The Sustainability of Budget Deficits with Lump-Sum and with Income-Based Taxation

The paper examines the substantiality of fiscal policies in a stochastic economy with a particular focus on two benchmark policies, balanced budgets and tax smoothing. These policies are typically sustainable if lump-sum taxes are available, but they are generally not sustainable in a stochastic environment, if taxation is constrained by the size of the economy. The sustainability problems arise because the debt-income ratio becomes excessive whenever there are sufficiently low realizations of aggregate income. I also compute the probability of reaching high debt-income ratios with different policies and I discuss the role of debt management for sustainability. It turns out that balanced budgets can be sustained forever with very high probability (but less than one), but so can policies with permanent primary or with-interest deficits. I argue that debt management is important for sustainability in a stochastic environment and show that the use state-contingent government liabilities can be helpful in designing sustainable versions of tax-smoothing and balanced budget policies.