Politics, Ecoomics, and the Destructiveness of Deficits; D.R. Lee and Cynthia D. Lee

It is difficult to argue that either Congress or economists are wrong, given their respective con cerns, even though the public is justified in its wor ry over the economic consequences of persistent Federal deficits. The public's concern is real, but it's an unfocused background concern that fails to translate into significant political pressure. So why should the concern over deficits by members of Congress go beyond rhetoric when they can spend the Federal budget into one large deficit after another and still look forward to re-election rates in excess of 98 percent? Economists don't have to worry about being re elected, but they are worried about making obvi ously foolish predictions, and they have noticed that the huge budget deficitsof the 1980shave pre cipitated none of the adverse consequences pre dicted by deficit doomsdayers. Economists are concerned with explaining the effect of budget deficits on such economic variables as interest rates, inflation, and the savings rate. These variDwight R. Lee is the Ramsey Professor of Economics at the University of Georgia, Athens. Cynthia D. Lee served as a research assistant in preparing this paper.

This paper is based on research done when Dwight Lee was the John M. Olin Visiting Scholar at the Center for the Study ofAmerican Business during the 1988-89 aca demic year. abIes have not responded to large deficits as pre dicted by standard macro-economic models, and economists have been busy developing alternative models explaining why they haven't. A major con clusion of these models is that budget deficits are almost completely neutral in their effect on the economy. An increasing number of economists have concluded that deficits have little effect, either positive or negative, on the economy, and see public concern over deficit spending as unfounded. While economic analysis can provide useful insights,it is alwaysrisky to dismissthe concerns of the public.The public may not have a sophisticated understanding of economic analysis, but this is not necessarily a liability.Sophistication in the analysis of narrow economic relationships can divert atten tion from broader features of the political econo my that are more relevant to our economic prospects. In particular, budget deficits may reflect flaws in the political decision-making process that are a threat to economic performance quite apart from any direct economic impact of the deficits themselves.

In this essay we discuss briefly the argument that budget deficits are unlikely to have the adverse economic effects commonly attributed to them. It is pointed out, however, that the theoret ical basis for the view that deficits are benign is hard to reconcile with the undeniable fiscal impulses of politicians. And given these impulses, the greater the political latitude to rely on deficit 10 THE FREEMAN • JANUARY 1991 financing the greater will be the level of govern ment spending. Even if deficits do not, for exam ple, noticeably crowd out investment directly through interest-rate increases, the political opportunity afforded by deficit spending can facil itate the expansion of public sector activity,which necessarily crowds out private sector activity.The consequences of substituting the less productive public sector for the more productive private sec tor may not register immediately in statistical measures of key economic variables. But the long run economic consequences of such a substitution are no less destructive because they go unnoticed by econometric studies and the myopic political process.

Do DeficitsMatter? What is the effect on the economy of an increase in deficit spending? The best known answer to this question is givenby the standard Keynesian model which predicts that increasing the deficit will increase aggregate consumption demand, thereby reducing the total savings in the economy and increasing the real interest rate. With a higher interest rate there will be a reduction in invest ment, and the deficit spending will have crowded out some productive capital. Harvard economist Robert Barro has attacked the standard Keynesian view by arguing that, under what he believes are plausible conditions, it makes no difference whether government spend ing is financed by taxing or by borrowing. 1 The argument begins with a proposition that dates back to the early 19th century, when it was put forth by the English economist David Ricardo. Ricardo argued that if government financed, for example, an additional $100 of spending by bor rowing, then, instead of being responsible for $100 in tax payments immediately, taxpayers would be responsible for $100plus accumulated interest at a later date. But the present value of the $100 plus interest later is equal to $100 now, so the taxpayer who expects to be paying taxes later will find deficit financing no less costly than tax financing.

The taxpayer willbe indifferent as to whether bor rowing or taxing is used to finance government spending. If borrowing versus taxing is a matter of indif ference to taxpayers, then it is also a matter of indifference as far as important economic variabIes such as the interest rate and investment are concerned. Assume that government increases the budget deficit by reducing taxes without reducing spending. Taxpayers will recognize that even though they experienced an increase in current disposable income, they have also experienced an equivalent increase in the present value of their future tax obligations. Because they are no better or worse off, there is no reason for them to increase current consumption and so the entire tax reduction will be saved. Consumption and saving therefore will not be affected by the increased deficit; both private and public consumption remain the same, and the increased public debt will be exactly offset by increased private saving.

