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"Good Debt" and "Bad Debt?"

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You've heard the story: A private business borrows money foolishly -- say, to finance a corporate jet used mainly to fly the CEO off to ski. That borrowing surely results in "bad debt" -- not necessarily debt that will not be repaid, but rather debt unwisely incurred, with little offsetting long-run benefit. On the other hand, the same firm might borrow to update its production equipment. That borrowing would increase debt, but it would be "good debt."

The same could be true of a family. Borrow to finance an expensive vacation that you cannot afford in cash, and you accumulate "bad debt." But borrow for education, or for a home where you build equity, and that is "good debt."

So why not extend the analogy to the federal government? Borrow for "consumption," and you get "bad debt." Borrow for things that increase future economic growth, and that is "good debt."

There are two schools of advocates of "good" public debt.

  • One school is the supply-side tax cutters. Borrow today to cut tax rates, and the lower tax rates strengthen incentives and increase economic growth, which increases revenues and reduces the deficit over the long haul. The larger budget deficit in the near term also "starves the beast" and slims down the wasteful government. (You might also hear the bait-and-switch approach: Tax cuts pay for themselves, so logically there is no need to worry about spending. Then after the revenues fail to arrive, the deficits are the fault of a failure to cut spending, or were intended to "starve the beast.")
  • The other school is the supply-side spenders. Borrow today for a massive public investment program, and the investment increases productivity and economic growth, and pays for itself. The initial debt is paid off with the resulting tax revenues.

The two schools are singing in different keys, but from the same hymnal. On this issue, I am an agnostic, and I believe the hymnal is wrong. Here is why.

The case against supply-side tax cutting is simpler. Each tax rate cut since the bad old days when the highest personal tax rate was 91 percent has reduced the leverage on incentives. (Take it to its extreme: If the highest rate were 1 percent, eliminating the income tax would be a 100 percent rate cut. Would taking home 100 cents on the dollar, instead of 99 cents, increase incentives meaningfully? I don't think so, either.)

Decrease tax rates by whatever percentage, and in the first instance the Treasury loses revenue on every dollar of income already earned. It takes an equal percentage increase in total incomes just to break even. How much more are people likely to work? Instead, they can leave their work (or saving) unchanged and still have more spendable cash. They can work (or save) less and have the same spendable cash. Experience suggests that most people behave the same, and the work-lesses at least offset the work-mores.

So some reasonable analysis - not to mention the experience of the 1980s, when the debt doubled as a percentage of the GDP, and the 2000s, which wiped out the progress of the reviled tax-increase 1990s - says that supply-side tax cuts do not produce "good debt." But what about supply-side spending?

First of all, the basic math of "investment" spending is just as daunting as it is for tax cuts. Say you incur a dollar of debt to "invest." Average tax rates in the economy are well under one-third. So that one-dollar investment would need to increase taxable incomes in the economy by at least three dollars just to break even.

How many public investments would yield that kind of increase in taxable incomes? Very few. In fact, much of the return to public investments is non-monetary - which is not to say "bad," merely that it does not yield higher tax revenues. Suppose that a highway investment saves every commuter 40 hours each year - which would be an extraordinarily successful project. Is that an extra week of work, and higher (taxable) incomes? Or even an extra week of vacation? More likely, it is just an extra five minutes to linger over morning coffee before getting in the car, and an extra five minutes to play with the children before dinner every evening. Is that a good investment? Depending on the cost, almost certainly yes. But would it pay for itself in the budget? Surely not.

But didn't the nation borrow to build the interstate highway system, and didn't that contribute massively to economic growth? The jury is out on the second question, which is extraordinarily complex. (What would the United States be like today without the interstate highway system?) But let's assume the answer is yes. Did we borrow to build it? Not really. Most of the cost was paid with user fees. And over the first 16 years following the 1956 authorizing legislation, the public debt as a percentage of our GDP was cut by about half. The answer is that we paid for it, as we went (i.e. drove) along.

Highway investments must be judged on a project-by-project basis. Most projects that pass a cost-benefit test are maintenance rather than new construction. (With the nation so much more developed than it was half a century ago, new highways near and through major population centers are much more problematic. Ditto for high-speed rail, which requires the straightest possible track to maintain those high speeds.) They entail not only long-term benefits and short-term construction costs, but also short-term disruption costs. And again, most of the benefits are non-monetary or entail avoidance of costs rather than increases of incomes - which again is not to say that they are bad investments, merely that in most instances they will not pay for themselves.

But what about a higher-speed Internet? It surely would enable some business uses now totally unknowable, some of which could add to productivity. But by how much? And how much would that public investment return through higher taxable incomes? Counting on those unknowable returns to pay for the investment would be gambling. Reducing business-use wait times by seconds would not realistically add much to output. And to the extent that the investment uses borrowed money to reduce wait times of non-business users for personal or social purposes, it obviously would not pay for itself.

Why not invest more in basic research? Sure. There will be returns to the public. But returns to basic research are highly uncertain, tend to be very long-term, and can be non-monetary. So again, public investments in basic research should be paid for. That findings from basic research are by their very nature unknowable up front firmly dictates that research not be counted upon to pay for itself, much less to reduce the deficit.

Finally, business borrowing and public borrowing are importantly different. Corporate debt instruments are rated. Prospective lenders look at the business, look at the proposed uses of the funds, and vote up or down. If a firm proposes an unjustified bond issue, it can be rejected by the market, and the project scrapped. And no individual corporate financing plan is really big enough to move the entire market.

In contrast, the federal government is by far the biggest borrower there is. It can sink the market all by itself. Its bonds are not tied to individual projects - if they were, the increase in complexity and marketing cost would be enormous - and they are rated only in the most formal sense. Rather, they are sold at auction - backed by the government's power to tax in the future, or in the extreme, by the government's printing press. If the federal government were to borrow unwisely, its new bonds still would have the same ostensibly gilt-edged standing as all of the old ones. Fiscal mistakes are corrected only after the economic cost already is felt.

So, is there "good" public debt? Debt can be necessary: Look at the massive borrowing to finance World War II. But consider the costs. We left World War II with a debt equal to 109 percent of our GDP. What if the nation had been spendthrift, and gone into the war with that level of debt? Excessive debt can prevent necessary borrowing in true emergencies. Debt entails debt-service costs, which crowd out productive public investment and force higher taxes.

Public investment is essential. But like the original interstate highway system, it should be paid for up front or through a pay-as-you-go mechanism (like the gasoline tax for the highways). Specific tax cuts can be wise. But they should be paid for with other tax increases, or with spending reductions. Public debt can be a necessary evil. But it always entails costs. There is no "good" public debt.