This paper analyzes the relationship between budget deficits and future economic growth, arguing that while deficits can stimulate short-term growth, they ultimately constrain long-term expansion by diverting future tax revenues to debt service. The paper distinguishes between productive deficit spending—such as investments in education, infrastructure, and defense innovation—which may generate returns exceeding their cost, and wasteful spending that transfers wealth from future generations without economic benefit. The analysis examines job training, defense spending, and tax policy as case studies, concluding that the composition of deficit spending matters critically: policies must be evaluated against their opportunity costs and ability to generate future revenue growth to justify the constraints they place on the economy.
Budget deficits today will tend to lower the rate of growth in the economy in the future. Budget deficits result in higher rates of public debt. While the United States borrows at very low rates, it nevertheless must pay interest on its debt, and it is that interest that represents a burden on future growth. What happens is that future tax receipts must be used to pay interest and principal on debt created by today's deficits, instead of being invested back into the country in the future. Thus, while running a deficit may create positive economic growth today, it does work to constrain future growth by placing constraints on the amount of future national income that can be dedicated to growth.
The reasons for the budget deficit definitely matter. As with any spending, there is a difference between spending on things that will build revenue growth for the future and investing in things that will not contribute to such growth (Auerbach & Gale, 2009). For example, investments in education and infrastructure will contribute to future growth, because better infrastructure and smarter people are capable of higher levels of productivity and efficiency. A nation's capital includes all of its resources, so in general any investment on the part of government that either improves the quality of those resources (such as education) or the ability of people within the economy to access those resources (such as improved transportation infrastructure) is an investment that contributes to future growth. Thus, the investment made today has a payoff in the future. As with any debt, if the debt taken today can be paid off using the proceeds of today's investment, then the debt is going to be worthwhile.
By contrast, spending that does not contribute to future growth—such as wasteful expenditures on unnecessary items—is not beneficial to the economy in the long run. In general, any debt that is not invested in something that will have a payoff greater than the cost of the debt is not worthwhile. Thus, if a government needs to spend money on projects that will have a future payoff greater than the cost of that debt, otherwise the debt is unwise. It definitely makes a difference what the deficit spending is spent on.
The defense budget is always a little bit contentious with respect to its merits as an investment. Certainly, there are some good investments. Most defense jobs are for Americans, both in the active military and among military contractors. Many defense jobs are well-paying, due to the amount of engineering work on building military hardware and the emphasis on information systems in modern defense. In creating so many well-paying jobs, the federal government is not only creating such direct employment, but there is also considerable indirect employment created as well, because those well-paying jobs support entire communities' worth of service industries.
In addition, defense spending has led to considerable innovation, which improves the multiplier effect for defense spending significantly. Silicon Valley, which is the global hub of the information age, began with engineers working on defense projects. The Internet, aerospace, and other hardware and information systems industries were spawned by federal defense spending. Technologies developed by Department of Defense contractors are repurposed for commercial uses. Even the automobile and steelmaking industries benefited significantly from World War II-era defense spending and emerged from the war as world leaders in their respective fields. While there might be some wasteful spending on defense, and there is definitely some spending on national security interests that is not evaluated on strictly economic terms, it is likely that on balance, defense spending is a net positive for the economy.
Tax policy is one of the more contentious forms of fiscal policy, especially with respect to its benefits. Deficit spending for tax breaks is only useful if those tax breaks spur either an increase in consumer spending or an increase in business investment. For example, a tax break on the working class, given that the savings rate is around 3.8% (FRED, 2012), is going to be spent, providing a short-term economic boost. This short-term boost is not worth deficit spending, however, if the boost does not lead to long-run economic growth. It might not, especially if there is considerable slack demand in the economy or if businesses perceive the boost to be temporary in nature and moderate their investments accordingly.
Taxes on the wealthy are less likely to be spent, since the wealthy have lower income elasticity of consumption, but they are likely to be invested. If the investments are overseas, as can happen with the ultra-wealthy, or if the investments do not spur a long-run boost to the economy, then the tax break would have been a poor use of deficit spending.
All forms of fiscal policy need to be weighed against their opportunity cost. The payoff associated with a policy is the critical factor in determining whether that policy is an effective use of deficit spending. Fiscal policies are directly responsible for the state of the budget deficit, because fiscal policies directly address both the revenue side of the budget (such as taxes) and the expenditure side.
By contrast, monetary policy only has an indirect role in the budget deficit. Monetary policy, which affects the cost of money and the amount of money in the economy, contributes to the overall health of the economy. This in turn affects a number of factors that contribute to the budget. For example, when the gross domestic product is rising at a healthy rate, tax revenues are also going to increase, which helps lower the budget deficit. If unemployment is falling, that also will increase tax revenues because there are more income-earners paying taxes. Again, that would lower the budget deficit. Thus, monetary policy contributes to the budget deficit in an indirect way, whereas fiscal policy contributes directly.
"Deficit justification depends on whether future revenue exceeds costs"
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