The Effect of Servicing the Public DEBT on Private Capital Formation

Abstract

This article employs a life-cycle model of consumption and U.S. time-series data covering 1929-1969 to estimate the long-run impact on capital formation of substituting one dollar of debt for a dollar of taxes to finance a given level of government spending. The income redistribution effects of debt service are shown to be critical to analyzing the impact of public debt upon saving and capital formation. The results indicate that one extra dollar of domestic debt induces a twenty-one cent rise in capital formation; an extra dollar of foreign-held debt has a nil effect. The positive impact on capital formation occurs because the negative wealth effects of taxes levied to finance debt interest causes an increase in saving that overbalances the induced fall in saving caused by the positive wealth effects of debt interest. In the case of foreign borrowing, the two effects just cancel each other.

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