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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?
• 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)
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
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
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 countercyclical (automatic stabilizers)
• Short-term tax smoothing implies countercyclical debt (increase debt in recessions)
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
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
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
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)
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
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
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
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.)