Reducing Government Debt in the Presence of Inequality

What are the welfare consequences of debt reduction policies? In this paper, we answer this question with the help of an incomplete markets economy with production in which households are subject to uninsurable income shocks. We focus on policies that raise revenues from taxing income. We make three contributions. First, we show that quantitatively sizable welfare gains can be reaped by reducing debt, at least in the long-run. Second, we find that, for some policies, the short-run losses that occur during the transition more than outweigh the long-run gains. And third, we show that both short-run and long-run welfare effects of government debt depend on the income composition of the consumption-poor. In our calibration, we thus target the skewed wealth and the earnings distribution of the US economy. Our results have important implications for the design of debt reduction strategies. Policies that imply more redistribution will find more political support, as they compensate the consumption-poor, who suffer the most during the transition.