Nov. 16 (Bloomberg) -- As President Barack Obama and congressional Republicans seek to resolve the so-called fiscal cliff, the combination of automatic tax increases and spending cuts scheduled for next year, a mutually agreeable solution is lurking in an unexpected place: the 18th century.
In the 1700s, Great Britain had a debt burden that was even more ominous than the $16 trillion the U.S. government now owes. In 1716, Parliament proposed an ingenious, and fairly uncontroversial, way to reduce this debt, called a sinking fund. The scheme was copied 74 years later by the U.S. Congress. And it could work just as well now as it did three centuries ago. The sinking fund was the brainchild of Robert Walpole, who was then the first lord of the Treasury and chancellor of the Exchequer. Its purpose was to chip away at a national debt that had swollen to 55 million pounds, which Parliament considered “insupportable.”
The concept is simple: A government imposes a special tax for the sole purpose of sinking -- reducing -- its debt. As the sinking fund cuts into the debt, it reduces the amount of interest that has to be paid every year. The crucial step is for these interest savings to be plowed back into the fund. If the annual interest rate was 2 percent, then every $100 reduction in the government’s debt would diminish its annual interest obligation by $2, which would allow another $2 to be diverted to the sinking fund -- not just in that year but every subsequent year. As the amount owed gradually decreased, the sinking fund would grow at an accelerating rate, not unlike the way compound interest swells an untouched savings account.
Richard Price, a British preacher and political economist, published a pamphlet in 1772 demonstrating that a country paying 5 percent interest on a 258 million pound debt could pay the whole thing off in 86 years if it established a 200,000 pound sinking fund and put all interest savings back into it. Parliament created another sinking fund in 1786, and it helped slow the growth of Great Britain’s national debt. Unfortunately, the temptation to raid the funds for other purposes was always strong. In “The Wealth of Nations,” which appeared in 1776, a sadder-but-wiser Adam Smith complained that often “a sinking fund, though instituted for the payment of old, very much facilitates the contracting of new debts.”
One 18th-century strategy for making sure tax dollars actually went to sinking the national debt was the concept of “certificate taxes.” During the American Revolution, the Continental Congress and the 13 state legislatures had no cash to pay soldiers and the army’s suppliers. So in 1783, when the war ended, they gave soldiers and suppliers IOUs, and the state legislatures adopted taxes to redeem them.
State officials knew these taxes wouldn’t actually bring in much money, because citizens had the option of paying them using the IOUs. If you were a veteran, you could use some of your promissory notes to pay your taxes, then sell the rest to neighbors who hadn’t fought in the war or sold supplies to the army and thus needed promissory notes to satisfy the tax collector.
Certificate taxes enabled soldiers, suppliers, and other holders of government promissory notes to turn them into cash without either the IOUs or the cash passing through the hands of the government. Those who had IOUs to sell got their money directly from fellow taxpayers.
Today, many Republicans might support a sinking fund in principle but worry that a future Congress would divert the new revenue to wasteful government expenditures. A modern-day certificate-tax system would reduce this risk: Taxpayers could have the option of discharging their portion of the sinking fund just like their other federal taxes, through payroll deductions or quarterly payments, or they could pay using Treasury bills -- and thus ensure that their money was being used to reduce the debt.
Alexander Hamilton, the first U.S. Treasury secretary, was so impressed with the sinking-fund idea that he proposed one in his first major report to Congress. He expected the postal service to make a profit of about $100,000 a year and wanted to put all of that money into a sinking fund to begin redeeming federal securities. In 1790, when Congress adopted their version of the proposal, they did Hamilton one better: They decided to use all income from the sale of western land -- at a time when the U.S. was forcibly acquiring Indian property west of the Ohio River -- to form a sinking fund.
Most economists now agree that going over the fiscal cliff would push the U.S. economy back into recession. But efforts to indefinitely delay dealing with government debt could eventually prove even more ruinous. Because if the 18th century is any guide, the most dramatic effects of government indebtedness might not be economic.
Enormous government shortfalls were largely responsible for all of the 18th century’s big revolutions. In the 1760s, the British Parliament’s determination to reduce the deficit led to the measures -- especially “taxation without representation” - -that provoked the American Revolution. In the ensuing war, the assistance that the rebellious colonies received from Britain’s principal rival, Louis XVI of France, bankrupted him, setting the stage for the French Revolution, which led to Haiti’s as well.
Debt was also a necessary precondition for the 18th century’s most significant nonviolent revolution, the junking of the Articles of Confederation and adoption of the U.S. Constitution. The Founding Fathers wouldn’t have felt the need for this transformation if the Continental Congress and the 13 states had managed to emerge from the Revolutionary War debt-free. Debt-retirement measures, especially high taxes, had ravaged the American economy and caused an alarming spike in farmers’ revolts.
Those of us who would prefer to keep such rebellions in the history books would do well to heed the warnings of the 18th century. And perhaps to consider one of its great remedies.
(Woody Holton is a professor at the University of South Carolina and the author of “Abigail Adams,” a 2010 winner of the Bancroft Prize. The opinions expressed are his own.)
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