One of the most tightly reasoned books ever written by an economist is my late Nobel-laureate colleague James Buchanan’s 1958 volume, Public Principles of Public Debt. The book is slim. The text of the 1999 Liberty Fund edition – which is volume 2 of Buchanan’s 20-volume Collected Works – comes in at a mere 164 pages. But each page packs a wallop of analysis and insight.
Buchanan’s main purpose in writing this book was to dispel the Keynesian myth that government debt imposes no burden on citizens as long as the debt is held internally – that is, as long as “we owe it to ourselves.” If this Keynesian tale were true, then deficit financing of government expenditures would miraculously free us humans from the bonds of scarcity insofar as we acquire goods and services through the state. Buchanan’s keen sense brought him to realize that the same fighter jet or post-office building that would impose a real cost on citizens if paid for with current tax revenues cannot possibly be made free if paid for instead with borrowed funds. (In my and Randy Holcombe’s new book, The Essential James Buchanan, we devote a chapter – and this short video – to Buchanan’s analysis of government debt.)
Government borrowing changes the identities of the particular taxpayers who incur the costs of government projects; government borrowing does not, however, enable taxpayers – considered as a group over time – to escape these costs. Government projects undertaken today and paid for with current tax revenues are paid for by taxpayers today. Government projects undertaken today and paid for with borrowed funds are paid for by those taxpayers who will be responsible for servicing and repaying the debt – namely, taxpayers tomorrow.
While in principle some worthwhile projects – such as a hydroelectric dam that will operate for 75 years – are better funded with debt than with currently raised tax revenues, even these projects are costly. Buchanan warned that debt-financing’s shifting of the burden of paying for government projects and programs from current taxpayers to future taxpayers will incite current taxpayers to consume too much through government.
Consider, say, an aircraft carrier that I, as a current taxpayer, believe to have some positive value but not enough to make it worth whatever is my share of its tax cost. If this boat will be paid for with current tax revenues, I will thus oppose government acquiring it. But if the aircraft carrier will instead be paid for with borrowed funds – say, with bonds redeemable in 30 years (when I’ll either be retired or dead) – I have less incentive to object to the boat’s construction. After all, I’m not paying for it.
If deficit financing is used, the people who will pay for this aircraft carrier are the future taxpayers who must service and ultimately repay this debt. Many of these people are today unborn. The availability of deficit financing, therefore, gives to me and other of today’s taxpayers economically perverse incentives to agree to have the government do too much, while those persons who will foot the bill for deficit-financed programs undertaken today have no say in the matter.
In short, by enabling today’s citizens-taxpayers to consume through government at the expense of tomorrow’s citizens-taxpayers, deficit financing fuels excessive government growth. The private-sector is inefficiently – and, not incidentally, also unethically – crowded out by the government sector.
Why Not Fund All Government Spending With Borrowed Funds?
The above reasoning – call it the Buchanan Thesis – is crystal clear and straightforward. Or so it seems to me. Indeed, I find this Thesis to be indisputable. But experience has taught me that many otherwise sensible and economically informed people – people who support free markets – do indeed dispute this reasoning.
A misconception common among free-market types who reject the Buchanan Thesis grows from two accurate observations. First, unlike taxpayers who transfer purchasing power to government only under coercion, creditors transfer current purchasing power to government voluntarily. Second, government can, and often does, service and repay existing debt with newly borrowed funds.
‘Therefore,’ conclude those who reject the Buchanan Thesis, ‘if government committed itself to funding all of its projects only with borrowed funds, we could avoid taxation, which is coercive, and rely exclusively on deficit financing, which is voluntary. Citizens would thus become freer because they’d not be coerced to pay taxes. Citizens would also grow more prosperous because the economy would no longer suffer the distortions inevitably created by taxes.’
This conclusion sounds lovely. I wish that it were true. Alas, it’s false.
First, a government that has the confidence of borrowers can indeed, for a time, pay off its outstanding debt with newly borrowed funds, but it can’t do so forever. Any confidence that creditors have in a government to repay its loans is rooted in creditors’ belief that that government has access to sources of revenue other than borrowed funds. And any government’s chief source of revenue is taxation – either overtly (as through income taxation) or covertly (as through inflation).
