Andrew Coleman looks at the options facing the Government for funding the Covid-related public debt

By Andrew Coleman*

James Buchanan, the economist who was awarded the Nobel prize for his work analysing the way politicians make economic policy decisions, attributed much of his insight to a year spent living in Italy in the late 1940s.

One of the things he discovered was that most Italians did not think that politicians had the interests of the people at the forefront of their minds; rather politicians were believed to pursue their own interests, and if these coincided with the interests of the people then the people were fortunate.

For Buchanan, this was the seed of Public Choice theory. Another thing he discovered was the work of an otherwise obscure Italian public finance economist, Antonio de Viti de Marco. de Viti de Marco had a great deal of influence on his thinking.

Unfortunately, I have not read de Viti de Marco’s book, first published in 1888, so what follows is second hand, based on some of Buchanan’s work and also the excellent book by Richard Salsman “The political economy of public debt.”

De Viti de Marco was interested in the circumstances in which large public deficits could be justified. He argued that deficits were occasionally appropriate when the government faced some sort of emergency and needed to raise a lot of funds to deal with the emergency. The most obvious example is a war: it requires the purchase of a large amount of military (and medical) equipment, as well as the recruitment of a large number of military and medical personnel.

He suggested that there were two basic ways a government could raise the funds. The first was to raise taxes by the full amount immediately. People would find the money by cutting back on expenditure, or by borrowing if cutting back on expenditure were too onerous and they had the ability to raise a loan.

The second was for the Government to borrow – essentially to borrow on behalf of the people, and thus reduce their need to cut expenses or borrow to pay the taxes. People who found it easiest to save would buy the government bonds, and provide a real service to those people who were less able to immediately increase their savings, or those who could only borrow at high interest rates. They would be repaid in due course for the service they provided to everyone else. Instead of a large immediate increase in taxes, taxes would increase by a smaller amount for a longer period in subsequent years.

The situation facing New Zealand at the moment seems similar, although there are two additional options.

In response to the Covid-19 virus and the restrictions imposed on society in response to it, the government could:

(i) tell people who lost their jobs that it was their bad luck to be working in the wrong sectors, and that they should borrow to get through the emergency until they could find employment in some other sector, or with their original employers if the jobs were still there when the emergency passed.

(ii) increase taxes by large amounts immediately on those who remain in employment (and those in receipt of capital income) in order to provide transfer payments to those unemployed or those whose businesses had suffered;

(iii) borrow from those most able to lend, to reduce the costs of option (ii), to be repaid by future taxes;

(iv) create money to provide the transfers.

Option (iii) is the option that seems likely de Viti de Marco would favour, were he 162 and still kicking around. But to some extent the first three options all involve borrowing and consumption cuts.

While the first option seems unpalatable at first sight, unless the size of the transfer payments is extremely generous, people who are unemployed (or who have much reduced business income) are likely to be forced to borrow on their own behalf to maintain consumption levels.

Indeed, the extent that option (i) is part of the solution depends on the size of the transfers.

In principle, people who lose their jobs/businesses as a result of the Corona crisis can issue an IOU to the bank in exchange for cash, to be paid from future income or asset sales. If they do, savers will emerge to hold the deposits associated with these IOUs.  

In the second option, the costs to the unemployed are distributed over the wider community through steep increases in taxes. To the extent that the steep increase in taxes cause hardship on individual taxpayers, taxpayers can issue IOUs to the bank to raise cash to pay taxes. Once again, savers will emerge to hold the deposits associated with these IOUs.

In the third option, transfers are made to unemployed people, but this time they are financed by government issued IOUs. Once again, savers emerge to hold the deposits associated with these IOUs, but in this case the interest rates are likely to be lower as the Government is a less risky borrower. (Thank you, Mr and Mrs Saver, wherever you are, for reducing the cost to the community of dealing with the disaster.)

Note, however, that in the third option, the people who have to repay the loan are not identified unless the government provides specific details about the taxes that will be imposed in the future to repay the loans. Thus, the third option differs from the second option not only because it is more efficient, raising funds from those most able and willing to pay, but because it is silent about who ultimately pays for the transfers.

This article is not the place to talk about the costs of the fourth option.

There is a long tradition of governments printing money to finance expenditure, some of which has been popularised in a new version of economic theory called “Modern Monetary Theory”.

Not many economists believe that monetarising debt is costless; rather it typically redistributes the costs in ways that are not well understood.

Historically the excessive issue of money rather than debt to finance government expenditure has been associated with inflation, which shifts the cost to those people who had lent money to other parties. MMT theorists would do the world a service if they provided formal analysis of the distributional consequences of governments issuing money rather than debt to fund emergency expenditures, but this has not yet been forthcoming in a manner that most economists find compelling.

The New Zealand Government seems to be opting for options (i) and (iii), although it is muddying the waters a bit by having the Reserve Bank purchase government debt.

There seems little doubt that the Government deficit is increasing, and debt is forecast to increase by a large amount over the next few years, perhaps by $60 billion. Once again we should be grateful to the savers, for by providing money at low interest rates they are preventing worse outcomes.

Niggling worries

There are two niggling worries.

The first, if you are a lender, is that the government may not pay you back in real terms what you think you will be getting.

Unfortunately, the post 1950 historical experience is that governments find ways to cheat their creditors, normally by inflation.

Will this happen again? Who knows? But the New Zealand Government has a long and inglorious history of short-changing lenders (savers). For example, it is one of the few countries that taxes the inflation component of interest income earned by people who are saving for retirement, a practice that most economists and most OECD countries find unconscionable.

Why the New Zealand government believes lenders deserve to pay the highest taxes on real income in the country is a mystery, although it could be because it believes that people who lend are either particularly undeserving or particularly unsophisticated so that it is either equitable or efficient to impose on them very high effective tax rates while subsidising people who borrow to invest.

This position was supported by the Tax Working Group last year, consistent with IRD and Treasury advice over a three-decade period, and seems unlikely to change. In addition, recent changes to the Reserve Bank policy targets agreement will make it easier to justify future inflation.

Is it really credible to believe that the next Central Bank governor, who ever she or he is, will be prepared to raise interest rates to control inflation if unemployment is persistently high?

The second issue is somewhat more straightforward. The Government has made no announcements of the types of taxes that are likely to be raised to repay the debt, and thus has made no attempt to identify the likely taxpayers of the future.

New Zealand governments have traditionally been willing to impose some of the highest taxes on capital income (particularly interest income) in the OECD, proving that governments have no fear of the possible distortionary consequences of capital income taxes.

Successive governments have also demonstrated a willingness to impose high taxes on young and future generations, by adopting unfunded pay-as-you-go retirement income policies.

In contrast, for three decades New Zealand governments have imposed some of the lowest taxes on labour income in the OECD, particularly on people with very high labour incomes.

I am completely out of the political loop, and have no knowledge whether current politicians think they should accentuate these positions, or reverse them. All I know, following the insights of James Buchanan, is that it is unrealistic to expect a government to announce plans to raise future taxes before an election, no matter how much it would be in the public interest to do so.

*Andrew Coleman teaches public finance at the University of Otago.