A Short Course on Public Debt

July 11, 2011

For release July 13 and thereafter (881 words)

Two questions come to mind when considering recent public debt accumulation by Indiana state and local governments and the federal government: How did we get ourselves into this situation? How do we get out? Here we first consider the short-run alternatives to dealing with existing debt and then reflect on behaviors needed to avoid increasing public liabilities.

In 2009, state and local debt per person in Indiana was $7,311 compared with $8,420 average for all states. Federal debt per person exceeded $38,600. The hodgepodge of TIFs (Tax Incremental Funds) makes it virtually impossible for the ordinary person to estimate local taxes paid indirectly for debt service; however, most of us realize that the tax liability is not insignificant.

James Baker, the former U.S. Treasury Secretary, has outlined the following short-term steps to bolster confidence in the public bond market and thereby avoid significant interest-rate hikes on existing public debt; interest paid out of tax dollars will increase four-fold to $916 billion a year by 2020.

1.  Commit government units to honor interest on existing obligations with agreements to cap total spending for anything other than that needed for debt servicing. The cap on total spending would be enforced by sequestering spending from specific programs. For example, if an Indiana county determines that additional funds for libraries are critically needed then funding for another program, such as highways, must be cut. If this approach is unacceptable, then cuts across the board on all programs are needed for any agreed upon additional spending. No exemptions or exceptions should be permitted because they defeat the purpose of sequestered funds or across-the-board caps.

2. Broaden the tax base by eliminating any loopholes and lowering marginal income tax rates. On the federal level in 2008, according to the Tax Foundation, 37 percent of all tax returns, reporting positive adjusted taxable income, had sufficient exemptions, deductions and tax credits to wipe out average tax liabilities. Without ignoring personal and political costs, Donald Marron in National Affairs suggests that making taxes simpler, fairer and more pro-growth would increase government revenue and reduce public debt. Any changes in tax rates should be revenue neutral, which means that increases or decreases in taxes for one group must be balanced by decreases or increases for another. To avoid failure and heated political debate, tax discussions should be separate from those concerning the aggregate levels of taxes and expenditures.

In the long run, more tax dollars will be needed to correct federal, state and local government’s fiscal problems. The present flow of tax revenue coming into government is inadequate to meet the flow necessary for income maintenance, social services, education, security and infrastructure. The least painful means to increasing government revenue is through economic growth. The best way to do this is through lower tax rates and less regulation on economic activity.

How did the public allow government to accumulate unacceptable debt? There is no consensus on the ideal percentage of total national, state or local income to be allocated for government spending but historically 15-20 percent of GDP has been collected from taxpayers.  Currently, combined with state and local taxes, the actual amounts exceed 25 percent of GDP.

Compare this revenue coming into government with current expenditures. In 2008, government spent 38 percent of GDP. Both debt and tax funds use to service debt is increasing, and this growth is unsustainable. Without a benchmark ratio of government share to total GDP, there is a tendency to overspend and under tax. 

Let’s say that there is more or less a consensus that total U.S. spending of the federal, state and local levels over several years should average 25 percent of GDP. The question becomes, “How do public decision makers decide how to allocate the budget between government programs?”  The idealistic answer is that they do what the people want. The cynical answer is that they do what they need to do in order to get reelected. Economics offers a decision rule of thumb for government expenditures that is neither idealistic nor cynical, but admittedly somewhat theoretical.   

Private goods like corn flakes, athletic shoes, vacations and automobiles are provided in markets, and individuals earn income to provide themselves and their families for these goods and services. Households are or should be responsible to provide themselves with food, clothing, housing, school supplies, recreation and holiday gifts. Government neither provides nor finances private goods. Public goods, on the other hand, like national security, police protection, courts, information on health and nutrition, primary education and transportation infrastructure, are lacking in the absence of government. Public goods are characterized by the fact that any subset of citizens has no incentive to provide them and once provided it is impossible or too costly to exclude others from enjoying them. Therefore, taxes must be collected to provide public goods.

Much of what federal, state, and local government currently provides does not meet the public-good criterion and exceeds, perhaps, deeply held and affordable community values. Some argue forcefully that each new government program or tree, for example, planted in a public park represents an increase in society’s well-being. However, logic suggests that at some point some legislative official or private citizen will cry out, “Enough already.  Resources are limited. What must be given up for this new program?”

Maryann O. Keating, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is co-author of Microeconomics for Public Managers, Wiley/Blackwell, 2009.



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