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The Consequences of Uncertain Debt Targets

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  • Alexander W. Richter
  • Nathaniel A. Throckmorton

Abstract

Recent proposals to reduce U.S. debt reveal large differences in their implied targets. These differences demonstrate the uncertainty surrounding future tax rates and long-run debt targets. We use a standard real business cycle model in which a Bayesian household learns about the state-dependent debt target in an endogenous tax rule. The household extracts the debt target state from a noisy tax process and jointly estimates the transition probabilities. We compare the household's ability to learn and the consequences of the uncertainty across different limited information sets. The information set influences the household's behavior but also impose two-sided risk. Despite the popular viewpoint that fiscal uncertainty has negative effects, limited information can result in welfare gains or losses, depending on whether the household's expectations are consistent with the realization of future states. Although the welfare distribution includes gains, we stress that the uncertainty created by the recent fiscal policy debate slowed the recovery and led to welfare losses. When Congress provides clarity about future policy, output and welfare increase and the economy quickly recovers.

Suggested Citation

  • Alexander W. Richter & Nathaniel A. Throckmorton, 2013. "The Consequences of Uncertain Debt Targets," Auburn Economics Working Paper Series auwp2013-18, Department of Economics, Auburn University.
  • Handle: RePEc:abn:wpaper:auwp2013-18
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    Cited by:

    1. Andrew Foerster & Troy Davig, 2014. "Uncertainty and Fiscal Cliffs," 2014 Meeting Papers 717, Society for Economic Dynamics.
    2. Bi, Huixin & Shen, Wenyi & Yang, Shu-Chun S., 2016. "Debt-dependent effects of fiscal expansions," European Economic Review, Elsevier, vol. 88(C), pages 142-157.
    3. Murray, James, 2014. "Fiscal Policy Uncertainty and Its Macroeconomic Consequences," MPRA Paper 57409, University Library of Munich, Germany.

    More about this item

    Keywords

    Bayesian learning; Limited information; Fiscal uncertainty; Welfare;

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • H68 - Public Economics - - National Budget, Deficit, and Debt - - - Forecasts of Budgets, Deficits, and Debt

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