Paul Krugman has a nice post which is entitled ‘Debt Is (Mostly) money we owe to ourselves’. It is a point I have often used in the past to help students understand that macroeconomics is different from microeconomics. Government debt appears to be a ‘burden’ on taxpayers because the government must raise taxes to pay the interest on the debt. But if the debt is owned by the same taxpayers, the interest goes to them, so in income terms they are no worse off. However, I think the idea can be pushed too far. I do think it is reasonable to describe excess government debt as a burden for future generations.
Before exploring this, we should note two factors that are very important but which we will ignore here. First, taxes will be raised in a way that distorts incentives, which has costs. Second, government debt can displace saving that go to produce capital, which reduces investment and the capital stock, which also reduces output. There is a lot more to say on both counts, maybe for another time. I ignore them here, because I want to focus on income flows at the aggregate level.
Consider this apparent paradox. Suppose some additional debt is generated by temporarily cutting taxes. Let us call those who receive this tax cut the tax cut generation. Suppose also that this debt is a ‘perpetuity’ – the debt is never repaid, but anyone holding it will receive interest forever. The debt is sold domestically. Those whose taxes are cut are clearly better off in income terms. But, as we noted above, future generations are not worse off in terms of simple income flows: in aggregate they pay higher taxes, but get the money back as interest on the debt they own. So we seem to have a free lunch: the tax cut generation gains, but no later generation loses. [This is a mistake - see the comment from Nick Rowe below, and my response. I say why and when this is a mistake is this later post. It does not affect my main point here.]
What is the source of this paradox? Well imagine the debt is no longer a perpetuity, but has to be repaid after a thousand years. To repay the debt, the government raises taxes. The generation paying taxes in a thousand years time loses out in a major way – their income decline matches the gain received by the tax cut generation. The paradox disappears. So the paradox arises if there is no last generation that has to repay the debt.
The same paradox arises with an unfunded social security scheme. This is where a government creates a pension scheme whereby pensions are paid using the contributions of those working. When the scheme is introduced, those who are just retiring are much better off: they get a pension ‘for free’. But those who pay into the pension scheme get their money back when they retire, so to the first approximation they are no worse off. (It is an approximation because we should worry about the return they get on this ‘forced saving’, but the important point here is that they get their contributions back.) Once again, we have a free lunch, but only because the pension scheme never comes to an end. If it did end, the last generation would pay contributions when working but receive no pension, so their loss would ‘match’ the gain of the retired when the scheme was introduced.
So it is possible that government debt need not be a burden on future generations, if it is never repaid. However, this is not a very realistic or sensible assumption. My own view is that it makes sense for governments to have a long run target for debt, and in that case any excess debt beyond this target will eventually have to be repaid. If that is the case, then additional debt incurred now is a burden on future generations, because they will in practice repay it (as the government slowly moves debt back towards its target).
Should this make those of us who advocate stimulus rather than austerity today think again? No – because the overall benefits still outweigh the costs. Would we really want to argue that expansionary fiscal policy should not have been used to avoid the Great Depression of the 1930s because it would mean we would be paying slightly higher taxes today? Of course not.