10 Myths About Government Debt

Antony Davies,

Release Date
October 16, 2017


Debt Economics Gov't Debt & Spending Government Politics & Policy Taxing

Myth 1 is that the government owes “only” $20 trillion. (In reality, it’s much more.) But luckily, Myth 10 is that there’s no way to fix this problem…

  1. How Big is the U.S. Debt? (video): A stunning visual representation of the ever-growing amount of debt and unfunded obligations being accumulated by the federal government, narrated by Prof. Antony Davies.
  2. How Should Governments Deal With Debt? (video): Nations that spend themselves into debt face very difficult choices. Prof. Steve Davies describes the three main choices that governments have to fix their debt problems.
  3. Debts, Deficits, and Spending Cuts (video): Prof. Jeff Miron of Harvard University explains we should focus on reducing spending, rather than managing the deficit, if we want to reign-in the runaway national debt.

ANTONY DAVIES: Myths about the government debt.
Myth number one, the government owes $20 trillion. How much is $20 trillion? Suppose you go to Germany, and in Germany, you go to every town. In every town, you visit every store. In every store, you look at every shelf and grab everything that is for sale. The amount of money you spend will not be $20 trillion. If you go to Germany and then to France and you go to every town, and within every town, you go to every store. In every store, you look on every shelf and you buy everything. You still will not have spent $20 trillion. You can go to England and while you’re there, you can go to the North Countries and buy everything that’s for sale, and you still will not have spent $20 trillion. In fact, to spend $20 trillion, you have to go to every country in Europe, visit every town, in every town, go to every store. In every store, look on every shelf and buy everything. And then you will have spent about $20 trillion.
But the myth is that this is how much money the government owes. It turns out that there’s more, called unfunded obligations. Unfunded obligations is money the Federal Government has promised but which it does not and will not have the money to pay. Largely, this consists of promises of retirement and medical benefits. If you would take the present value of all the future promises of retirement and medical benefits the government has made and subtract from that the amount of money that’s in the government’s Social Security and Medicare trust funds, and then subtract from that the amount of money the Federal Government anticipates collecting under the current law from future Social Security and Medicare taxes, you will still have an amount of money left over that the government does not have.
And that’s the unfunded obligations, an amount of money the government has promised, which it does not and will not have the money to pay. Estimates of unfunded obligations vary from the astronomical to the unbelievable. On the low end, people have estimated unfunded obligations to be about $80 trillion, on the high end, $200 trillion. This means that the Federal Government’s total financial obligations range somewhere from 100 to $220 trillion. Let’s say, roughly speaking, the Federal Government owes about $150 trillion.
Myth number two, the government owes $150 trillion. Well, it turns out there’s more to it. There are federal agencies that don’t appear on the Federal Government’s budget. There are government-sponsored enterprises like Fannie Mae and Freddie Mac that don’t appear on the government’s financial statements, and they owe another $8 trillion. There’s then state and local governments that collectively owe about $3 trillion and have another 5 trillion in their own unfunded obligations. When we put it all together, the total US governmental financial obligations total about $165 trillion.
Myth number three, government borrowed from the Social Security trust fund isn’t really debt because we owe it to ourselves. Well, it turns out there is no ourselves here. The trust fund belongs to current and future retirees. So when people retire and the government does not have the money that it has promised them, one of two things must happen. Either the government must increase taxes on future workers to pay for the Social Security and Medicare obligations it has promised, or the government has to cut the promised Social Security and Medicare benefits that it had promised to retirees. Either way, someone must pay.
Myth number four, the government can’t go bankrupt. This is technically true because the government promised to pay back a certain number of dollar bills. And so as the government starts to run out of money, it can simply print more, thereby satisfying its obligation. But while that’s technically true, it’s effectively false because when the government prints money, it erodes the purchasing power of dollars, thereby creating inflation. For example, suppose you have a bunch of people and these people buy things. They buy things from Wal Mart, from Mcdonald’s, and Ford. In buying these things, they give these businesses money. In return, they receive goods and services from these businesses. The ratio of the dollars they pay to the goods and services they receive, we call prices. We have the average price of a hamburger, the average price of a pair of shoes, the average price of a car.
