Transfer with Foreign Debt:

Having considered the role of domestic borrowing, we now turn to that of borrowing from outside sources. The mechanism of  burden transfer through   foreign borrowing differs in several respects. A first difference is that there is now no need for  generation 1 to reduce its expenditures. Outlays in the private sector can remain intact because the additional resources needed for the public outlay are acquired abroad via an import surplus. Loan finance now imposes a burden on generation 2 not by  leaving it with a reduced capital endowment at home but by saddling it with an obligation to service the foreign debt. Taxes must now be paid to finance interest paid to foreigners rather than to domestic holders of debt. Generation 2 no longer owes   the debt to itself. This foreign debt burden replaces the loss of capital income which generation 2 would have suffered had there been domestic loan finance and a resulting reduction in capital formation.

Compare now three sources of finance: (1) taxation, (2) domestic borrowing, and (3) foreign borrowing. Assuming 1 to fall on consumption and 2 on capital formation, 1 will burden the present generation while 2 and 3 will burden the future. Even though 2 and 3 are similar in this respect, the choice between them may not be a matter of indifference. The answer depends upon the cost of borrowing at home and abroad. If the cost is the same (if the return on domestic capital is the same as the outside rate of interest), the burden on generation 2 will be the same in each case. But if the domestic cost is higher, foreign borrowing may be preferable.