with the necessity to raise the money to build the road. Still, the willingness to pay may not be there, and the can may be pushed down the road as long as it takes, which may prove unsustainable in the sense that public debt will not be retired even at the end of times. Then, by backward induction, it will be unsustainable now, if spending is not cut at some point in time.

Peščanik.net, 10.01.2013.