The Great Debt Retirement Fallacy

Copley News Service, 02/25/2000

A misguided bipartisan policy consensus has congealed in Washington, D.C.: Raise tax rates to balance the budget and keep federal revenues at or near an all-time high of 20.5 percent of GDP to run budget surpluses and retire the public debt. Within the past few months, President Clinton and House Speaker Dennis Hastert have committed the Democratic and Republican parties to retiring every dollar of debt held by the public no later than the year 2015. Both parties are making a profound mistake.

First, leaders of both parties obsess over the size of the public debt ($3.6 trillion) without considering the nation’s growing income-producing capacity to service that debt ($9 trillion in 1999 and currently growing at a trend rate of 3.2 percent a year after accounting for inflation). They miss the fact that although the debt held by the public rose by more than 50 percent from 1990 to 1999 (from $2,410 billion to $3,618 billion), the debt burden on the economy actually fell from 42.4 percent of GDP to 41.9 percent because the economy grew faster than the debt during the same period. Likewise, if the federal budget remains in balance and the economy grows during the next 15 years no faster than it has on average throughout the post-World-War-II era (3.2 percent a year), by 2015 the debt burden on the economy will have fallen to less than 18 percent of GDP without a single dollar of debt ever being retired.

Second, both parties obsess over the amount of interest due on the public debt (approximately $3,450 billion between 2000 and 2015) but fail to take into consideration the private investment opportunities that would have to be taxed away ($3,618 billion) in order to retire the public debt and eliminate those interest payments. Average annual debt service on the public debt is running about 6.3 percent currently, while even the stodgiest mutual fund earns rates of return in excess of 10 percent. Private investment of the surpluses is the more productive use of taxpayers’ money, even though it entails rolling the public debt over and paying interest on it in perpetuity.

Third, both parties make unsubstantiated claims about how debt retirement will lower interest rates and strengthen the economy. Interest rates are determined by the combined effects of inflation, inflation expectations and the prevailing real rate of return to capital. There is no evidence that the current level of public debt raises interest rates by so much as a single basis point, so there is no reason to expect that retiring the debt would lower interest rates.

The current federal tax code is unfair, economically destructive, impossibly complex and overly intrusive. Every additional dollar of tax revenue raised through this tax code damages the economy far more than any offsetting beneficial results achieved by using that revenue dollar to retire public debt. Indeed, the current tax code is so destructive that for every additional dollar in tax revenue raised, overall GDP is reduced by about $1.50.

The cost of raising the surplus revenues through the current tax code would make debt retirement the fiscal equivalent of taking three steps back for every two steps forward. It makes more sense to overhaul the tax code and return budget surpluses to taxpayers than to employ the current tax code to maintain surpluses and retire the public debt at the expense of stifling saving, retarding investment and shrinking the economy.

Think of it this way: What if you suddenly got a raise, came into an inheritance and also were given an opportunity to refinance your current mortgage at a lower interest rate, all at the same time? What would you do? Of course you would refinance your mortgage at the lower interest rate. Between your higher income and the lower mortgage interest rate, the debt burden of your mortgage would fall without having to accelerate repayment of the mortgage principle by so much as a single day. You then would be able to use your inheritance to take advantage of the investment opportunity that yields a rate of return higher than the interest rate on the mortgage.

Prudent financial management is precisely the choice America faces. National income has risen because the economy is growing faster. The nation has a sudden windfall of revenues in the form of budget surpluses. And it is possible to refinance the national debt at the lowest interest rates in a generation.

Incredibly, both establishment political parties in Washington are asking Americans to give up a lucrative national investment opportunity. Both parties have abandoned the growth economics that Ronald Reagan used to revive the economy from the stagflation of the 1970s by cutting taxes and have adopted the austerity economics that Herbert Hoover pursued into the Great Depression by raising tax rates in search of a balanced budget.

To learn more about the great debt-retirement fallacy, go to This Web site is titled “Deficits, the National Debt and Economic Growth,” and it is the creation of Steve Conover, who has created the best treatment of this subject I have seen. Then e-mail the Web address to your members of Congress and to all of the presidential candidates. It’s one way average voters can educate their elected representatives, all of whom seem trapped by the debt-retirement fallacy inside the same cramped little austerity box. It’s your economy, and you’d better take a hand at directing the politicians on what you expect them to do before they run it smack into the ground.

Jack Kemp is co-director of Empower America and Distinguished Fellow of the Competitive Enterprise Institute.