A government that swore off taxation would tell the world that, as regards raising revenue, it plans to operate as a private entity – that is, no longer as a government. If this government then announced that it also plans to continue to supply citizens with goods and services paid for exclusively with borrowed funds – that is, never by charging citizens taxes to pay for these goods and services – this ‘government’ would immediately find itself unable to borrow as much as a cent.
Those who doubt this conclusion should ask what would happen if, say, McDonald’s swore off charging its customers for food. Suppose, for example, that McDonald’s said to creditors: ‘Our company will continue to supply food and drink to people, but we’ll give these things to our customers free of charge. We’ll finance our operations exclusively with borrowed funds. And when our existing debts come due, no problem. We’ll simply borrow more to repay these.’
If you’re a bank or some other potential creditor, how eager would you be under these circumstances to lend money to McDonald’s? If you don’t immediately and definitively answer ‘Not at all!’, I recommend that you avoid a career in finance.
Eliminating taxation requires eliminating the state. This essay isn’t the place to debate the practicality of a society operating successfully without the state. What is not debatable, however, is the fact that as long as the state exists, taxation will exist. The belief that the state can be funded exclusively with funds loaned to it voluntarily by creditors is equivalent to believing in the possibility of a perpetual-motion machine. Regardless of how lovely such a thing would be, it simply ain’t happening.
It’s GOOD that Government Cannot Fund Itself Exclusively with Borrowed Funds
But let’s assume, contrary to fact but for argument’s sake, that an actual government – an agency with a monopoly on the lawful authority to initiate coercion – can forever fund all of its operations with borrowed funds. This fairytale government repays and services all of its debts simply by borrowing, infinitely into the future. Contrary to the belief of many, this situation would be especially bad for freedom and free markets. Government would grow even larger and more intrusive.
As argued above, deficit financing allows real-world governments to grow too large and intrusive by enabling today’s citizens-taxpayers to free-ride on the resources of tomorrow’s citizens-taxpayers. Yet in the real-world there remains at least some constraint on government growth – namely, the need eventually to raise taxes or to cut programs.
But in the fairyland world in which government never collects taxes, even this relatively small constraint on government growth disappears. Dominant coalitions of citizens-taxpayers can get whatever they want from government in whatever quantities they desire, with the monetary expenses all being paid by an infinite series of creditors.
Why is this situation bad if the full monetary costs of government programs are financed only with funds from creditors who voluntarily lend their purchasing power to government? A chief reason is that government – retaining all governmental powers except that of taxation – can use these borrowed funds to impose programs that benefit special-interest groups at the greater expense of the general public.
Consider agricultural subsidies. A government funded exclusively with borrowed funds will still be pressured by the same interest groups who operate in the real world to grant such inefficient subsidies. But in the fairyland world in which all government revenues come from borrowed funds, the size of such subsidies would be even greater. In this fairyland world there would be even less incentive than there is in the real world for government to constrain the size of these subsidies.
When creditors in the real world lend money to private producers to expand their operations, these creditors have strong incentives to lend only to projects that are efficient. Lending money to projects that turn out to be excessively costly – that is, inefficient – results in creditors not being repaid in full, and sometimes not being repaid at all.
In contrast, a government that subsidizes production has no incentive to consider the efficiencies or inefficiencies of the production that it subsidizes. Ability to extract funds from taxpayers allows government to subsidize inefficient operations. The only constraint on such government subsidies in the real world is that which comes from the need to make budgetary trade-offs: Should the government expand the subsidies by another $100 billion if doing so requires a tax hike or a cut in some other program?
As weak as this constraint is, at least it exists. But even this weak constraint would be absent in a world in which government could perpetually borrow all that it spends. In such a fairyland world, market-distorting subsidies – subsidies that over time make the citizenry poorer by channeling resources into inefficient uses – would be even more commonplace and gargantuan than they are in the real world in which governments must eventually raise taxes or cut spending to meet their debt obligations.
Conclusion
The costs and consequences of government action are not limited to the amounts that it extracts in taxes. The full costs and consequences of government action are ultimately manifested and measured in the impact that the government has on society and the economy. Because a government freed from the need to collect taxes would be a government even less constrained than is any real-world government in granting privileges to special-interest groups, and in simply acting recklessly, we should all be pleased that, in the final account, government cannot escape the need to extract tax revenues in order to fund its operations and depredations.
Indeed, those of us who decry large and intrusive government should demand that government annually balance its budget. The tighter the constraint on government’s access to resources, the freer and more prosperous the people will be.
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