This being the case, increasing the deficit, with government spending held constant, will not reduce long-run economic productivity by exert ing upward pressure on the interest rate and crowding out private investment. Of course, as recognized by both Ricardo and Barro, complete indifference between taxation and government debt requires that everyone alive when government increases its debt be responsible for all of the future tax increases that servicingthe debt requires. But many people realize that they will no longer be alive when the future taxes required by current deficit spending come due. Why won't these people treat the deficit as a real reduction in their tax burden (with a correspond ing increase in the tax burden of future genera tions), and respond by saving less and spending more? Barro confronts this question by arguing that most people willbe reluctant to increase their con sumption when debt is substitl,ltedfor current tax ation even if they know that they will not be alive to pay the higher future taxes required by the debt.

According to Barro, this reluctance is based on the obvious fact that people are concerned with the well-being of their children beyond their own life times. This concern is reflected in the investment parents make during their lifetimes in their chil dren's human capital and the bequests they make to their children. Given this bequest motive, Barro argues that parents willrecognize that substituting debt for taxes in the financing of government expenditures will reduce the well-being of their offspring by increasing their future taxes. In other words, parents willrealize that the value of the tax es they willavoid because of increased reliance on POLITICS, ECONOMICS, AND THE DESTRUCTIVENESS OF DEFICITS 11 deficit financing will represent a reduction in the value of their bequest to their offspring. The natu ral response to this is for parents to increase their bequests, and therefore their saving, by an amount equal to the tax burden that is passed from them to their children because of the increased deficit. The substitution of debt for taxation therefore leaves total saving in the economy unchanged with no crowding out of private investment and no reduc tion in the long-run productivity of the economy.

Barro recognizes that bequest adjustments will not offset completely the effectsof deficitspending, but he argues that these adjustments are more com plete than most people would expect. But Barro ultimately rests his case on what he sees as empiri cal support for the economic neutrality of deficit spending, with this support consisting of sophisti cated econometric studies that find little connec tion between budget deficits and interest rates. No amount of empirical testing willever provide conclusive support either for or against the Barro thesis. Aggregate economic data are always of questionable accuracy, and empirical techniques are alwaysless powerful and robust than would be desirable. Fortunately, additional evidence can be brought to bear on the relevance of Barro's proposition to fiscal policy without having to rely on.economic data and sophisticated econometric techniques. This evidence comes fr<?m the clearly observed behavior of politicians and it suggests caution in accepting the Barro position. Further more, this behavior suggests that we be concerned about budget deficits for reasons not addressed either by Barro or by economists in general.

The PoliticalCostof Deficits If the cost to the taxpayer is the same whether government spending is financed through taxes or deficits, then politicians should be indifferent as to the mix of these two means of financing. The evidence is clear that they are not. Why, for example, are politicians so reluctant to respond to the public's general disapproval of large deficits (a disapproval that is hard to square with the idea that debt and taxation have equivalent effects on the well-being of both current and future taxpayers) by simply financing all govern ment expenditures with taxation? The proposi tion that deficits are economically neutral is sim ply inconsistent with the obvious reluctance of politicians to reduce deficit spending significantly. The attractiveness of persistent budget deficits to politicians suggestsstrongly that current taxpay ers do not believe that the future taxes they will have to pay because of additional government debt are as costly to them as the current taxes that the debt replaced. If this is the case, then over some range politicians will find it is less costly politically to finance spending through debt than through taxation. This suggests that the existing combination of debt and taxation prevails because it is the combination that allows existing spending levels to be financed at the least political cost. This being the case, it is clear that politicians will be reluctant to reduce deficit spending unless the political cost of deficit financing is increased. Also clear is that any increase in the public's tolerance of deficit spending will lower the political cost of government spending and, therefore, motivate both larger deficits and greater spending. Can any one doubt seriously that government spending would increase if increased public tolerance of deficits lowered the political cost of further expanding deficit spending?

