Do future generations pay for deficits?.

by on February 12, 2006 at 9:17 am in Economics | Permalink

Assume that government spends some money today on consumption.  That money could have been spent on a durable bridge, but it wasn’t.  Some current people benefit from the consumption and future generations get nothing.

Above and beyond that effect, do future generations bear the burden of deficit spending?  That it, are they worse off if we finance the consumption with government bonds rather than higher taxes?

Under one scenario, future generations bear no additional burden.  Assume the government bonds are paid off fifty years from now.  Future generations pay the taxes.  But they also inherit the bonds.  Might that be a wash? 

Wealth effects complicate the story.  The old people, who are holding bonds, may spend more in the meantime (spend more relative to a tax increase, that is) and this may pull away some resources from future generations.  If old people just sit on their bonds and make no other expenditure changes, the burden on the future is nil.

If old people spend more today, and John is born thirty years later, how much worse off is John from this extra spending?  And would having saved that same money necessarily have directed resources toward John, as opposed to directing resources toward the later consumption of the elderly?  What if the extra spending doesn’t occasion much in the way of a supply response?  Then it is just a sloshing around of some paper.  To ask an Austrian question, what is the net injection effect here from the bonds?

I don’t know.

Often deficit critics focus on the moral issues.  On average future generations are better off than their parents, at least in a growing economy.  They are less well off if their parents spend more rather than less.  Is this immoral on the part of the parents?

Alternatively, let’s say we pay off the debt in fifteen years’ time.  Furthermore assume that the future elderly (who are now middle-aged) have stopped paying taxes, but they are not yet dead.  They are still holding the government bonds.  Then we must tax the young, who currently are described by the phrase "future generation."  Then, through a different mechanism, future generations will bear a chunk of the tax burden. 

Even then the burden will not be full.  By letting the elderly off the hook, we increase the sizes of their eventual bequests (what is their marginal propensity to bequeath?).  Furthermore a VAT tax, or means-testing of benefits, will keep the elderly paying taxes and diminish the potential burden on future people.

Offsetting bequests, a’ la Robert Barro, makes deficits less relevant rather than more.  If people know their children will pay higher taxes, maybe bequests will go up a bit to make up for that burden.

There is also tax smoothing.  Nominal tax rates can only be so high in each period before a taxation system breaks down.  By postponing tax boosts, we make it harder for future generations to engineer other tax increases for other reasons.  This could make them either worse off or better off, depending on your point of view.

You can put these scenarios together in different combinations and achieve many differing results.

The bottom line: We are running large deficits.  The case for boosting taxes today rather than tomorrow lies in the fear that financial markets will get spooked, rather than in intergenerational considerations.  Some time ago I put this spooking at p = 0.2; I have revised that estimate upwards only slightly.

Pedro Romero Aleman February 12, 2006 at 11:36 am

I think your comment is valid mostly in developed countries, but not in developing ones where there is financial repression and practically no capital markets.

Michael H. February 12, 2006 at 1:12 pm

What you are describing is Ricardian equivalence and that only makes sense
in a closed economy. But it the bonds are sold to people outside the country
then the next generation will never inherit the bonds. Deficit spending
together with a large trade deficit enables the present generation to dip
into the future earnings of the next generation.

nick February 12, 2006 at 10:01 pm

I think it’s important to look at the incentives at work. The issue of more government bonds increase the incentive to invest in the bonds (i.e. in government spending) today and decrease the incentive to invest in taxed activities tommorrow. Unless the government spending is more economically productive than the taxed activity, it’s a net loss.

benny February 13, 2006 at 5:52 am

i think the more important question when looking at future benefits or costs of huge deficits is not if households are worse off in the future (because in relation to today they propably won’t), but if the private sector has incentives to not go for greatest effiency and productivity gains possible, to not invest or to not create wealth, because of the huge deficits.

the market for entrepreneurs is quite fluktuating. people start new business every day and also people go bankrupt with their business. now the question which is important: do large government decifits lead to an unefficient outcome, because entrepreneurs fear high taxes? do they leave the country? are certain industries completly useless in this new situation?

So still if money and income wise households in total won’t be worth off because of huge government deficits its the things that don’t come to existance, that are the real loss to the future generation.

So whats an argument over government vs private sector capital investment/consumption leading us too? Thats another moral question…

Michael February 13, 2006 at 10:37 am

We need to be sceptical of a claim that the current generation can enjoy a free lunch, financed by government borrowing, that is no burden on future generations. “Under one scenario, future generations bear no additional burden. Assume the government bonds are paid off fifty years from now. Future generations pay the taxes. But they also inherit the bonds. Might that be a wash?” No. If the old generation had financed its lunch with taxes, then it could have bought bonds from other countries instead of its government, and the next generation would inherit bonds but no tax laibility for the lunch. Note this means it does not matter whether these particular bonds are sold to foreigners or residents. The only way around this is the Ricardian equivalence story that savings rise with the deficit-financed lunches, and those bonds are given to the next generation. There *is* a case to boost taxes today, that it is a way to achieve tax smoothing for the inevitable future tax increases.

Karl Smith February 13, 2006 at 12:49 pm

You don’t need Ricardian Equvilance for Tyler’s story to hold. You just need a closed economy. In that case the bond holders must reside in the same nation as the taxpayers.

The problem is two fold.

One, the economy is open and the Chinese government is, in fact, holding an important fraction of our bonds not our children.

Two, the bridge exception is not trivial. If the interest elasticity of savings is very low then we are reducing invesment and thus the wealth of future generations. Some of that if offset by foreigners holding the debt but to the extent that is happeing we run into problem one.

still working it out February 13, 2006 at 6:59 pm

Future genereations bear no additional burden only in a closed economy. But since America is not a closed economy this reasoning may not be relevant to the real world.

In the simple case: If the US government funds today’s consumption by selling bonds to China, Americans will be worse off in the future. Future American generations pay the extra taxes, but future Chinese generations inherit the bonds.

The moral argument is not based on the burden to the world as a whole (the closed economy case), but only the burden on future Americans.

Andrew McGuinness February 15, 2006 at 7:47 am

What have future generations ever done for us?

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