Confronting the lazy consensus on debt burdens
Peter Warburton - 1 July 2019
The return of crazy lows in government bond yields tempts the thought in some quarters that debt burdens could safely be increased: mortgages on bigger income multiples, higher credit card limits, larger EBITDA multiples for private equity deals. As an antidote to this insanity, in the June Market Focus we have examined developments in debt service ratios (DSRs) for the private non-financial sector in 31 countries. Even if policy interest rates are held close to current levels, we maintain that household and corporate interest rates will normalise to reflect rising credit risks in the global financial system, as debt defaults increase. Countries for which the combined private sector DSR remains at or close to multi-year lows (including US, Japan, Germany, UK, Italy, Spain, Portugal and Denmark) look especially vulnerable to a DSR reset over the next 2 or 3 years. Countries whose private sectors are already bearing higher DSR levels look better placed to ride out the next credit storm. These include Switzerland, Canada, France, Korea and Malaysia.
The structural increase in personal and corporate debt-to-income ratios since 1980s represents an important constraint on the scope of taxation. Interest rate suppression (and yield curve control) artificially lowers the cost of debt service for households, non-financial companies and, of course, government. However, rate normalisation – which can be policy-led or credit market-led – implies rising debt service ratios and painful debt dynamics for those who have grown very comfortable with bargain basement borrowing costs. Moreover, rising private sector debt service ratios exert downward pressure on tax yields, depriving households of disposable income from which consumption and indirect tax revenues derive. The twofold fiscal stress of a rising public sector debt service burden and a diminished scope for tax collection creates the potential for an explosion in the budget deficit.
The critical variable in this analysis is the DSR, the share of current income used to service debt, given interest rates, principal payments and loan maturities. It provides a more comprehensive assessment of credit burdens than the debt-to-income ratio or simple measures of interest payments relative to income, because it takes both interest payments and amortisation into account. There is a striking contrast between private non-financial sector DSRs for advanced economies. Whereas there is a clustering of Eurozone countries in terms of tax burdens, there is wide dispersion in private sector DSRs, ranging from Germany (9.7 per cent) to Netherlands (27.5 per cent).
What evidence is there that rising DSRs inhibit additional tax collection? The personal burden is composed of direct taxes (mainly on gross income) and indirect taxes (mainly sales taxes and customs and excise duties). A priori, the higher is the DSR, the lower is disposable income and consumer spending, and hence indirect tax receipts. Based on an average personal income tax burden of 20 per cent, levied on gross income, an indirect tax rate of 20 per cent levied on total consumer spending and a personal saving rate of 5 per cent of gross income, then the total tax burden of the personal sector would be 33 per cent for a DSR of 10 per cent and 30 per cent for a DSR of 25 per cent.
Empirically, we find (figure 1) is that the marked reduction in household debt service ratios from 2008 to 2014 has created the headroom for household income tax burdens to be increased as part of the attempted fiscal normalisation after the global financial crisis. The UK is a noticeable outlier, in that a decline of more than 3 percentage points in the DSR was not accompanied by an increase in the income tax burden for households. This reflects the pledge of the 2010 coalition government to restore the real value of the basic income tax threshold.
Clearly, elected governments are free to act independently in the face of a rising or falling DSR. However, there is evidence that governments have been opportunistic in their response, lifting the household income tax burden after a fall in DSR and at least moderating the tax burden when DSRs are rising.
Data sources: Bank for International Settlements and OECD
NB Change in household income tax burden (income tax receipts as a percentage of GDP) is calculated as the maximum value in 2014-16 minus the minimum value in 2008-10. Underlying regression: ΔHITB = 1.05 – 0.234 ΔDSR
Share on LinkedIn: