Archive for February 28th, 2013

what limits public debt

The fiscal cliff is coming back. If no agreement is reached prior to March 1, $85 billion in automatic spending cuts will take effect. That is just 2.3 percent of the total federal budget but enough to cause a stir.

Thus it might be of interest to review a study by two Swiss economists, Eichenberger and Stadelmann, in the Review of Law & Economics.

How Federalism Protects Future Generations from Today’s Public Debts

Their paper deals with a phenomenon called ‘capitalization’ and goes back to an article by Wallace E. Oates in the Journal of Political Economy in 1969 (link). The idea is that demand for property is negatively affected by taxes. That is to say, in areas with high taxes, property prices should be lower. And since taxes have to grow with the public debt burden, property prices should be lower in communities with higher debt. This observation has been described as government debt capitalizing into property values.

Eichenberger and Stadelmann argue that this debt capitalization in property values is more pronounced in case of local government debt (as compared to federal debt). This is because people can move to another community more easily than to another country. Thus, if a community is highly indebted, property prices have to decline substantially for people to decide to live and work there (they know that the government must raise taxes in order to pay for the debt). As a result, people who own property and pay taxes to their local community have a smaller incentive to vote in favor of debt-financed government expenditures.

The study concludes:

Debt capitalization provides for a natural and more effective brake for government debts at the local than at the central level. Thus, decentralized countries with a larger local budget share can be assumed to be less prone to opt for deficits and debts than centralized countries.

The United States, however, has moved away from being a nation of fifty fiscally individual states. Since 2000, government expenditure as a share of GDP has increased by only 1 percentage point at the state level, while growing 7 percentage points at the federal level (source). If this trend continues, the next fiscal cliff is just around the corner.

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