Tomorrow and on Friday, the heads of the G7 leading industrial nations are to gather in Japan to discuss common security and economic problems. A major common problem that deserves their attention is an unsustainable increase in the major developed nations’ national debt. Failure to address the explosion of government borrowing is likely to have adverse effects on the global economy and on debt-burdened nations themselves.
The problem is bad and getting worse almost everywhere. The US Congressional Budget Office estimated that the US federal government debt doubled over the past decade, from 36 percent of GDP to 74 percent of GDP. It also predicted that, under favorable economic assumptions and with no new programs to increase spending or reduce revenue, the debt ratio 10 years from now would be 86 percent of GDP.
Even more worrying, the annual deficit ratio is likely to double in the next decade to 4.9 percent of GDP, putting the debt on track to exceed 100 percent of GDP, it said.
The situation in Japan is worse, with gross debt at more than 200 percent of GDP. Japan’s annual deficit of 6 percent of GDP implies that the debt ratio is likely to continue to rise rapidly unless action is taken.
Conditions differ among the eurozone nations, but three of the EU’s four largest economies — France, Italy and the UK — all have large debts and annual deficits that point to even higher debt ratios in the future.
A rising level of national debt absorbs funds that would otherwise be available to finance productivity-enhancing business investment. Businesses now fear that the increasing deficits would lead to higher taxes, further discouraging investment.
That is a worrying prospect for everyone. When interest rates rise, as surely they must, the cost of servicing the debt would require higher taxes, hurting economic incentives and weakening economic activity. The persistence of large deficits reduces the room that governments have to increase spending when there is an economic downturn or a threat to national security.
Reducing deficits is obviously a task for those responsible for tax revenue and public spending: governments and legislatures.
However, central banks also play a role, affecting the problem in two ways. Low interest-rate policies in advanced nations are depressing the current size of budget deficits, but at the cost of reducing pressure on political leaders to address future deficits and encouraging voters to favor more spending programs and larger tax cuts. Central banks can help by announcing clearly that interest rates are to rise substantially in the future, making it more expensive for governments to borrow and to roll over existing debt.
Reducing annual deficits requires either increased tax revenue or decreased outlays. Raising marginal tax rates is both politically unpopular and economically damaging. In the US, there is scope to raise revenue without increasing tax rates, by limiting so-called tax expenditures — the forms of spending that are built into the tax rules rather than appropriated annually by the US Congress.
For example, an American who buys an electric car receives a US$7,000 tax reduction. Larger tax expenditures in the US include the deduction for mortgage interest and the exclusion from taxable income of employer-paid health insurance premiums.
Although eliminating any of these major tax expenditures might be politically impossible, limiting the amount by which a taxpayer could reduce his or her tax liability by using these provisions could raise substantial revenue. So I do my best to persuade my Republican friends in the US Congress that reducing the revenue loss from tax expenditures is really a way to cut government spending even though the deficit reduction appears on the revenue side of the budget.
The good news is that a relatively small reduction in annual deficits can put an economy on a path to a much lower debt-to-GDP ratio. For the US, cutting the deficit from the projected 4.9 percent of GDP to 3 percent of GDP would cause the debt ratio to drop toward 60 percent.
The same is true elsewhere. The long-run debt-to-GDP ratio is equal to the ratio of the annual budget deficit to the annual rate of growth of nominal GDP. With 4 percent nominal GDP growth, a budget deficit of 2 percent would bring the long-term debt ratio down to 50 percent. That should be the goal for which all of the G7 nations aim.
Martin Feldstein is a professor of economics at Harvard University.
Copyright: Project Syndicate
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