Another battle looms. It may not be as serious as the Middle East conflicts, but this month’s debates over the federal debt limit will impact us for a long time.
Earlier this year, the federal debt ceiling was raised to $16.7 trillion, but the U.S. Treasury projects that the government will once again run up against its borrowing limit in early October. So the action turns to Congress, where there are likely to be rancorous fights over cuts to spending or new tax revenues.
Two long-known economic theories offer much for policymakers to consider during this debate.
The first is known as Barro-Ricardo equivalence. The theory was first proposed by David Ricardo in the 19th Century, but current Harvard economist Robert Barro produced a more thorough model of the economy that reaches the same conclusions.
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Barro-Ricardo equivalence states that the timing of government spending has no effect on the economy today. If the government borrows more to spend now with the idea it will pay off the debt with tax revenues later, it is just the same as if the government raised taxes today. The public buys up the new bonds, and in so doing reduces current consumption just as they would with a new tax.
The second economic theory with relevance to the debt limit debate is known as the permanent income hypothesis. This theory, proposed and developed by Nobel laureate Milton Friedman, states that consumers make consumption decisions based not on current income but on income expectations. Any short-term change in disposable income has little or no effect on the economy.
Recent tax receipt data illustrate Friedman’s theory. Federal tax receipts rose dramatically this year over last year due to some one-time thing. The payroll tax cut and investment tax credit from a few years back expired at the end of 2012. As such, these tax changes had little effect on our economy.
The permanent income hypothesis suggests that if tax changes are part of the debt ceiling resolution, they will only help if they are part of broader tax reform. The U.S. Tax Code spans some 10,000 pages, making spending and investment decisions difficult for households and businesses. A temporary rise in tax rates to reduce federal debt today will complicate the matter further.
Idaho policymakers face a similar challenge. Gov. Otter has proposed increased spending on education. But legislators will need to balance the desire for a better-educated workforce against limited tax revenue in a still weak economy. Borrowing to pay for these new initiatives will constrain economic activity today.
For many, the debt ceiling battle appears to be just a procedural matter for today. Not so: Any policy to address the issue has real long-term consequences.