Difference between Taxation and Borrowing

This article will help you to learn about the difference between taxation and borrowing.

Difference between Taxation and Borrowing

The primary difference between borrowing and taxation is that the former allows each person greater freedom in choice of time for downward adjust­ment of private sector consumption. With taxation he has to make the adjustment immediately.

But with borrowing, he may make it now if he wishes (reducing his spending and using the funds to purchase bonds and thus offset his liability for public debt) or he may defer his reduction in spending to a future date, when his taxes are higher because of repayment of principal along with interest. (In fact, tax liability of an individual automatically increases when the government makes debt repayment from its tax revenue.)

If he follows the former alternative, borrowing offers no advantage. But the borrowing technique alone gives him the advantage of postponement. From the government’s point of view the borrowing method is advocated on the ground that the government can borrow more cheaply than individuals because of lesser risk.

In fact, consumption is reduced much less and, under conditions of full employment, investment is reduced much more by borrowing than by taxation. This is so because there is diversion of funds from the private to the public sector. More government bonds are purchased by people and less of private credit instruments (like equities or preference shares) due to wealth constraint.

However, under conditions of full employment borrow­ing, like taxation, reduces private sector spending as smaller sums are available for consumption or investment; the difference is the greater impact upon the investment relative to consumption.

Moreover, if the government borrows idle funds, total private sector spending will not fall. If, in such a situation, the velocity of circulation increases, there will be price inflation as in the case of money creation.

The heavier relative reduction in investment results, in a sense, in a portion of the burden of current governmental activities being transferred forward to future generations. This is because the future generations will inherit fewer capital goods and their per capita output will low.

This reasoning is valid only with full employment; with unemployment, financ­ing of governmental activities may increase total spending in the economy because the funds would not have been used either for consumption or investment; thus both investment and consumption may increase through absorbing unemployed resources.

Borrowing introduces a much greater degree of uncertainty about each person’s ultimate tax liability. If the current tax approach is used uncertainty is lessened but not entirely removed. The significance for one’s decision will depend upon one’s estimates of future tax liabilities.

If a taxpayer believes that he is likely to pay less in the future than he would pay now, he will have greater preference for borrowing. This attitude may be found on the part of persons close to retirement age. On the other hand, if a person expects his tax liability to rise, as would younger persons expecting increases in their incomes, he will be less sympathetic toward borrowing.

James Buchanan argues that a prime reason persons oppose borrowing is their fear that other persons will not prepare themselves for payment of their share of the debt, and thus one who succeeds will bear a disproportionate amount. Accord­ingly they prefer taxes which others cannot escape.

A final influence that affects the choice between borrowing and taxation is people’s concern for two things:

(i) the interest burden created by the borrowing and

(ii) the significance of both the interest and the debt for the functioning of the economy.

While any individual may escape his share of the interest cost by reducing his consumption immediately — as he would do if he were taxed — and buying bonds, most persons appear not to consider this alternative.

Moreover, a debt may have adverse consequences for economic development. Taxes necessary to pay interest charges may retard investment and fear of public debt, and interest payable on it may confidence-reducing People may also fear that a heavy outstanding debt may deter establishment of new industry.

In short, people will be most inclined to favour borrowing in preference to taxation:

1. When financing by taxation would require a sharp temporary cur­tailment in consumption.

2. When they expect their own tax liabilities to be less in the future than at present.

3. When they feel that shifting of burden to future generations is desirable, either as a simple device to escape tax or because the expenditures will yield benefits in the future.

Their preference for borrowing will be greater:

1. The lower the interest rate level and thus the interest burden.

2. The less the fear that borrowing and the debt will have undesirable consequences for the economy.

3. People are confident that the government will not continue to bor­row in future.

In short, a part from use in periods of unemployment as an instrument of fiscal policy, borrowing is primarily confined to:

1. Financing of local government capital investment projects believed to be of a non-recurrent nature, yielding their benefits over long periods of time.

2. Financing of wars or sudden increases in spending on defence or on other activities that would necessitate very sharp increases in tax rates and drastic curtailment of consumption.

3. Financing deficits when governments are subjected to strong de­mands for services yet equally strong opposition to tax increases. Such borrowing does not usually continue for long periods.