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The Consequences of Uncertain Debt Targets

Alexander Richter () and Nathaniel Throckmorton

No auwp2013-18, Auburn Economics Working Paper Series from Department of Economics, Auburn University

Abstract: Recent proposals to reduce U.S. debt reveal large differences in their implied targets. These differences demonstrate the uncertainty surrounding future tax rates and long-run debt targets. We use a standard real business cycle model in which a Bayesian household learns about the state-dependent debt target in an endogenous tax rule. The household extracts the debt target state from a noisy tax process and jointly estimates the transition probabilities. We compare the household's ability to learn and the consequences of the uncertainty across different limited information sets. The information set influences the household's behavior but also impose two-sided risk. Despite the popular viewpoint that fiscal uncertainty has negative effects, limited information can result in welfare gains or losses, depending on whether the household's expectations are consistent with the realization of future states. Although the welfare distribution includes gains, we stress that the uncertainty created by the recent fiscal policy debate slowed the recovery and led to welfare losses. When Congress provides clarity about future policy, output and welfare increase and the economy quickly recovers.

Keywords: Bayesian learning; Limited information; Fiscal uncertainty; Welfare (search for similar items in EconPapers)
JEL-codes: D83 E32 E62 H68 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cta, nep-dge, nep-mac and nep-pbe
Date: 2013-10
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Journal Article: The consequences of an unknown debt target (2015) Downloads
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