Can Economic Growth Help Solve Our Debt Problem?

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Can Economic Growth Help Solve US Debt Problem?

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This is part of our educational blog series, “The Short Form,” to simplify taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
issues and explore the world through the lens of tax policy. Learn more about taxes with TaxEDU.

The U.S. is among the most indebted countries in the world—and the problem is only getting worse.

The federal government’s debt is currently $33 trillion and annual deficits just reached the highest in U.S. history outside of the pandemic years (at nearly $2 trillion). Not only are we spending more than we’re taking in, but the long-run growth in our spending is outpacing the growth in our revenue.

If the lessons from other countries dealing with similar problems are any indication, fixing this problem is going to require a combination of spending cuts and tax hikes. But there’s a third factor that could help alleviate some of the pain involved: economic growth.

Economic Growth, Deficits, and Debt

The faster the economy grows, the less pressure there is to raise taxes and cut spending.

With more businesses and workers, the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
expands, meaning the government can collect more tax revenue without raising rates.

To illustrate, suppose we have an economy with a GDP of $1 trillion and an average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes.
of 20 percent. Total tax revenue would be $200 billion. Let’s say the economy grows by 5 percent, bringing the new GDP to $1.05 trillion. With the tax rate unchanged at 20 percent, the new tax revenue would be $210 billion—a $10 billion increase without touching the tax rate.

A growing economy brings in more tax revenue, which reduces the relative debt burden. This gives lawmakers some breathing room to address fiscal imbalances (think gradual tweaks, not drastic measures).

What Is the Debt-to-GDP Ratio and Why Does It Matter?

The debt-to-GDP ratio is a measure of how much debt the federal government holds compared to how much it produces (i.e., the size of its economy) in a year. For example, say you borrowed $10,000 to start a business and you sold $50,000 worth of products. Your personal “debt-to-GDP” ratio would be 20 percent.

But what would happen if your debt-to-GDP ratio was 115 percent (like the U.S. in 2021)? You’d owe more than you produced in a year.

This ratio gives valuable insight into the sustainability of a country’s economy. If it gets too high, a country might struggle to pay back its debts, leading to a host of undesirable consequences. For example, interest costs to service the debt would become a bigger part of the budget, taking resources away from other priorities. And sometimes governments are tempted to print money to deal with the problem, which causes inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power.
. While there’s disagreement about how high is too high, a debt-to-GDP ratio of 100 percent is a common milestone economists look out for.

How Taxes Affect Economic Growth

One way policymakers can promote economic growth is through tax policies that encourage people to work, save, and invest.

For example, allowing businesses to write off investments in the year they occur rather than over time (which decreases their value) makes investments more profitable. This, in turn, encourages more investments, which boosts productivity and can lead to more jobs and higher wages.

To be sure, some of these tax policies would decrease revenue, but the growing economy could help partially offset the reduction.

The Way Forward

With much of the 2017 tax reform law expiring in less than two years, Congress will get the chance to rewrite the tax code. And while a sustainable approach will require addressing the underlying drivers of the debt—i.e., mandatory spending programs like Social Security and Medicare—lawmakers should prioritize policies that lower the country’s debt-to-GDP ratio the most.

The bottom line: improving the country’s fiscal situation won’t be comfortable, but economic growth can help cushion the blow.

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