When borrowing is cheaper than free?

FRED Graph

So what happens if we simply suspend taxation for a few years and then pay it back later?

I know, I know there are issues about market freak out and the signals that such a move would create. Some will also object that such a move would alter interest rates based on sheer volume but I doubt that actually.

Even still lets put all that aside for the moment.

If the government suspends taxation and then tries to raise the money later to repay what it borrows it will actually be extracting less real resources from the economy.

Okay but there is the issue with rates. Won’t they have to double and doesn’t that mean the deadweight loss will quadruple you say.

I’m glad you asked.

Because even though negative real interests rate make the point obvious what really matters are real interest rates relative to real economic growth. Here are real interest rates over 30 years.

FRED Graph

Now do you believe that the real US economy will grow faster than 1.1 percent per year over the next 30 years? We should hope so, because if it doesn’t then lots of our forecasts are going to be waaay off.

Well that means that if we suspend taxation, borrow to fund the government and then keep rolling in the interest payments into the debt, our total obligation as a fraction of the economy will keep falling every year over the 30 year horizon.

Suppose real growth is 3 percent per year. Then this years obligation as a fraction of GDP falls by 1.9 percent per year, every year for 30 years. This means that in 30 years this obligation as a fraction of GDP will be only 56% as large.

Even if we then pay it all off in one lump payment we will only have to increase taxes by 56%. That increases deadweight loss by 146%. However, we saved 100% of deadweight loss in the current period. So our net increase in deadweight loss is only 46%.

And that’s paying it all back in one year. Stretch it out over a number of years and you can actually reduce the deadweight loss.

Fundamentally that is because the US government is earning a positive spread on its borrowing. The US tax base is growing at a faster rate than is the cost of delaying taxes. In such an environment you make money by pushing taxes into the future.