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The Deceptive Debt Ratio

By Erik Voorhees - June 8, 2010 2:18 PM

National debt clock

Image via Wikipedia

The United States has a growing debt problem. It also has a problem measuring the same. The statistic normally used is the "Debt to GDP" ratio, referring to the amount of debt versus the nation's sum total of transactions. As of Q1 2010, the US debt to GDP ratio was 87%. However, the Debt to GDP ratio should be ignored, because it is meaningless.

It is worse than meaningless, because it disguises the true problem and lulls us into a false sense of solvency. Why is Debt to GDP a poor metric? Because the debt must be paid off with the income from taxation. It cannot be paid off through some relative percentage of economic expenditure. This is an important distinction. The debt is not serviced from a portion of the economy's activity as a whole; it is serviced from tax revenues. As such, the ability to repay debt is based on tax revenues, not on the GDP.

It cannot even be said that a growing GDP will necessarily assist in the payment of debt. Consider that when the Government spends money it increases the GDP side of the ratio, thereby helping to minimize the appearance of its own debt! In other words, if Washington spent four gazillion dollars, our Debt to GDP would only be about 100% (roughly 4 gazillion in debt and roughly 4 gazillion in GDP). This is only 13 percentage points higher than our current level. Greece could actually decrease its Debt to GDP ratio by spending 4 gazillion Euros - from its current 125% to a much more manageable 100%. Debt to GDP is a highly deceptive metric.

"Debt to Tax Revenue" is a much better statistic for examining government debt (it is also much more accurately calculated). If the Government owes $1 trillion (wouldn't that be nice?) and takes in half a trillion in tax revenue, then the Debt to Tax Revenue ratio would be 2:1, or 200%. Using all tax revenue to service the debt, it could be paid in 2 years (if, of course, all other government services were canceled for those two years).

Using this much more honest metric, how does the US fare? There exists currently about $12.7 trillion in national debt (this doesn't include state debt nor unfunded future liabilities). The 2008 tax receipts were $2.5 trillion (2009 data is not yet available). Thus, the Debt to Tax Revenue ratio is roughly 12.7:2.5, or 508%. Put another way, it would take 5.08 years' worth of taxes to pay off the debt assuming every single federal program was cancelled during that time. Not even the Washington accountants administering the debt payments would receive a paycheck. Soldiers in Iraq would receive neither pay nor ammo nor a plane ticket home. Everything would have to stop, and it would still take over half a decade to pay the debt. This is akin to an individual spending absolutely nothing for 5 years in order to pay off his credit cards. Within a few weeks he'd be dead of starvation.

Let's compare with Greece. Greece currently has $405 billion in national debt, with the CIA estimating its most recent tax revenue at $108 billion. Greece therefore has a Debt to Revenue ratio of about 375%. Take California, the state everyone knows is already bankrupt - it had a debt in 2008 of $122 billion and 2008 revenue of $151 billion, creating a Debt to Revenue ratio of only 81%. Relative to tax revenue, both Greece and California are significantly better off than the US Federal Government.  Yet, that's not the impression people get when observing erroneous Debt to GDP figures.

Spending more of one's money does not make one more credit worthy, yet that absurdity is propagated when we use the nation's Debt to GDP ratio as our gauge of solvency. If every citizen went out and bought a car this year, the GDP would skyrocket, and suddenly the Government's debt ratio would fall. Does anyone really believe that a better fiscal situation would have been attained? No. In fact, a much worse situation would exist, because Americans would be then less able to pay for other expenses - such as government debt - after purchasing the new car.

In short, we are currently measuring sovereign debt with an arguably deceitful statistic. Whether one believes that the Federal Government should increase or decrease spending, we should all agree that dishonest accounting is not a policy of prudence.

Debt to GDP examines debt based on a nation's volume of transactions. It therefore suggests that debt burdens can be reduced to the extent we consume. How does that make any sense? Conversely, Debt to Tax Revenue examines debt based on a government's ability to pay it back.

We should not be surprised that the Government uses the ratio which paints the rosier, though much less accurate, picture.


Erik Voorhees is a frequent commentator on political economics through his blog at OnLifeAndLiberty.com and a member of The Free State Project (freestateproject.org).

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2 Comments

No matter. It will all come crashing down eventually. Every 'democratically' run society has committed suicide in this way, provided that they didn't succumb because of military weakness first.

Off topic but extremely enlightening:

Are You Smarter Than a Fifth Grader? Self-identified liberals and Democrats do badly on questions of basic economics.

Full-article: http://online.wsj.com/article/SB10001424052748703561604575282190930932412.html?mod=WSJ_Opinion_LEADTop#printMode

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