Optimal Redistribution with Government Debt

We analyze the tight relationship between government debt and redistribution in Overlapping Generations Economies (OLG). We do so in an heterogeneous agents economy where the government collects capital and progressive labor taxes to pay government spending, debt, and redistribute income. In this environment, the Ramsey planner uses all taxes, even in the long run. We show that rising inequality leads not only to more progressivity, but also to more government debt and capital taxation. The necessary increase in debt to achieve the optimal redistribution policy can be substantial. We explore how limits to government's borrowing choices severely restrict its ability to redistribute income. We calibrate the model to the U.S. in the 2000-10 decade and estimate the optimal response to the observed change in inequality. We find that the optimal level of debt should approximately double.