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Auerbach: Long-term objectives for government debt

Auerbach: Long-term objectives for government debt. Discussion by Kjetil Storesletten, Oslo University January 29, 2008. Auerbach’s Dictum. Long-term Objectives for Government Debt: Tax smoothing Inter-generational equity Economic performance. Should we care about debt?.

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Auerbach: Long-term objectives for government debt

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  1. Auerbach: Long-term objectives for government debt Discussion by Kjetil Storesletten, Oslo University January 29, 2008

  2. Auerbach’s Dictum • Long-term Objectives for Government Debt: • Tax smoothing • Inter-generational equity • Economic performance

  3. Should we care about debt? • First approximation: Ricardian equivalence • Non-distortive taxes • Altruism • debt is irrelevant • Second approximation: tax smoothing • Taxes are distortive (& distortion is increasing) • Altruism => Optimal taxes are smooth (adjusted only when economy is hit by surprise shocks)

  4. Tax smoothing => debt policy • Long-term smoothing • Absorb surprise spending shocks with debt • Population ageing: fewer workers and more retirees => more expenditures & less tax revenue (even w/constant tax rates on labor) • Tax smoothing dictates: • Set the tax rate high enough to be constant and sustainable • Build up large fund when dependency ratio is low to cover future expenditure on health and pensions • Fund should be very large (multiples of GDP) in OECD countries

  5. Tax smoothing (continued) • Precautionary buffer: • Difficult to predict government’s future expenditure needs (wars, health care costs, longevity, global warming, …) • Cannot buy insurance against such shocks • Solution 1: change taxes in response to shocks (but violation of tax smoothing) • Solution 2: build up a buffer of government savings to be used for ”rainy days” • Buffer should be huge. Not observed anywhere

  6. Tax smoothing (short run) • Business cycles: • Constant tax rates imply strongly pro-cyclical tax revenue (due to pro-cyclical employment and consumption) • Unemployment benefits and (perhaps) optimal government consumption are counter-cyclical (automatic stabilizers) • Short-term tax smoothing implies counter-cyclical debt (increase debt in recessions)

  7. Inter-generational equity • Suppose aim of debt policy is equity across generations • But no reason let distortions fluctuate • Benchmark: constant tax rates and constant quality of government services • But future generations have higher wages • Suggests increasing debt and increasing taxes • Future generations may suffer from hazardous environmental policies • Suggests lowering debt

  8. Economic performance • Popular argument: higher debt hampers economic performance • Closed economy: larger debt crowds out capital => higher R, lower W • Open economy: no effect of debt on capital stock. But high (sovereign) debt can increase interest rate R • Reality: Effects of debt on R seems small • Japan has highest debt in OECD but still lowest R • Large differences in debt across Euro countries. But minuscule differences in R

  9. Too much debt? • OECD countries: surge in government debt since 1970 • Reasons to fear debt would rise, threatening fiscal sustainability and, hence, tax smoothing: • Myopic voters: government increases debt to get reelected (higher debt allows lower taxes and higher spending) • Strategic use of debt: • Current governments disagrees with future governments on size and composition of spending. Temptation: Increase debt to limit future government's ability to spend. • Natural conflict: young versus old

  10. Inter-generational conflict • Assume altruism is weak • Increasing current debt implies • More public expenditure and less taxes today • Larger tax burden and less expenditures in future • Young and old disagree on debt policy: • The old want higher debt (don’t suffer) • The young may want to limit debt accumulation • The discipline of the young depends on how future debt payments are financed: higher taxes (good) or lower expenditures/pensions (bad)

  11. Inter-generational conflict (cont.) • Debt is outcome of game between generations • Policy implications: • More difficult to build up large buffer of government savings because larger temptation to indulge • Important to regulate debt policies with “rules” or bi-partisan guidelines in order to combat inter-generational conflict

  12. Case: Norwegian oil fund • Aim: let current and future generations get the same share of oil revenue • All tax revenue collected from petroleum is saved in the fund • Bi-partisan agreement about rules for spending and portfolio allocations

  13. Oil-fund spending rules • Rule 1: withdraw (on average) 4% of fund annually for general government expenditure • The fund started in 1990’s and will reach maximum size in 2030 • Fund is small (large) when dependency ratio is small (large) => smooth taxes during population ageing • Rule 2: larger withdrawal in recessions • Difficult to discipline because “recession” is ambigous • Simple rules, easy to communicate to voters

  14. Oil-fund portfolio rules • Huge fund: $400 billion, two times GDP • 60% stocks, 40% bonds • No domestic stocks • No more than 5% stake in any single stock • Unfortunately no short-selling of oil-related stocks • Tempting for politicians to meddle with investments (ethical concerns, etc.)

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