Once the government has decided to spend money, it needs to finance that money. The money is primarily raised by taxes and debt. One of the problems of using debt is that the government has to pay interest on the debt. Those interest payments represent the main cost of the debt. There are other costs, like the cost of selling the debt, but those costs are negligible - it turns out our government can auction off billions of dollars worth of treasury debt for a miniscule fraction of the money raised.
Many people don't realize that there are also costs associated with taxes. According to a report by the Tax Foundation, the cost of complying with the income tax code in 2005 represented 22 percent of the income taxes collected from individuals, businesses, and nonprofits. That's an estimated compliance cost of over $265 billion for $1.2 trillion in federal income taxes collected. That's a lot of money!
However, before we can compare the compliance costs of taxation with the costs of debt, there are a few considerations that must be addressed. The Tax Foundation's mission is to put out alarmist reports like the one above in order to illustrate to the world that the tax code should be greatly simplified and the tax burden reduced. All well and good as far as I'm concerned, but let's face it - they have a very strong underlying bias. I've studied the report and I think (but admittedly haven't verified) that they've overestimated a number of the compliance costs. Nonetheless, I also think that the basic concepts of the compliance costs described in the report are sound. I think that if their compliance cost number is cut in half it's probably a reasonable estimate. So let's assume 11% instead of 22%.
The next issue to be considered is the difficulty in determining the marginal costs of collecting another dollar in taxes instead of borrowing it. The compliance cost for the next (or last) dollar collected may cost far more or less than the first dollar collected. The Tax Foundation's report does not address this, there's no such data available, and there's no easy way to calculate the marginal cost of the next tax dollar.
However, I think a linear approximation is justified and possibly even conservative. The reason lies in figuring out why there are nearly 1.3 million words in the federal tax code. The primary factor, I believe, is that the collected income tax is such a huge amount of money, that it's worth it for every politician, every lobbyist, every business, and every special interest group to fight over it and carve out special favors for themselves. As the amount of money has increased over the last decades, so has the size of the tax code in an almost lockstep fashion (see Figure 3 on page 5 of the report). Thus, the more taxes collected, the more it will cost to comply.
The United States pays a real interest rate of between 2% and 4% per year on its treasury instruments. So using my 11% estimate, when choosing between taxes or debt, it takes about 4 years for debt to start costing more than taxes to collect. That's assuming that having that extra 11% available in the private sector yielded absolutely no other benefits for those 4 years, such as the benefits that usually accrue from capital investment, the stimulation to economy from the demand side, and the resultant creation of new knowledge and intellectual property that arise from the combination of the supply and demand side stimuli. But those benefits (which are actually much more important), I'll visit in another post.
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