Now, if the government were to print enough money to double the money supply, we would have twice as many dollar bills floating around but the same amount of goods and services. All that would happen is the prices of these goods and services themselves would double. With twice as many dollar bills, a hamburger now goes from a price of $4 to a price of 8. The car goes from $30,000 to a price of $60,000. One of the prices that will double is people’s wages. Interestingly, you’re left with the following. Under scenario one, without the government printing money, let’s suppose you earn $50,000 a year and the price of a hamburger, shoes, and a car, things you would buy, are $4, $30, and $30,000.
And then along comes a government who prints lots of money, and in printing the money, it doubles all the prices, including your income. So now, in scenario two, you’re earning twice as much as you were before, $100,000, but the prices of the things you buy have all doubled as well. If I ask you, are you better off in scenario one or scenario two, the answer is you’re the same in both. It doesn’t matter to you whether you’re earning $50,000 and a car costs 30, or whether you’re earning $100,000 and a car costs 60. It’s the same car.
Now, there is a difference in the two scenarios, and the difference shows up when you look at your savings. Let’s suppose, in scenario one, you had $10,000 in savings, you’re earning $50,000, and a hamburger costs $4. Along comes the government, it prints money. In printing money, all the prices double. That means that the hamburger now costs twice as much, the shoes cost twice as much, you’re earning twice as much, but your savings is the same. It’s the same $10,000 sitting in savings. What has happened, when the government comes along and prints money, in effect, what it’s doing is draining away the purchasing power of your savings. Economists say it this way, “Inflation is a tax on savings.” When the government prints money and thereby creates inflation, we get the same exact effect as if the government had imposed a tax on people’s savings. The fact is that the government ultimately pays for bankruptcy by taxing the purchasing power of people’s savings.
Myth number five, the government can solve its financial problems by raising taxes. Well, it turns out the government can’t raise taxes at all, it can only raise tax rates. Taxes are what happens when the tax rate that the government impose interacts with people’s behavior. This is perhaps the most interesting picture in all of economics. It’s interesting precisely because it’s so boring. What you’re seeing here is federal tax receipts. This is all tax revenue from all sources combined, payroll taxes, income taxes, estate taxes, tariffs, everything, federal taxes, all sources combined, as a fraction of GDP. What you see is, from 1950 up to the present, this has remained relatively stable at about 17%. That is, over time, if you think of the economy as a pie, the government has collected a constant 17% slice of this economic pie.
Now, let’s superimpose on top of this, for example, the top marginal income tax rate. Back in the 1950s, the top marginal income tax rate was north of 90%. It dropped in the 1960s, reached an all-time low during the Reagan years, goes back up during Bush the first, comes back down, goes back up again. This is the top marginal income tax rate. When you talk about taxing the rich, this is the rate that applies to the rich. But notice what happens here. In years in which we taxed the rich at a very high rate, the government collected 17% of the economy as tax revenue. In years in which we lowered the tax rate on the rich, the government still collected 17% of the economy as tax revenue.
The same is true of, for example, the capital gains rate. When capital gains taxes were particularly high, the government collected 17% of the economy as tax revenue. When capital gains taxes were particularly low, the government collected 17% of the economy as tax revenue. The same is true of the average effective corporate tax rate. When corporations paid higher fractions of their profits to the Federal Government, the Federal Government collected 17% of the economy as tax revenue. When tax rates on corporations were lower, the government still collected the same 17% of the economy as tax revenue. It didn’t matter whether we taxed the rich or capital gains or corporations. It didn’t matter whether we taxed them a high amount or we taxed them a low amount. Regardless of what the government has done, historically, it has consistently collected the same 17% of the economy as tax revenue.
