The Determination of Public Debt under both Aggregate and Idiosyncratic Uncertainty

RePEc Short ID: pch650
ORCID iD: 0000-0002-6820-1197

Chien, YiLi; Wen, Yi

doi:10.20955/wp.2019.038

Working Paper Revision

The Determination of Public Debt under both Aggregate and Idiosyncratic Uncertainty

Abstract: We use an analytically tractable model to show that the Ramsey planner's decisions to finance stochastic public expenditures under uninsurable idiosyncratic risk implies a departure from tax smoothing. In the absence of state-contingent bonds the government's attempt to balance the competing incentives between tax smoothing and individual consumption smoothing---even at the cost of extra tax distortion---implies a bounded stochastic unit root component in optimal taxes. Nonetheless, a sufficiently high average level of public debt to support individuals’ self-insurance position is welfare improving, consistent with the strictly positive quantity of government debt observed throughout human history.

Keywords: Ramsey Problem; Incomplete Markets; Tax Smoothing; Optimal Public Debt;

JEL Classification: E13; E62; H21; H30;

https://doi.org/10.20955/wp.2019.038

Status: Published in Journal of Economic Theory