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Tax or Borrow?

Assume an economy with no government debt and a balanced budget of $2,000 billion.  Suppose the government plans a one-year program to refurbish the highway system at a cost of $100 billion.  The funds could be acquired from the public either through additional taxes or borrowed at interest from the public.  Which of the two financing options is more equitable, and why?

The Taxing Option

Assuming an effective income tax rate of 20%, $20 billion of the funds will be acquired from the workers themselves by the tax on the income they receive on the program.  The simplest way for the government to obtain the remaining $80 billion would be a one-time tax surcharge of 4% on everyone’s income.  We will ignore the second order effects.

 At the end of the year the budget will be balanced with no government debt.  A total of $100 billion of the public’s money will have been redistributed to those who did the work.  Because of the tax bite, their net income will be only $80 billion.  However the total monetary assets of the public remain unchanged since tax revenues are balanced by government spending.

The Borrowing Option

In the borrowing option, again $20 billion will be obtained from the income tax on those who did the work.  The remaining $80 billion must be acquired through the sale of government bonds, which we will assume pay interest of 5% per year. 

At the end of the year the government will have a debt of $80 billion on which it must pay interest of $4 billion per year.  To maintain a balanced budget going forward, the government could roll over the debt continuously and cover the interest payments with additional taxes.  The required increase would be 0.2% of the $2,000 billion per year paid before the program was launched.     

An Evaluation

In both options the public as a whole, including the bond buyers and those who do the work, ultimately pay for the work through increased taxes.  In the taxing option, the government extracts the funds in proportion to each tax payer’s normal tax liabilities.  In the borrowing option the government obtains the funds on a voluntary basis, according to the investment preferences of the public.  Those who buy the bonds gain no advantage since the others can use their funds to purchase other investments of the same value.

In both options the government program causes a circulation of the public’s money supply, which results in additional employment and income.  Neither option changes the monetary wealth of the public as a whole.  In effect the public acquires a refurbished highway system in exchange for the work of a few, and remunerates those who do the work.

Individuals benefit economically from the program in varying degrees depending on their use of the highways and the taxes they pay. The program causes a redistriibution of financial wealth, but that is true for any government spending. While both options are equivalent in terms of aggregate financial impact, the borrowing option has one potential advantage. The benefits of the refurbished highway system will last well beyond the current generation. To the extent that there are any financial inequities across generations, it is fair that they should be shared. For that reason, the borrowing option is likely to be more equitable in this case.

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