Now, you might say, “All right, but we’re looking at tax revenue as a fraction of GDP. Tell me what’s happening to tax revenue, straight up.” Let’s look at what happens to tax revenue as tax rates change. What you see here is the top marginal income tax rate. This is data from 1940 to 2015. Across the bottom as we move to the right, we’re taxing the rich at a higher rate. As we move to the left, we’re taxing the rich at a lower rate. Up and down, we’re measuring tax revenue per person, one year later. This is total federal tax revenue on a per capita basis, one year after the tax rate goes into effect, and this is all adjusted for inflation. The story we hear when we hear things like, “Well, we need more tax revenue so we need to tax the rich more,” implicit in that statement is as you increase the tax rate on the rich, we will collect more tax revenue.
But if we actually look at the data, what we see is a different picture. The actual data looks like this. On average, as we have increased the tax rate on the rich, one year later, the Federal Government has actually collected, on average, less tax revenue. There are exceptions to this but there’s also a very clear trend that the tax revenue moves in the opposite direction that we think it should. This is not just true of the top marginal income tax rate. We also see it if we look at the capital gains tax rate. Now, the relationship here is not as tight but it’s disturbingly in the same direction. On average, as the government has increased the capital gains tax rate, one year later, it has collected less tax revenue than it did before. We see the same phenomenon with the corporate profits tax. We see the same thing with the estate tax. In fact, of all the federal taxes, I’m only aware of two which, historically, as the government has increased these tax rates, its tax revenue has actually gone up. Those two taxes are Social Security and Medicare. The disturbing part of this is these are the taxes that fall most heavily on the poor and the middle class.
Myth number six, the rich aren’t paying their fair share. What constitutes a fair share? What you see here is average market income of various income groups in the United States as of 2013. We have the poorest 20% of Americans at the top. Their market income, that is income they earn from participating in market activities as opposed to money the government gives them, their market income is about $15,800 on average. Here’s the middle-income Americans, their average income is about $53,000, and the top 1%, just over $1.5 million. Let’s ask, what is a fair tax rate for these people to pay? As we talk about tax rates, let’s talk about effective tax rates. What I mean by that is after you have done all of your legal and accounting gymnastics and write-offs and deductions and exemptions, when all that’s finished, what fraction of your income did you end up paying to the IRS? That’s the effective tax rate.
We can argue about what constitutes fair. A lot of people tend to answer the following way, the poor should probably pay somewhere around 2%. A lot of people think that the middle-class Americans should pay around 15%. And a lot of people think that the top 1% should pay around 30% of their income as taxes. Now, we could argue about whether these things are indeed fair but these seem to be numbers that lots of people will tend to agree with. Let’s look at what these groups actually pay. If we look at the federal taxes collected from each of these groups, we see something like the following. The average household amongst the poorest 20% of Americans pays, on average, $800 in federal taxes. The average middle-income household in the United States pay about $9,000 in taxes. The average household amongst the top 1% pays about half-a-million dollars in federal taxes.
Now, this isn’t the end of the story because we don’t just pay money to the Federal Government, the Federal Government also gives money back. A lot of this comes in the form of the earned income tax credit or Social Security benefits or unemployment compensation, but all of these things are instances in which the government has first collected money and then turned around and given the money back. Let’s account for this, and economists call this transfers. Transfers are money the government gives to people. The average household amongst the poorest 20% received an average federal transfer of about $9,600 in 2013. The average middle-income household received about $16,700. The average top 1%-er earned about $800, most of that is likely coming from Social Security retirement benefits.
But notice what happens now, if we calculate the effective tax rate by accounting not just for what people pay to the government but for the money the government pays them back, what we find is something astounding. We claimed that a fair tax rate for the poorest Americans is 2%, and a fair tax rate for the top 1% is 30%. If we run these numbers, what we find is the poorest 20%, on average, are actually paying -56%. That is, when all the dust settles, they’re actually receiving more money back from the Federal Government than they paid in the first place, making their effective tax rate below zero. This is true all the way up through middle-income American. The average middle-income American is receiving back 15% more from the Federal Government than he paid in, the top 1%-er paying about 34%.
Here, we have an interesting conclusion. On average, and there are exceptions but on average, only the top 40% are net payers into the Federal Government. This raises an interesting point because every time someone says, “Well, we should cut taxes,” someone else responds with, “Well, you mean tax cuts for the rich.” But in fact, our tax system, at least at the federal level, has become so progressive that virtually every tax cut, by definition, is a tax cut for the rich because on average, those are the only people who are actually paying.
