No Way to Run a Railroad

January 18, 2023

On January 19 – possibly at the very moment you’re reading these words – the US government will hit the $31.3 trillion debt ceiling. Roughly, this translates into maxing out Uncle Sam’s American Express card. That doesn’t mean he’ll stop spending, of course. Instead, we’ll be treated to the slow-motion trainwreck of watching a divided Congress raise that credit limit. The ceiling itself is an arbitrary number. It doesn’t create any new spending. It just gives the Treasury statutory permission to borrow more to cover what they’ve already spent. But failing to find a solution would essentially mean missing a payment on that AmEx bill. That, in turn, would destabilize credit markets, raise borrowing costs, and perhaps even trigger a recession.

In the meantime, the Treasury will turn to “extraordinary measures” to keep the government spending machine chugging along. In this case, “extraordinary measures” means a grab-bag of spending gimmicks, one step removed from check-kiting, that would embarrass an Enron accountant. It starts by suspending contributions to government retirement programs (with promises to make everyone whole when the crisis passes). As things get tighter, it turns into the government equivalent of scrounging through couch cushions to buy ramen noodles until the next paycheck hits.

Treasury Secretary Janet Yellen has told Congress she can delay the day of reckoning until sometime in June. At that point, if Congress hasn’t acted, we’ll have to turn to the real gimmicks. That could include minting a trillion-dollar platinum coin to give to the Federal Reserve to pay down part of the debt. And there’s another idea that could solve the problem, with a bit of tax planning thrown in on the side. It’s called the premium-bond gimmick.

Ordinarily, when you buy a government bond, you give the Treasury cash equal to the face value of that bond. The Treasury pays interest over time – say, 4.5% for a one-year note – then repays your principal. When the Treasury sells the bond, that action increases the federal debt – and uses up part of the available debt ceiling – by the face amount of the bond.

However, while the debt ceiling limits the amount the Treasury can borrow, it doesn’t limit the interest it can pay. So, try this on for size: the Treasury can issue a $100 bond today and promise a 109% interest rate. That bond is clearly worth more than $100 – in fact, it’s theoretically worth the same amount as two hundred-dollar bonds paying 4.5%. That means buyers should be willing to pay a $100 premium to get their hands on that bond. And voila – now the Treasury has collected $200 but increased their debt-ceiling allowance by just half of that amount. Clever!

Where do taxes come in? Here’s the problem: if you pay $100 for the bond, and the Treasury pays you $109 in interest, you’ll owe tax on the $109. But $100 of that really ought to be a tax-free return of your original principal. Fortunately, tax rules let you take the extra $100 premium you paid above face value and amortize it over the life of the bond or use it to raise your basis in the bond. Either strategy can avoid the extra taxes that Uncle Sam would have to compensate you for to entice you to take the deal.

Some people nickname their accountant “the chef” because of the way he cooks the books. If the premium-bond gimmick sounds like something “the chef “would whip up after a three-day bender, you’re probably not wrong. Is it madness? Is it genius? Is it both? Whichever, we’re here to help you take it in stride!

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