Year: 2025
Type: article
Abstract: Federal debt can grow over time but not faster than GDP in the long run.Revenue must cover spending plus interest owed on the debt.Calculating the tax increase required to stabilize the debt-GDP ratio after 30 years requires estimating primary deficits (not including interest payments), borrowing rates r and growth rate g for many years after the Congressional Budget Office's (CBO, 2025a) 30-year projection.CBO never reported a stabilizing rate.I am sure that Edelberg et al. (2025) reasonably extrapolated CBO data to estimate their 3% GDP value.But modest changes in assumptions create large differences: A 100% debt-GDP ratio and a 300% debt-GDP ratio could both be reasonably estimated to require the same future 3% of GDP, or even 6% or 9%. 1 Using a microsimulation (not OLG) model, where the first decade was purposely aligned to CBO's (including CBO's no growth of discretionary spending 2 ), Gokhale and Smetters (2024) estimated a permanent 6.6% GDP shortfall in 2024 when the debt-GDP ratio was 98%. 3 The Government Accountability Office (GAO, 2024) projected a debt-to-GDP ratio of 229% by 2054.CBO (2025b) projected ratios "exceeding" 250% by 2055 under assumptions that are reasonable and even more consistent with the reduced-form literature.Uncertainty is common in long-term projections, and debates over reduced-form parameter values can be endless.Moreover, a standard insight from the field of finance is that more probability weight should be placed on worse outcomes.4 Otherwise, eliminating the tax system altogether would be optimal.5 1 Stabilizing the debt-GDP ratio requires a tax that covers future spending plus an "r -g tax" times existing debt.In words, federal debt can grow over time but not faster than GDP.Primary deficits (not including interest payments) are also large and must be projected.2 By law, CBO is required to model the first decade as having no real growth in discretionary spending, thereby falling relative to GDP.3 That shortfall is equivalent to either increasing all federal taxes immediately and forever by 30% or decreasing all federal spending immediately and forever by 25%, or some combination.4 The reduced-form exercise is a risk-neutral pricing calculation that would normally recognize that the government borrowing rate is not risk free beyond its average duration.Same is true with the economic growth rate and the marginal product of capital (and, hence, the equity premium).Risk-neutral pricing kernels place more weight on worse aggregate outcomes to produce a single risk-adjusted number.5 Without risk adjustment, the government should simply issue debt, invest the proceeds into the stock market, and use the expected difference to finance its operations.
DOI: 10.1002/pam.70039
Author: Kent Smetters
Institution: University of Pennsylvania
Language: English
Subfield: Economics and Econometrics
Domain: Social Sciences
Open Access status: hybrid
Estimated APC paid: $3,770
OpenAlex ID: W4413285508