Myth number seven, the government can settle its debts by selling off its assets. The government has some debts and unfunded obligations of about $150 trillion but it’s also sitting on a bunch of assets, 8,000 tons of gold in Fort Knox, 500 million acres of land out in the West and Midwest, and then miscellaneous assets on top of that. These total actually only about 2 or $3 trillion. When we’re done, even if the Federal Government were to sell off all of its assets, we still have a shortfall of $147 trillion.
Myth number eight, the government needs to pay off its debts. The good news here is the government actually doesn’t need to pay off its debt. Just as a household with a credit card does not have to pay off the credit card, all it has to do is keep up with the minimum monthly payments, so too the government only needs to keep up with its minimum monthly payments. We call this servicing the debt. The bad news is if we count all of the money the Federal Government owes, $150 trillion, and the Federal Government currently pays about 2.5% on its debt, to service the full $150 trillion of obligations, the Federal Government would have to come up with $3.8 trillion per year. That is, to service the debt and obligations the Federal Government currently has, it would have to pay $3.8 trillion a year in interest. Yet, the Federal Government’s annual income is only about 3.3 trillion. That is, the Federal Government actually is bankrupt right now. Even if it were to devote all of the tax revenue it collects solely to servicing its $150 trillion in debt and obligations, it still would not have enough money to service that debt.
Myth number nine, well, the government could just keep on borrowing. The problem here is the government has borrowed so much money that it’s running out of places to find more. Currently, the American people, state and local governments have loaned about $6 trillion to the Federal Government. Social Security, Medicare, Veterans Benefits trust funds have loaned about $5 trillion to the Federal Government. Foreign governments have loaned another 4 trillion. The Federal Reserve has loaned 3 trillion, and foreign people have loaned about 2 trillion. This is the total amount of money that people the world over have loaned to the Federal Government.
The problem with this is Social Security, Medicare, Veterans Benefits trust funds have run out of money. They have no more left to loan to the Federal Government. In fact, in the case of Social Security and Medicare, they’re starting to pull back the money that they had loaned to the Federal Government, which they now need to turn over to retirees in the form of benefits. Foreign governments and foreign people have been slowing the growth of their lending to the Federal Government. The American people, state and local governments have been slowing, and in some cases, actually cutting back on how much they loan the Federal Government.
That means that as time moves forward and the Federal Government wants to borrow more and more money and these groups are all tending to cut back on how much they loan, the one place left the Federal Government can turn to for money is the Federal Reserve. The problem here is when the government borrows from the Federal Reserve, unlike its borrowing from any of these other groups, it creates inflation. Inflation is a tax on savings. In effect, as the Federal Government runs out of places to borrow, it must turn to the Federal Reserve to borrow money. When it does that, it creates inflation, which erodes the purchasing power of all of our savings.
Myth number 10, there’s no way to fix this problem. It turns out that there is. We could have a balanced budget within five years if we followed this recipe. First, cut all spending this year by 10%, no exceptions. If there’s some things you don’t want to cut by 10%, then cut something else by more so that when you’re done, in total, you have cut by 10%. When I say cut by 10%, I mean the word in the way any normal human being uses it. When politicians say, “Cut the budget,” what they mean is to increase the budget by less than they would actually like. This is a actual 10% cut. We spend 10% less than we did the year before. Then hold spending constant for four years, don’t even adjust for inflation. What happens over these four years is as the government holds its spending constant, the economy continues to grow.
At the end of the fifth year, the economy is now large enough that it can support the government that exists. At the end of the fifth year, we’ll have our first balanced budget. Thereafter, the Federal Government can continue to increase its spending if it likes, provided that the increase does not outpace the growth rate of the economy as a whole. This solution stops the bleeding. It prevents the debt problem from getting worse, but it doesn’t solve the debt problem. However, we can grow out of this. It took perhaps 100 years for our debt problem to grow to the size it is now. If we can stop the problem from getting worse, over the course of the next 50 or 100 years, the economy will grow enough that the current $150 trillion debt won’t matter.