Beware, budget deficits can increase inequality
There’s been much talk about the Trudeau government’s attempts to enact redistributive policies, which would reduce income inequality in Canada. One think-tank in Quebec surveyed a panel of 70 policy experts (I contributed as a dissenter from the majority opinion) who noted that the latest federal budget would, on the whole, reduce inequality.
However, it’s rarely considered that the way these measures are funded may end up increasing inequality. More precisely, deficit financing can increase inequality in the long run.
Consider any government that decides to run a deficit by increasing spending. When it goes into deficit, it must sell government bonds to borrow the funds. Imagine those who buy these bonds are the richest in society. However, the burden of the debt financing falls on the whole population—everyone pays taxes. In such a case, the debt redistributes resources from the entire population to the wealthy holders of government debt. When (or if) the government decides to buy back those bonds to reduce the debt, it will also have to use tax revenues to do so. As a result, a transfer will occur towards the richest in society. In essence, it’s thus a regressive policy bound to increase inequality as long as those who buy the bonds are the richest.
We have a strong historical example of this—England during the 18th and 19th centuries. From the early 18th century until 1815, England is intermittently at war with the rest of Europe and wars are costly. England finances these wars mostly by borrowing on financial markets. By 1815, when they defeat Napoleon at Waterloo, the public debt is two-and-a-half times larger than the whole British economy. That proportion is larger than the one observed with the two World Wars. This was a massive debt – largely funded by wealthier British households.
Simultaneously, taxes increased rapidly and applied to a wide variety of goods and services, which the poorest in England consumed. These poorer households paid the taxes necessary to service the debt. Even when the wars were over, they had to keep paying. It’s thus unsurprising that economic historians observe rising income inequality over the period.
But wait, there’s also modern evidence that corroborate this finding—that large and persistent deficits, which increase the public debt, also impact the distribution of income. This is why some scholars find that reducing the deficit by reducing the forms of public spending that are most detrimental to economic growth actually lead to reductions in income inequality. More importantly, the evidence is clear that, over time, government securities have been increasingly held by the richest. For example, in the United States, the richest one per cent of taxpayers held close to 15 per cent of government securities in 1970. Today, that proportion stands closer to 45 per cent. With such proportions, there’s again room to consider that deficits could very likely increase inequality.
To be sure, this outcome depends on how progressive is the taxation (i.e. how much government revenues come from the richest) and who benefits from the additional government spending. Governments could reduce inequality by taxing the rich more heavily.
There is, however, one downside from this and one thing to keep in mind. Taxes on the wealthy often translate as taxes against investment and innovation, which slows future economic growth. While this reduces inequality, it also makes the poorest worse off by slowing down the improvement of their conditions. More importantly, one must bear in mind that income stemming from securities gives the richest the ability to alter public policy in ways that benefit them. For example, they are better able to push for key loopholes in the tax code. Thus the status of bondholder grants greater political strength in ways that may reinforce inequality.
There’s uncertainty regarding the net effect on inequality, but there are good reasons to believe that deficits could increase inequality. Given this uncertainty, it seems reasonable that governments—including our current federal government—should pause and consider that we may be doing more harm than good with recurrent deficits.