Tuesday, 20 July 2010

Only dummies think that deficits mean future tax increases.

The Financial Times has a series of articles this week on the deficit debate. So I’ll pick out some low hanging fruit offered by deficit terrorists and do some piss taking.

As Martin Wolf rightly points out, one of the main arguments put against deficits is that households think that deficits equal additions to the national debt, and that the latter will have to be paid back out of taxes. Thus households allegedly save more as soon as they see deficits on the horizon. And this allegedly nullifies the stimulatory effect of deficits.

This argument is nonsense from start to finish.

First, the idea that the average house calculates, or is even ABLE to calculate the deficit per household is farcical.

Second, a fairly large amount of deficit is required simply to keep the national debt and monetary base CONSTANT as a proportion of GDP in real terms, not to mention the effects of a rising population and rising real output per head. Here is a quick “back of the envelope” calculation as to the size of deficit required simply to keep things constant. Assume the following. 1. Real output per head is rising at 2% a year. 2. Population is rising at 1% a year. 3. Inflation is averages 2% a year. 4. National debt plus monetary base equal GDP.

On the above assumptions, the deficit would need to be 2 + 1 + 2 = 5% of GDP just to keep things constant. This 5% is NEVER EVER PAID BACK assuming GDP etc keep increasing as assumed above. Don’t believe it? Well look at the figures for national debt or monetary base for the last fifty years at the St Louis Fed site.

Third, governments will not, or at least ought not to raise taxes to pay back national debt until an inflationary boom looks likely. And taxes consist of government siphoning off household income before households can spend it. Thus anyone who saves up to pay back national debt is engaged in double counting. They are as deluded as someone who saves up to pay a tranche of tax where the relevant tranche is siphoned off by the tax authorities at source. An example is the PAYE income tax system in the UK under which wage earners have their income tax deducted before they even see their pay packets.

Readers who have not fully understood the above might be tempted to answer the latter point something along the lines, “Ah, but you’ve admitted taxes DO have to rise to pay back national debt. And any tax rise equals a standard of living cut. Thus households are being perfectly sensible to save in the face of those forthcoming cuts”.

The answer to that, briefly, is that those tax increases only reduce household income and spending from totally unrealistic or fantasy levels to realistic levels. Put another way, if (as is the case where an inflationary boom is imminent) money incomes are sufficiently high to cause serious inflation, what might be called the “excess portion” of those incomes just has to be wiped out.

The latter is no more of a standard of living cut than is waking from a dream in which one is a billionaire, and finds one has to live life on an average income.

This final para is a bit of a quibble, so stop reading now if you like. The above paras were based on the simplifying assumption that governments aim to keep national debts more or less constant as a proportion of GDP in the long term. Various articles on this and related sites advocate abolishing the national debt. So there might seem to be a contradiction here. I actually favour abolishing national debts. But for the purposes of this article, I’m just sticking with conventional ideas like “keep national debt more or less constant as a proportion of GDP”.


  1. A very interesting article.

    Just one question though (because IANAE) you write that "National debt plus monetary base equal GDP" - is this an identity or an empirical rule of thumb?

  2. NJ: That bit about national debt and monetary base was just a simplifying assumption made to help set out a simple illustration of the point I was trying to make. As to whether that assumption is accurate, with national debts the US and UK approaching 100% of GDP at the moment the assumption is certainly not WILDLY unrealistic.


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