Are Government Bonds Net Wealth or a Liability? ---Optimal Debt and Taxes in an OLG Model with Uninsurable Income Risk

YiLi Chien, Yi Wen and HsinJung Wu

No 2020-007, Working Papers from Federal Reserve Bank of St. Louis

Abstract: A positive national debt is often rationalized either by the assumption of dynamic inefficiency in an overlapping-generations (OLG) model, or by the hypothesis of heterogeneous-agents and incomplete-markets (HAIM) in an infinite horizon model. Both assumptions imply insufficient private liquidity to support private saving and investment, thus calling for a positive level of public debt to improve social welfare. However, since public debt is financed often by distortionary future taxes, optimal debt and tax policies ought to be studied jointly in a single framework. In this paper we use a primal Ramsey approach to analytically characterize optimal debt and tax policy in an OLG-HAIM model. We show that (i) public debt can be a liability instead of net wealth, despite insufficient private liquidity to support private saving and investment, and (ii) such a debt policy can dramatically change the government's optimal tax scheme since the sign and magnitude of the optimal quantity of debt dictate the sign and magnitude of optimal taxes as well as the priority order of tax tools (such as a labor tax vs. a capital tax) in financing the public debt.

Keywords: Role of Public Debt; overlapping generations; Ramsey Problem; Incomplete Markets; Optimal Fiscal Policy (search for similar items in EconPapers)
JEL-codes: E13 E62 H21 H30 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2020-04-08, Revised 2021-01-03
New Economics Papers: this item is included in nep-dge, nep-mac, nep-pbe and nep-pub
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DOI: 10.20955/wp.2020.007

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