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Takeaway: Every dollar of sovereign debt is a dollar of [future] tax. Who's going to foot the bill?

SUMMARY BULLETS

  • In the note below, we review a recent analysis put forth by the bi-partisan American Enterprise Institute titled: “A Simple Measure of the Distributional Burden of Debt Accumulation” which was co-authored by Aspen Gorry of UC Santa Cruz and Matthew Jensen of AEI.
  • One of their primary conclusions was that sovereign debt expansion implies incremental taxes and, like tax policy, these costs of servicing incremental federal debt is incredibly progressive.
  • A key takeaway we had was that, because of this highly progressive nature of debt service, the rich will bear the lion’s share of the burden in a revenue boosting scenario and the poor (i.e. households who receive a disproportionate amount of gov’t benefits) will bear the lion’s share of the burden in an expenditure reduction scenario. Moreover, if the GOP has its way, the poor will pick up the tab via regressive spending cuts; if the Democrats have their way, the rich will pay via progressive tax hikes.
  • Lastly, to the extent this continues to edge higher, the marginal propensity for politicians to pursue tax hikes (via voter preference) should also increase.

Those who’ve grown familiar with our team’s work over the last few years know that we aren’t afraid to evolve, often borrowing new ideas from risk managers, authors and academics alike. Moreover, we like to use those ideas to help develop the structural views and biases we manage immediate-to-intermediate-term risk within.

In this vein, one of the more prominent conclusions we’ve weaved into our own research process is the idea that there is a critical threshold (~90% of GDP) where the stock of sovereign debt in an economy structurally impairs economic growth. This thesis was originally demonstrated through the empirical analysis of Carmen Reinhart and Kenneth Rogoff as has since been expanded upon and cited by other scholars in the field. Their work is one of the primary reasons we continue to hold the view that economic growth is likely to remain structurally depressed across a number of developed economies for the foreseeable future.

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Why sovereign debt slows economic growth at that critical threshold is still up for debate. From our vantage point, sovereign debt loads that great imply to a certain extent that the government is crowding out private investment, on the margin, due to its deficit financing needs. Another hypothesis we’ve posited is that the threat of future tax hikes and spending cuts loom large in the psyches of consumers and businesses alike, causing them to slow their rate of consumption and investment growth – two occurrences that perpetuate incremental sovereign budget deficits! A third, more simple hypothesis is that it likely takes economies some time to grow the stock of sovereign debt to 90%-plus of GDP and that is may just well be that an older, less productive society is left behind to foot the bill.

There’s likely a handful of other explanations to the aforementioned question; in the prose below, however, we focus specifically on the second hypothesis from above – particularly with regards to the costs of servicing sovereign debt imposed upon US consumers.

A few days back, the bi-partisan American Enterprise Institute published a paper titled: “A Simple Measure of the Distributional Burden of Debt Accumulation” which was co-authored by Aspen Gorry of UC Santa Cruz and Matthew Jensen of AEI. From a critique standpoint, we like that there are no major assumptions in their analysis and that it is overwhelmingly fact-based, sourcing the [presumed] bi-partisan CBO and Tax Policy Center for the bulk of their forward-looking data (though we are all aware of the fact that the CBO’s forecasts of “long run” real interest rates and GDP growth tend to be a bit aggressive). The article mostly walks through their methodologies – which we find generally sound – allowing the reader to focus extensively on the detailed tables of data analysis presented throughout the paper. They even do a good job of remaining bi-partisan, as advertised. All told, the paper is definitely a good read and the analysis is quite thought-provoking; we send our thanks to the client who initially passed it along.

The primary conclusions from the article is that incremental sovereign debt implies incremental taxes and, like tax policy, these costs of servicing incremental federal debt is incredibly progressive. Moreover, when operating under the key assumption that the revenue source for all federal expenditures (including sovereign debt service) is the government’s power to “tax” the public via outright tax hikes or lower future expenditures relative to previously-established policy, we should arrive at the conclusion that any budget outlook with persistent deficits implies equally persistent tax hikes.

One key takeaway that we had is that, because of this highly progressive nature of debt service, the rich will bear the lion’s share of the burden in a revenue boosting scenario and the poor (i.e. households who receive a disproportionate amount of gov’t benefits) will bear the lion’s share of the burden in an expenditure reduction scenario. Now we know why President Obama was so keen to focus on Governor Romney’s alleged “$5 trillion tax cut” during Wednesday night’s debate.

Lastly, the paper sheds light on exactly why both the existing stock of debt and the rate of future debt accumulation are so critical when discussing changes to fiscal policy: it’s not just about having an ideological debate about spending, taxes and the size of the government, but rather about the most important discussion of them all – who’s footing the bill? If the GOP has its way, the poor will pick up the tab via regressive spending cuts (assuming they are in conjunction with tax cuts); if the Democrats have their way, the rich will eventually pay via progressive tax hikes (though lower-income earners could still wind up “paying” via incrementally faster inflation and incrementally slower economic/employment growth).

Given that there’s 15.3x the number of US households at or below the median income than those making $200k-plus (91 million vs. 5.9 million), it’s not difficult to anticipate a future where tax hikes are increasingly favored over spending cuts – especially considering that politicians in a democratic government are generally incentivized to pursue populist means. It’s worth noting that the US’s Gini Index (a standard measure of income inequality) rose for the first time since 1993 last year (at .477 currently). To the extent this continues to edge higher, the marginal propensity for politicians to pursue tax hikes (via voter preference) should also increase.

A collection of the key tables is below; we encourage you to check out the appendix of the paper as well  - some great data. We especially enjoyed the tables highlighting the annual projected debt service costs levered upon US households as a result of the Bush and Obama presidencies.

Darius Dale

Senior Analyst

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