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Spending Cuts and Tax Hikes: What Else Can be Done About the Debt Crisis?

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In the ongoing debate about the U.S. debt crisis, politicians have always narrowed the available strategies to higher taxes and reduced government spending. Both of these options have undesirable side-effects for the economy and remain unpopular. We are told repeatedly that if policymakers are serious about reducing government borrowing they will ultimately have to come up with a mixed package of spending cuts and higher taxes.

Yet in addition to these obvious options, there is a third option for addressing the debt crisis that has never been considered in the United States: Restructuring the debt by mandating some individuals and institutions to purchase government bonds. Mandatory bond purchase by some citizens and domestic institutions does not reduce the total government borrowing but it can help reduce the amount that has to be borrowed from foreign lenders. Such a step can help restore international confidence in US dollar. It will also reassure them that the United States is at least serious about containing its international borrowing.

Mandatory purchase of government bonds is practiced in several countries such as India and China but it is an alien concept in the United States and it might even be viewed as unconstitutional. If we set aside its political feasibility, however, it might have some economic benefits under current circumstances. First let me clarify what I'm proposing. The mandatory government bond purchase can be designed as a supplement to income tax payment with a progressive rate structure. Furthermore, government can require a minimum holding period of several years before these bonds can be sold by the original owner.  

The amount of government bonds that each individual or corporation will be obligated to buy can be determined as a percentage of its taxable income in the same way that the income tax is calculated. By linking the purchase rates to specific income levels the government can determine how the burden of these mandatory purchases will be distributed among various income groups. For example, the scheme can be made highly progressive by introducing a high minimum income threshold (i.e. $250,000 per year), below which no purchase is required. The rate can start at a modest level (for example 3%) at the threshold and increase to higher levels for larger incomes.

As a stand-alone policy, under normal circumstances, the mandatory government bond purchase might not seem beneficial. However, if a government is faced with a growing debt crisis and still needs to raise additional revenue by choosing between additional taxes or mandatory purchase of government bonds, the second option might cause less economic distortions. Consider the impact of these two options on an individual tax payer. Paying $1,000 in additional taxes means that the taxpayer's after-tax income will decline by $1,000 and he has lost this amount forever. Paying the same amount to the government through mandatory purchase means that he has been forced to save $1,000 which will be available to him at some point in the future (as long has he has trust in the government). Clearly he will prefer the second option which does not reduce his net wealth and income by $1,000.

From the national economy point of view, if government has no alternative but to borrow an additional $1,000, it is better to raise this amount through mandatory purchase of government bonds than a general sale of new government bonds to the public. The current high level of government debt has diminished international confidence in the U.S. economy and currency. International creditors and investors will view the mandatory government bonds and ordinary government bonds differently. They will see the former as domestic government debt which is less risky than the government's foreign debt obligations.

Mandatory government bond purchase should not be viewed as a substitute for raising taxes and reducing some government expenditures. Rather it should be viewed as complementary to these two options. A comprehensive response to the current debt crisis clearly requires both additional taxes and spending cuts. Mandatory bond purchase can be added to this package as an intermediate step to raise additional revenues domestically without raising the taxes too much or cutting spending too deep in the initial years of the fiscal reform.  

Mandatory government bond purchase can also serve as a temporary confidence-building compromise measure if policymakers fail to agree on a deficit reduction policy by the August 3 deadline. It can signal to the world that if we cannot reduce our government borrowing fast enough we are at least going to reduce our international borrowing by assuring that a portion of government bonds will be purchased and held by American taxpayers and domestic institutions.

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Nader Habibi is the Henry J. Leir Professor of Practice in Economics of the Middle East at Brandeis University's Crown Center for Middle East Studies. His research has focused on economic and financial conditions of oil-exporting Middle Eastern (more...)

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