Idea: To prevent debt crises, tie tax rates to interest rates on government bonds

by Alan Cohen

Source: Wikipedia

Recently it seems everyone is concerned about national debt. The Americans are concerned, the Quebecers are concerned, the Greeks are concerned, the Germans are concerned. But what, exactly, is bad about debt for a country? The answer is not immediately obvious (unless, of course, one takes a moral stance that borrowing is by definition wrong). However, events in Greece, Italy, and Spain suggest there is a real risk that by having too much public debt, a country risks scaring investors (be they individuals, institutions, or other governments) about its capacity to pay back the debt owed. That, in turn, will cause these investors to demand a higher rate of return on their investments – i.e., higher interest rates on government bonds. And this makes the cost of borrowing more expensive to a country, which has all kinds of  bad consequences on the economy, including decreased ability of businesses and individuals to borrow and grow, increased need for revenue, and decreased tax revenue. In the worst case, a positive feedback loop could get started wherein interest rates rise due to concern about debt burden, this hurts the economy and furthers investor concerns, driving interest rates still higher, and so forth… (Caveat: I am not an economist; this is my layman’s reasoning. Economists, please correct me if I’m wrong here.)

Yet, as Paul Krugman points out, US interest rates are incredibly low despite large public debt, and in fact they are so low that some people are actually paying the US for the right to put their money in its government bonds. And Spain was apparently relatively responsible fiscally, but got screwed nonetheless when its housing market when bust, and then suffered the same interest rate inflation as Italy and Greece. So what really is the risk of debt? How much is too much, and what is a reasonable policy to limit it?

As far as I can tell, the only potential harm to government debt is this risk of rising interest rates. If I’ve missed something here, the rest of the argument may not hold (please correct me). But if I am right, there is a very attractive (and simple) potential policy solution to the debt question: tie marginal tax rates to the interest rate on government bonds.

In other words, the interest rate on government bonds is a sort of canary in the coal mine for the risk of problems due to debt. It may be too late to tackle the problem when things get bad, due to the positive feedback mentioned above. So best to nip it in the bud: as soon as interest rates start to rise, take in more tax revenue and pay down the debt. (Extra tax revenue based on this policy should be allocated directly to debt reduction, not to government programs.) The exact amounts of how much to increase revenue for what size increase in interest rates would have to be determined with careful study, but there should be a mathematical relationship between the two that would make for effective policy.

When interest rates start to rise, the economy will suffer in any case. High tax rates are also bad for economic growth, but my instinct says that it may be best to get the pain out of the way early with high taxes that stop the problem and then revert back down, rather than to let interest rates continue to rise. Obviously, serious research would need to be conducted on this to confirm it.

The flip side is that when interest rates are low, taxes should go down. The low interest rates are telling us that there is no reason not to keep borrowing for the moment, and lower tax rates could boost economic growth more. As the economy grows and with gentle inflation, the burden of today’s debt will decrease relative to tomorrow’s dollars.

Another advantage of this policy is that it takes some responsibility for determining tax rates out of the legislature’s hands. This means that in a crisis situation, good economic policy is not held hostage to political constraints. The legislature could still set the scale by which taxes shift relative to interest rates, but keeping the principle in place would do a lot of good already.

As noted, I’m not an economist. Maybe some economist has thought of this. Maybe it’s been rejected for good or bad reasons. Maybe the details of the policy become constraining, or maybe there is a high risk of disastrously low or high tax rates under certain situations. But the principle seems solid, and I’d be interested to know if any of my readers know any reasons why this wouldn’t work.

PS – Thanks to John Tillinghast for the conversation that led to tis idea!

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