Debt Burden and Intergeneration Equity

A controversy among economists relates to the question whether the borrowing method of financing shifts burden to future genera­tions. The controversy gives rise to a far ranging debate over debt burden in 1930’s and 1940’s.

One such heated debate was between the conservatives, who feared that the creation of debt in the course of deficit finance would burden the future. Their contention is that if taxes are used, person pays for the activities now. If funds are bor­rowed, the present generation escapes, and the burden rest on per­sons in future generations paying interest and principle.

The liberals defending public debt, as a source of government finance, went against the conservative contention, that in loan finance, burden is shifted to future generation and persons in future generations are born with “a chain around their necks”. I.e., the obligations to pay off the national debt.

The liberal view was that there would be no need to pay off debt, since it would be refunded and that only interest pay­ments would be at stake.

Moreover, such interest would impose no burden on future generations, since the future generations would contain both tax payers and interest recipients. Gains and losses would therefore wash out leaving no problem of net burden.

However, neither the conservative view nor the liberal outlook clearly provides the nature of debt burden. A closer analysis is needed in this regard.

Hence the basis debate is whether a debt burden is borne by the present generation, which actually creates a debt, or whether the burden is passed on, instead to future generations. The classi­cal reasoning regarding the intergeneration transfer of debt burdens, which was later adopted by Keynesian economists, where challenged by a team of economists. In recent years, Buchanan, Bowen, Davis,

Kopf, Musgrave, Modigliani and others challenged the classical prepo­sition. The orthodox position holds that a debt burden may be shifted to future generations, only if the present generation reduces its rate of saving, as a result of debt creation activity.

This argument origi­nated from Davi Ricardo and later on systematically and brilliantly stated by Prof. A.C. Pigou. Eventually this principle was adopted by Keynesian economic theorists, such as A.P. Lerner and Samuelson.

Hence, the following approaches deserve special mention in debt burden controversy:

1. Capital Stock Transfer Theory:

This theory is coined by David Ricardo and later on developed by A.C. Pigou. According to this theory public investment projects can be financed either through tax revenue or through borrowed capital. Whether this shift the burden to future generation depend upon the extent of real capital inherited by it.

The welfare of future generation depends upon the sacrifice of present consumption without which capital cannot be pooled to build up large productive base. However, the curtailment of current consumption depends on the reaction of present generation to the withdrawal of real resources from the pri­vate economy, for the creation of public investment projects.

If the investment project is financed by borrowed funds, which are through floating public debt, the bond holders are likely to curtail investment than consumption. The purchasers of bond will pay for them more out of saving than out of consumption. This is because; they con­sider their net wealth position better under loan finance than under tax finance.

If projects are financed by taxation, taxpayers are more likely to curtail consumption, because their disposable income is reduced. But under situation of loan finance, the bond holders can easily monetize their debt, by selling them at any time in the money market. Hence they are as liquid as money. Hence the bond holders never feel that lending has reduced their disposable income.

Hence they feel that they have become richer. Even though loan finance carries with it the obligation of future generation to pay interest and repayment of debt, nobody is sure about the exact amount he has to pay in future.

Due to these reasons, the bond holders never sub­scribe public debt by way of reduced consumption to finance invest­ment projects. Rather they pay for debt out of the saving which can otherwise be spending on other type of investments.

As a result, the reduced level of saving causes less ‘real produc­tive capital’ to be inherited by future generations. Thus a real burden in the form of ‘reduced output potential’ is passed along through this “indirect” means to future generations.

As a conclusion it can be stated that this orthodox approach ‘interprets intergenerational debt burden’ in terms of the ‘real resources’ that are ‘available to the future generation due to debt financing by the present generation.

2. The Buchanan’s Thesis (Welfare Attitude Theory):

James. M. Buchanan made a ringing challenge against the tradi­tional position in 1958, in his book “Public Principles of Public Debt”. Buchanan holds the view that loan financing of public investment does shift burden to future generation.

Since the government securi­ties are purchased ‘voluntarily’, those in the present generation who purchase them, do not consider themselves to be undergoing a sac­rifice whereas those in future generations who pay the interest and redeem the bonds do experience a sacrifice through compulsory tax payments.

The attack of Buchanan upon the traditional approach, center around the question of the meaning of the concept of ‘burden’. Buchanan interprets the concept ‘burden’ in terms of individual atti­tudes towards their economic well-being rather than in terms of changes in private sector output and real income.

For example if the required resources for funding the project is financed by tax resources, the taxpayers feel worse off because tax is a compulsory contribu­tion. Such compulsory payments involve an element of sacrifice and taxpayers feel deprived of their enjoyment of income and hence this will lead to a reduction of aggregated welfare.

Whereas this is not the case in loan finance. Buchanan argues that during periods of borrowing and spending activity, no burden of any kind is created. Individuals voluntarily exchange liquid funds (money) for government bonds. This is done by diverting money from consumption purpose or for investment purpose in private sector, output of equal value.

No one feels himself to be any worse off, when bonds are repaid in future generation; funds are taken from the tax­payers to pay the bond holders. In this situation, the taxpayers feel worse off, since their disposable income is reduced.

