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The Federal Debt Is Nothing to Lose Sleep Over

Narayana Kocherlakota

(Bloomberg Opinion) -- Policy makers and voters often express concern about the level of the federal deficit, which topped $1 trillion last year, and the national debt, now more than $23 trillion. But, unlike a household that owes money to a bank, the U.S. government has the ability to tax its creditors. This power means that the federal government can afford any level of debt that is owed to American taxpayers.

Here’s an example of what I mean.

Suppose that the government’s debt is $100 million per person -- a huge amount that is many times larger than the current debt -- and the interest rate is 5%. How can the government begin to pay this, a figure that amounts to $5 million per person per year? It’s actually simple.   

Suppose first that all U.S. taxpayers are exactly the same financially and so they each own the same amount of U.S. government debt. Then, the government can tell each person: your tax bill for this year and every year thereafter is equal to $5 million. People can pay this seemingly huge tax by handing over the $5 million in interest that they receive from the government.  The entire process of taxation and debt finance ends up being a complete wash.  

Of course, not all U.S. taxpayers are the same and so they don’t own the same amount of U.S. government debt. But the government could simply announce that it is levying an annual 5% tax on all of the Treasury instruments now owned by U.S. taxpayers. That tax would generate enough money to allow the government to pay the interest that it owes.(1)

Neither of these tax plans is inflationary. Their effectiveness doesn’t depend on the federal debt being denominated in U.S. dollars. And, of course, there’s nothing special about 5% or $100 million -- the argument works for any level of debt and any interest rate. Indeed, if it wanted, the government could retire its entire debt in a similar fashion, rather than simply paying the interest.

The logic of the argument does depend -- critically! -- on the debt being owed to U. S. taxpayers. When the U.S. government borrows from non-taxpayers, such as the Chinese government, it becomes much more like a household that is borrowing from a bank. There is, accordingly, a limit on the level of debt or deficit that can be considered sustainable. Right now, the federal government owes about 30% of one year’s gross domestic product to foreign entities, which translates into a non-taxpayer interest obligation of less than 1% of GDP.  This number seems eminently affordable to me -- but I would agree that, unlike the overall deficit or debt, this number does warrant watching.

Does this argument mean that the government should borrow a lot more? Not at all; it simply says that this is the wrong question. Policy makers and voters should always be talking about the appropriate scale of government resource utilization -- through infrastructure expansion, for example -- given the state of the business cycle. And we should always be talking and thinking about the incentive and distributional effects of our tax and transfer-payments system. But we should never make policy on the presumption that some level of debt owed to taxpayers isn't affordable.

(1) As opposed to the first tax (where each person pays the same amount), this second tax would likely reduce the ability of the U.S. government to engage in future borrowing (why would people buy U.S. debt if they expect that the income from that debt is going to be taxed away)? But I see this as a separate issue. My point is that, if the debt is owed to taxpayers, the government always has enough tax capacity to pay its interest. The usual tax policy question does remain: how should the tax system be designed to limit the disincentives associated with the government’s exploiting that tax capacity?

To contact the author of this story: Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.

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