Front Page Titles (by Subject) 5.6.: The Power to Borrow - The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution)
Return to Title Page for The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution)
The Online Library of Liberty
A project of Liberty Fund, Inc.
Search this Title:
5.6.: The Power to Borrow - James M. Buchanan, The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution) 
The Collected Works of James M. Buchanan, Vol. 9 The Power to Tax: Analytical Foundations of a Fiscal Constitution, Foreword by Geoffrey Brennan (Indianapolis: Liberty Fund, 2000).
About Liberty Fund:
Liberty Fund, Inc. is a private, educational foundation established to encourage the study of the ideal of a society of free and responsible individuals.
Foreword and coauthor note © 2000 Liberty Fund, Inc. © 1980 Cambridge University Press.
Fair use statement:
This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.
The Power to Borrow
In the earlier section on Leviathan’s time preference, we examined restrictions on government’s ability to lend and hoard as a means of influencing its choice between alternative tax instruments. At that point, we deferred discussion of the power to borrow. The reason for separate treatment of government borrowing is that while this instrument may, of course, provide a means for Leviathan to allocate desired revenue use intertemporally, its major importance stems from the fact that public debt offers an additional revenue source in its own right.
A government’s power to borrow (to issue debt) is a power to create current assets which carry an obligation for governments in future periods to pay to the holders of those assets (government bonds) designated sums, presumably to be financed from the tax revenues collected in those future periods. For purposes of meaningful analysis, we shall assume that debt obligations must be honored. A government observed, or even expected, to default could not readily market debt instruments.
The total amount that a government can borrow is or may be constrained in three ways: (1) by the ability of the government to service and redeem the debt—that is, the future revenue capacity assigned to government defined by its constitutionally allowable taxing powers; (2) by the relative preferences of individuals as between government bonds and other assets; and (3) by the general extent to which individuals wish to postpone current consumption (and acquire assets). These possible constraints may be separately discussed.
In the first place, the power to create bonds is futile unless the government also has power to tax. The power to borrow in itself assigns to government no power that is not already embodied in the assigned revenue instruments to which it has access. What the power to borrow permits government to do, within the limits imposed by the other constraints mentioned, is to appropriate now, in some current period, rather than later, the capitalized value of the future revenue streams. Under “perpetual Leviathan” the chief significance of such borrowing power is its effect on the time stream of public spending rather than the aggregate level. The situation becomes dramatically different under probabilistic Leviathan assumptions. Here, the power to borrow implies that the revenue-maximizing government, finding itself in office and not anticipating to remain, may, by means of borrowing, appropriate to itself the full value of tax revenues in all future periods, including those in which such a Leviathan is no longer operative. In other words, the power to borrow effectively transforms the “probabilistic Leviathan” into “perpetual Leviathan” from the viewpoint of the potential taxpayer at the constitutional stage—or at least does so up to the point at which the two other constraints mentioned become operative.
We should note, however, that the time-stream effects of borrowing—under perpetual Leviathan—may indeed be desired, under certain conditions. A recurrent theme in classical (i.e., pre-Keynesian) public finance is the idea of “extraordinary expense” (e.g., wars) and the extraordinary revenue devices that might be restricted to the financing of expenses of this type. Here, constitutional provision limiting government access to potentially large and multiperiod revenue sources might take the form of restricting the use of such sources to periods of fiscal “emergency.” The precise definition of such emergency situations is, of course, highly problematic. One would hardly wish to grant Leviathan ready access to enormous fiscal powers by the simple expedient of declaring a state of emergency. Nor would one wish government to have positive incentives to create emergency situations with an eye to their revenue implications. For these reasons, borrowing may be precluded altogether: the legitimacy of its use under the “extraordinary expense” rubric may be simply too dangerous.
Limits to governmental power to borrow, and hence to lay claim to future revenue streams, may also be set by “supply” characteristics of assets markets. If the marginal return on investment declines over quantity, government will find it necessary to pay higher and higher rates on its bonds as it increasingly displaces private investment opportunities. Future government revenue may be exhausted before all private assets are replaced by bonds.10
Finally, limits are set on the ability of government to sell bonds by the maximum level of the community’s capital formation. In Figure 5.5, the maximal capital accumulation for the representative individual depicted is given by AM′—the level of savings when the price-consumption curve reaches its minimum at M. Whatever the level of future tax revenues, government cannot acquire more from this person than that level of savings in the current period. But can the governmental Leviathan, finding itself in power for a single period, extract this maximum from the individual as long as we continue to assume that bond purchases are voluntary?
The answer to this question depends critically upon the reaction of the individual concerning the future-period taxation that current-period debt issue purchase implies. If the individual fully discounts the future-period liability that any current-period debt issue embodies, he will recognize that he can escape at least some portion of this liability, in present-value terms, by consuming more in the initial period. In this setting, public debt issue becomes equivalent to the capital levy in our two-period model previously discussed. The maximum revenue that can be secured from the sale of bonds in period 1 is the amount measured by AS in Figure 5.5.
However, much more revenue may be secured by debt issue if the individual does not discount future tax liabilities and modify his consumption-saving behavior accordingly. If the individual whose choice calculus is depicted in Figure 5.5 acts solely in response to the apparently attractive offers of interest returns on bonds, he can be induced to purchase bonds in the maximal limit indicated by the distance AM′, the limit at which saving from current-period income is maximized.
When we consider government borrowing, it is also necessary to distinguish between internal and external sources of funds. Such a distinction is not necessary in the treatment of alternative tax arrangements, since government’s power to tax externally is prima facie implausible, at least directly.11 But borrowing involves a voluntary exchange between government and bond purchasers (lenders), and there is no apparent constraint against the sale of bonds to foreigners. This prospect of external debt has important implications for the maximum amount of revenue that Leviathan might raise in a single period, regardless of the possible individual anticipation of future tax liability embodied in such debt. In this case, there is an important distinction between allowing government to have access to internal and external borrowing. If Leviathan can sell debt instruments externally, there is no way that the individual can make offsetting behavioral adjustments even if he fully anticipates the future-period tax liabilities. And if no such anticipation occurs, the maximal saving does not limit debt issue as in the internal debt case.
How much can Leviathan borrow in such circumstances? The limits here are those imposed by the full capitalized value of future-period tax revenues. The governmental Leviathan, finding itself in office, can levy revenue-maximizing current-period taxes and, in addition, can appropriate the present value of all future tax revenues. This finding suggests that the total “burden of debt” will potentially be much larger under external than under internal debt, simply because more debt will be issued in the former case. Constitutional constraints on the ability to borrow externally would, then, tend to be more restrictive than constraints on the ability to borrow internally. But in both cases, the power to borrow implies the assignment to Leviathan government of the power to gratify revenue appetites over the indefinite future, when that Leviathan government is no longer operative. One would, therefore, expect that restrictions on the power to borrow would be particularly severe.
[10. ] Leviathan may be able to compel individuals to buy bonds, or by use of tax or other concessions induce them to do so. We do not examine coerced purchase here.
[11. ] See the discussion in Chapter 9 on possible tax exportation within a constitutional choice perspective.