Events at CERGE-EI

Prof. Johannes Brumm

Karlsruhe Institute of Technology, Germany

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Authors: Johannes Brumm, Jakob Hußmann

Abstract: We analyze public debt policies within a calibrated stochastic OLG model with distortionary taxation. The risk-free interest rate is realistically sensitive to government debt and lower than the growth rate. The risky rate is substantially higher, due to convenience benefits of government debt, idiosyncratic return risk, aggregate risk, and, potentially, market power and wealth inequality. We analyze deficit-maximizing debt (DMD) and welfare-maximizing debt (WMD). Although free-lunch deficits can reduce tax distortions, we find that DMD tends to exceed WMD. Both rise substantially if the risk-free rate falls due to increases in risk, convenience benefits, or longevity, yet not necessarily if it falls due to lower growth or government spending. Taking market power into account barely changes DMD, but substantially reduces WMD. When wealth inequality is included, the poor favor lower public debt than the WMD in the representative agent case, while the rich favor much higher debt-to-GDP ratios.

JEL Classification: E43, E62, H62, H63
Keywords: public debt, debt-to-GDP ratio, free-lunch deficits, real interest rate, risk premium, risk-sharing, convenience yield, distortionary taxation, market power, wealth inequality

Full Text: Optimal Debt to GDP: A Quantitative Theory