David R. Henderson  

Should the Cost of War Include Interest Payments?

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In a recent article, Bob Murphy responds to my statement that counting the interest cost on the debt generated by war spending is not justified. I argued that it's double counting and that the initial outlay is the correct measure of the cost. Bob lays out my argument more completely than I did. The argument is essentially that the cost of the spending, if paid totally by taxes, is the amount of spending and that the cost of the spending, if paid entirely by debt, is the present value of the interest payments and ultimate payment of the principal. These should be the same.

Bob then goes on to criticize my view and his doing so has caused me to revise my argument. He writes:

The biggest flaw with the standard analysis is that government interest payments to bondholders do "hurt the economy," because they are financed through coercive taxation. (The government can also pay interest on its debt through further borrowing, which just postpones the problem, or through inflation, which is a form of indirect taxation.) Once we take this aspect into account, it's no longer true that interest expenses are a form of "double counting."

Good point. Bob elaborates:
Because of what mainstream economists call the "deadweight loss" of taxation, our hypothetical annual streams of $5 billion interest payments really do make society as a whole poorer, in terms of forfeited goods and services that could have been produced in the private sector.

It's because of this deadweight loss that I realize I didn't state the analysis correctly to begin with. So here's my current thinking.

The cost to the United States of fighting a war paid for by taxes is the amount of the taxation times (1 + d), where d is the deadweight loss per dollar of taxes. If, instead, the U.S. finances a war using debt, then the cost of the war is the present value of all the interest payments and repayment of principal, except that each of these interest payments and the principal are multiplied by (1 + di) where di is the deadweight loss per dollar of taxes raised when the taxes are actually raised to pay the interest or the principal. In other words, the mistake in my original formulation is that I left out deadweight loss. But there is no particular reason why the di in a particular period is greater than d today. In fact, I remember Bob Barro arguing somewhere in the 1970s that when the war is really expensive, the way to minimize the present value of deadweight loss for a given expenditure is to have relatively even tax rates over time, which implies using some debt to pay for the war. In fact, Bob Murphy, I think agrees with me. He essentially admits my point in his footnote 2.

So thanks to Bob for helping me get my own thinking straight.


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CATEGORIES: Fiscal Policy



COMMENTS (6 to date)
Doc Merlin writes:

Hey David,
I would argue that there is a deadweight loss to government borrowing. Because the government has the option to use coercion or redefine the real value of the dollar, the risk premium on its debt is much lower than free market alternatives could achieve. This means that government debt is, effectively, subsidized by society and creates deadweight loss in the investment market above and beyond what would be from just taxation.

Another way of thinking about it is that government debt creates a price floor in the investment markets, no one is going to buy any debt that has worse yields than sovereign debt.

Another way of thinking about it is that increasing the supply of government debt (and thus the relative yields) increase the opportunity costs of investment.

Hyena writes:

How would you resolve the issue that there is no such thing as "financed by debt" in government? How much of the deficit should be considered war spending?

Hugh Watkins writes:

Presumably this applies to all government spending - not just to wars.

As Hyena rightly points out, the deficit is general and cannot be specifically attributed to either war - or foodstamps.

Johnalee writes:

I agree that this principle applies to war costs, but it's also applicable to any other government spending. Any program that's not paid for directly through tax dollars is being funded by debt. Since these government debts are paid off later (usually much later), interest rates have to be taken into consideration.

It's the same idea as a civilian purchasing a house. If it's paid for in cash, no worries. However, if a mortgage is taken out and the house has to be paid for over a period of several years, the interest must be accounted for in determining actual cost.

Doc Merlin writes:

This is yet another reason why taxes are preferable to government debt. And deficit financed government spending is even worse than tax financed.

Mark Mc writes:

Sounds like a Thesis...

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