Tax Smoothing with Financial Instruments (Reprint 004)

The paper explores how the structure of government debt affects the budget in a stochastic environment. In the theoretical part, I present two models that motivate why governments should care about the risk inherent in its choice of liabilities. The models are based on tax-smoothing and risk aversion of taxpayers, respectively. Debt should be structured to hedge against macroeconomic shocks that affect the government budget, in particular against shocks to aggregate output. The optimal structure of government liabilities generally includes some "risky" securities which are state contingent in real terms. The empirical part studies state-contingencies implemented by some specific securities. I find that nominal debt and long-term debt have desirable properties as hedges. This may motivate the current practice issuing non-indexed debt of various maturities. The argument justifying "risky" nominal and long-term debt suggests that the government may improve welfare by taking a short position in the stock market. This is strongly supported by the data. Finally, I find that issuing selected foreign currency bonds may be beneficial.