At the same time the bond holders do not feel themselves better off. Since they have merely exchanged bonds for liquid cash. Since in the future generation, the bond holders are not better off, but taxpayers are worse off, the aggregate welfare of society is reduced in the case of loan finance of public investment project. Thus we can conclude that public debt shift the burden to future generation.

3. Bowen-Davis-Kopf Thesis:

Another volley was directed towards the orthodox debt position by William. G. Bowen, Richard. G. Davis and David. H. Kopf. In defending the traditional analysis they put forward a case in which present saving (i.e. saving by generation I) is not reduced.

The importance is that in orthodox argument, present saving is the locus, whereby intergeneration our den transfer can materialize.

These economists argue that the first generation actually incurs debt to carry out a public project, within its life time. When generation I, purchases the bonds to finance a public investment project, in reality, saving ini­tially take place by this generation.

Now suppose that generation I sell the bonds to generation II, to obtain additional cash for purchas­ing consumer goods during retirement. Moreover it is assumed that all the bonds are sold and all funds accumulated therein are spending on present consumption by the first generation. That is, there is no inheritance passed on to generation second.

The sale of all bonds to the next generation constitutes a ‘dissaving’ for generation first, which equates its ‘initial saving’. Hence, Bernard. P. Herber states that as per the arguments of Bowen-Davis-Kopf in effect the first generation does not reduce saving and capital formation.

On the contrary, sup­pose during the life time of generation second, the government de­cides to retire the debt, this is done by taxing the second genera­tion, to pay for the bonds, which it has purchased from the first generation.

This will result in a reduction in the life time consumption of generation second. In nutshell, it means that the second genera­tion bears the burden of the debt even though the saving of the first generation was not ultimately reduced.

Whereas, Prof. Modigliani opines that intergeneration burden analysis should concentrate upon stock as well as flow variables, long run as well as impact effects. Modigliani argues that govern­ment expenditure financed through public debt will place a gross burden on future generation.

This is taking place through a reduction in the stock of private capital, which in turn tends to reduce future income and future flow of goods. However, this depends on the way the resources have been used and the mode of financing the debt.

4. Musgrave’s Thesis of Intergeneration Equity:

The most appropriate answer to the debt burden controversy was provided by Richard. A. Musgrave. He argues that debt finance for public investment projects necessarily spreads the burden among different generations, whereas tax finance causes the present generation to bear the burden.

The Musgrave’s approach is based upon the ‘benefit principle’ of equity in debt burden distribution. He is of the opinion that the cost of public investment projects should be borne by the users in proportion to the benefit they enjoyed.

By illustrating a particular case, Musgrave shows that in loan finance, the cost of investment project is evenly distributed among the ben­eficiary generations, exactly in proportion to the benefit enjoyed by them. He further argues that such intergeneration equity in burden distribution is practically impossible through tax finance. The follow­ing case is provided by Musgrave to substantiate his argument.

Consider a project whose service become available in equal in­stallments over three periods. Also suppose that the life span of each generation covers three periods and that the population is stable.

Finally assume that loans advanced by any one generation must be repaid within its life span. In each period the benefit accrue to three generations, including generations 1, 2, 3, in the first period, 2, 3, and 4, in the second and 3, 4, 5, in the third period. To contribute their proper share, generation 1 and 5 should pay 1/9 of the cost. Generation 2 and 4 should pay 2/9; and generation 3 should pay 3/9.

This can be summarized in the following chart form:

During the life time of the project, the first and fifth generation each appears once, the second and fourth generation each appears twice, while the third generation appears thrice.

Let us now suppose that the total cost of the project is Rs. 900/ – and that the same is to be allocated accordingly. Let us further assume that the loans advanced by any one generation have to be repaid with in its life span.

The project outlay of Rs. 900/- has to be mobilized and spent in the first period. Of this Rs. 300/- is obtained by taxation divided equally between the first, second and third generations.

The balance is raised by way of loans. Loans will be raised from second and third generation. There can be no loan from first generation, due to the rule that each generation must be repaid dur­ing the life span.

The first generation is the oldest one. In the second period, tax revenue at equal rate as before are raised from the second, third and fourth generation and are used to repay the debt held by the second generation in full.

Moreover, a loan of Rs. 150/- is advanced by the fourth generation to retire part of the debt held by the third generation. In the third period, the loans to be rapid amount to Rs. 150/- each to third and fourth generation. This will be retired by way of tax revenue contributed by the third, fourth and fifth gen­eration at the rate of Rs. 100/-. In this case, the allocation of interest cost is disregarded.

The following table will make the point clear:

Intergeneration Equity Through Loan Finance

Thus, the total project cost has been divided between the five generations in accordance with the benefit received by them. Hence Prof. Musgrave observes that loan finance not only provided credit to taxpayers but resulted in factual division of the cost between generations. This can never be realized through tax finance.

Hence, the above example illustrated by Prof. Musgrave admits an intergeneration transfer of costs including debt costs, among the five generations, which provides for the attainment of equality between ‘cost burden’ and ‘benefits received’ for each generation.

Thus, Richard. A. Musgrave argues that loan finance necessarily spreads the burden among different generations while tax finance causes the present generation to bear the burden.

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