There is no obvious direct measure of the marginal political cost of deficits,so it is difficultto imagine a direct test of the proposition that a decrease in that cost will increase government spending. But a testable implication of such a response to a reduction in the marginal political cost of deficit spending is that an increase in the ratio of deficit financing to tax financing will be associated with an increase in government spend ing as a percentage of the Gross National Product (GNP). The budget experience of the federal gov ernment is consistent with this implication. Yearly Federal budget data from 1960 to 1988 show that when the ratio of deficit to non-deficit financing (almost all of which is tax revenue) increased by 1 percent, government spending as a percentage of GNP increased by .087 percent. There can be little doubt that the political cost of deficit financing has been reduced by the political embrace of a simplis tic version of Keynesian policy prescriptions, an embrace which began with the 1960 election of John F. Kennedy and lasted, though with reduced enthusiasm, into the 1980s.There can be even less doubt that the decrease in the political cost of deficit financing, whether caused by Keynesian economics or not, is largely responsible for the increase in the relative size of the federal govern12 THE FREEMAN. JANUARY 1991 ment since 1960(from 18.2percent of GNP in 1960 to 22.3 percent of GNP in 1988).

The EconomicCostof Deficits The connection between deficit spending and the relative size of government suggests a cost associated with deficits that is easily overlooked by standard investigations of the economic effect of deficits. The expansion in government that is facil itated in a regime of chronic budget deficits reduces economic productivity and growth. To argue that government expansion reduces eco nomic growth is not to deny that over some range government is a source of improved economic per formance. A few government activities are neces sary to establish an economic order that promotes productive specialization and exchange. But it also has to be recognized that organized interests per sistently exert pressure in favor of expanding the scope of government activity beyond productive limits. These interests are often quite successful owing to the fact that the cost of expanding gov ernment is typically diffused over a dispersed and unorganized public, which lowers the political cost of this expansion below the social cost. The result is that governments at all levels have expanded well into the range where, at the margin, they are reducing our economic wealth.

Recent cross-national studies of the relationship between the relative size of government (as mea sured by government expenditures as a percentage of Gross Domestic Product) and economic growth provide a quantitative dimension to the negative marginal impact of government. One such study of 115 countries by economist Gerald Scully found that a 1 percent increase in government expendi tures (as a percentage of GNP) reduced average annual economic growth by one-tenth of a percent.2 Using Scully's estimate of the connection between government size and economic growth and our earlier estimate of the connection between the ratio of deficit spending to taxation and gov ernment size,it is possible to make a ball-park esti mate of the cost, in terms of forgone GN~ associ ated with increased deficit spending. If the ratio of deficits to tax revenue doubled from 10 to 20 per cent (at the Federal level this ratio averaged about 3 percent during the 1960s, while from 1980 through 1988 it averaged 22.5 percent) then our earlier estimate predicts that government spend ing as a percentage of GNP will grow by 8.7 per cent. This means that if government spending began at 20 percent of GNP it would have increased to 21.74 percent of GN~ which accord ing to Scully's estimate would reduce economic growth by .174percent. With a GNP in the U.S. of approximately $5 trillion, this reduction in growth is approximately $8.7 billion per year. This may appear to be a relatively modest amount as gov ernment budget numbers go, but with the figure increasing each year with economic growth, and accumulating over time, this deficit-related cost is of genuine significance.

While reasonable people can disagree over the magnitudes involved, it is hard to deny that the easier it is to engage in deficit spending, the lower the political cost of increasing government spend ing. Equally hard to deny is that the increased spending that will result, other things being equal, transfers resources out of the productive private sector and into the far less productive public sector. The clear conclusion is that there is a cost associated with deficit spending that is not the direct economic result of deficits themselves. By attempting to determine the direct effects increased deficits have on such economic variables as interest rates and savings,economists have been ignoring what may be far more important conse quences of deficit spending. Even if deficits have little direct economic effect, they can still be eco nomically costly.It is not the deficits per se that are the problem, but rather the political environment that is created when politicians face little resis tance to relying on deficit financing. The move to such an environment increases the control politi cians have over productive resources, reduces the responsibility imposed on them in exercising that control, and, as a consequence, diminishes the pro ductivity of our economy. D 1. Robert J. Barro, "Are Government Bonds Net Wealth?" Journalof PoliticalEconomy,Vol. 81 (1974), pp.

1095-1117. 2. Gerald W. Scully, "The Size of the State, Economic Growth and the Efficient Utilization of National Resources," Public Choice,63, (1989), pp. 149-64. Scully's findings are supported by similar studies. For example, see Daniel Landau, "Government Expenditures and Economic Growth: A Cross-Country Study," Southern Economic Journal(January 1983), pp. 782-92;and Michael L. Marlow, "Private Sector Shrinkage and the Growth of Industrialized Economies," PublicChoice,49 (1986), pp. 143-54.