1) Large government debts in many countries following the Great Recession are associated with slow economic recoveries compared to Germany which avoided a large rise in debt. 2) High debt raises fears that fiscal imbalances will be addressed through tax increases rather than spending cuts, discouraging investment and growth. 3) An economic model shows that expected future US tax increases could quantitatively account for the downward shift in US growth from its historical trend, supporting the hypothesis that high debt and taxes weaken recoveries.

1. Government Debt, Taxes, and the
Weakness of the Global Recovery
Carlos E. J. M. Zarazaga
Federal Reserve Bank of Dallas
Research Economist and Policy Advisor
The views expressed herein are those of the author and do not necessarily reflect those of the Federal Reserve
Bank of Dallas or the Federal Reserve System.

5. By contrast, real GDP is back on its pre-recession trend
in Germany...
Index, 2001Q1=100
130
125
120
115
110
Germany
105
100
95
'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

7. ... and whose Net General Government Debt
has NOT risen much
Percent of GDP
60
55 Germany
50
45
2005 2006 2007 2008 2009 2010 2011

10. Large government debts seemingly
associated with slow recoveries
• Comparison with Germany suggests the
hypothesis that the burden of large
government debts is impairing economic
recovery everywhere else.
• Hypothesis consistent with historical evidence
examined by Reinhart and Rogoff in recent
controversial paper “Growth in a Time of
Debt” (American Economic Review Papers and
Proceedings, 2010.)

11. Why large government debts can
induce anemic recoveries
• Large government debts raise specter fiscal
imbalances will be addressed with tax
hikes, rather than spending cuts.
• Prospect of tax hikes discourages investment
and employment.
• Economy grows at same historical rate as
before, but along a trajectory significantly
below the one that it was following before the
recession.

12. U.S. economy traveling at historical average speed,
but now along the lower deck of the highway
Index
Index, logarithmic scale
1.4
1.2
1
U.S. real GDP 2011
0.8
0.6
0.4
0.2
0
1980 1985 1990 1995 2000 2005 2010 2015 2020

13. Higher taxes and the weakness of the
U.S. economic recovery
• Can fear of higher taxes account quantitatively for the
downward shift in the trajectory of U.S. real GDP?
• Yes, according to economic model designed to answer the
question.
– Technical details in “Fiscal Sentiment and the Weak Recovery
from the Great Recession: A Quantitative Exploration,” by Finn
Kydland and myself. Forthcoming in Dallas Fed Working Paper.
• Model incorporates Congressional Budget Office—a non-
partisan agency—assessment of U.S. fiscal situation:
– To bring back Debt-GDP ratio to 50% levels recorded in mid
1990s, fiscal deficits must be reduced by about $3.8 trillion over
the next decade (CBO’s Director Testimony Before the Joint
Select Committee on Deficit Reduction on 9/12/2011).

14. Tax policy assumed in the model
• Economic agents in model assumed to expect a switch to a
higher tax rates on capital income regime, with the following
features:
– Between 2013 and 2022:
• capital income tax rates go up above current ones by as much as
necessary to reduce fiscal deficits in amounts suggested by CBO:
– $3.8 trillion over ten years, or
– 2.5% of GDP per year, on average.
– From 2023 on:
• capital income tax rates go up above current ones by as much as
necessary to generate additional revenues of “only” 0.3% of GDP per year
(to cover permanent increase in Social Security payments induced by
demographics.)

16. Are tax rate hikes of the implied
magnitude plausible?
• Yes.
• Some capital income tax rates will jump as
much as 20 percentage points in 2013 under
current law:
– top dividend tax rate from 15% to 43.4%.
– estate tax rate from 35% to 55%

18. Conclusions
• Recovery from Great Recession particularly weak in
countries with high and growing levels of
government debt.
• Fears that fiscal imbalances will be resolved with
higher taxes one of the potential causes.
• A model calibrated to the U.S. economy suggests
dangerous to summarily dismiss the hypothesis:
– Choosing higher taxes on capital income as the best
solution to fiscal imbalances might also mean keeping
many world economies traveling along the lower deck of
the highway for many years to come.