A Positive Theory of Government Debt

All developed countries have government debt, usually a sizeable proportion of output. This paper proposes that governments that cannot commit to future policy choices face a trade-off that explains the level of debt. On the one hand, the government would like to increase debt and delay taxation, so as to reduce current distortions. On the other hand, inflating current prices lowers the real value of nominal debt and so there is a motive to reduce it now. This trade-off generates a level of long-run debt that is interior and independent of initial debt, a feature missing in previous theories. The sign and size of long-run debt will depend on how the incentives to increase and decrease debt play out against each other. The critical determinant is how easy or difficult it is for households to substitute away from goods being taxed by inflation. Under reasonable assumptions, the model is successful in replicating certain U.S. facts, most importantly its debt-to-output ratio. Permanent changes in fundamentals —other than the degree of substitutability of the good being taxed by inflation— have small effects on long-run debt. This is consistent with the empirical observation that macroeconomic variables cannot alone explain cross-country differences in public debt levels. The model is extended to include stochastic government expenditure. In line with the tax-smoothing argument, the model predicts that governments increase debt when expenditure temporarily rises. However, labor taxes fluctuate significantly.