There are four potential problems with public debt that we should be aware of:
1/ Repayment of the debt affects income distribution in that working taxpayers will be paying interest to those who hold the debt. If those who hold the debt are primarily in the upper-income groups, income distribution may be made more unequal;
2/ If the tax burden of paying the interest on the debt becomes excessive, it may damage incentives to work, save, and invest;
3/ Debt owed to foreign investors could increase the nation's burden since interest payments leave the country;
4/ Some public borrowing may "crowd out" private borrowing. The crowding-out effect is the notion that government borrowing to finance a deficit may crowd out or reduce private borrowing. To the extent that this occurs, the expansionary impact of fiscal policy is reduced because increased demand by the government is partially offset by reduced demand in private investment.
Are we passing the burden to the future generation by incurring public debt?
Assume that the marginal propensity to consume is 0.75 for the economy. How does the effect of a discretionary cut in taxes of $40 billion on the economy differ from a discretionary increase in government spending of $40 billion? Based on your answer to this numerical question, do you agree with the statement, "Increasing government spending is preferred to a cut in taxes when the US government seeks to fight a recession"?
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