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

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Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2020-06-10

Number: 2019-038

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