Auerbach: Long-term objectives for government debt Discussion by Kjetil Storesletten, Oslo University January 29, 2008

Auerbach’s Dictum Long-term Objectives for Government Debt: –Tax smoothing –Inter-generational equity –Economic performance

Should we care about debt? First approximation: Ricardian equivalence –Non-distortive taxes –Altruism  debt is irrelevant Second approximation: tax smoothing –Taxes are distortive (& distortion is increasing) –Altruism => Optimal taxes are smooth (adjusted only when economy is hit by surprise shocks)

Tax smoothing => debt policy Long-term smoothing –Absorb surprise spending shocks with debt –Population ageing: fewer workers and more retirees => more expenditures & less tax revenue (even w/constant tax rates on labor) –Tax smoothing dictates: Set the tax rate high enough to be constant and sustainable Build up large fund when dependency ratio is low to cover future expenditure on health and pensions –Fund should be very large (multiples of GDP) in OECD countries

Tax smoothing (continued) Precautionary buffer: –Difficult to predict government’s future expenditure needs (wars, health care costs, longevity, global warming, …) –Cannot buy insurance against such shocks –Solution 1: change taxes in response to shocks (but violation of tax smoothing) –Solution 2: build up a buffer of government savings to be used for ”rainy days” Buffer should be huge. Not observed anywhere

Tax smoothing (short run) Business cycles: –Constant tax rates imply strongly pro-cyclical tax revenue (due to pro-cyclical employment and consumption) –Unemployment benefits and (perhaps) optimal government consumption are counter- cyclical (automatic stabilizers) Short-term tax smoothing implies counter- cyclical debt (increase debt in recessions)

Inter-generational equity Suppose aim of debt policy is equity across generations But no reason let distortions fluctuate Benchmark: constant tax rates and constant quality of government services But future generations have higher wages –Suggests increasing debt and increasing taxes Future generations may suffer from hazardous environmental policies –Suggests lowering debt

Economic performance Popular argument: higher debt hampers economic performance Closed economy: larger debt crowds out capital => higher R, lower W Open economy: no effect of debt on capital stock. But high (sovereign) debt can increase interest rate R Reality: Effects of debt on R seems small –Japan has highest debt in OECD but still lowest R –Large differences in debt across Euro countries. But minuscule differences in R

Too much debt? OECD countries: surge in government debt since 1970 Reasons to fear debt would rise, threatening fiscal sustainability and, hence, tax smoothing: –Myopic voters: government increases debt to get reelected (higher debt allows lower taxes and higher spending) –Strategic use of debt: Current governments disagrees with future governments on size and composition of spending. Temptation: Increase debt to limit future government's ability to spend. Natural conflict: young versus old

Inter-generational conflict Assume altruism is weak Increasing current debt implies –More public expenditure and less taxes today –Larger tax burden and less expenditures in future Young and old disagree on debt policy: –The old want higher debt (don’t suffer) –The young may want to limit debt accumulation The discipline of the young depends on how future debt payments are financed: higher taxes (good) or lower expenditures/pensions (bad)

Inter-generational conflict (cont.) Debt is outcome of game between generations Policy implications: –More difficult to build up large buffer of government savings because larger temptation to indulge –Important to regulate debt policies with “rules” or bi-partisan guidelines in order to combat inter-generational conflict

Case: Norwegian oil fund Aim: let current and future generations get the same share of oil revenue All tax revenue collected from petroleum is saved in the fund Bi-partisan agreement about rules for spending and portfolio allocations

Oil-fund spending rules Rule 1: withdraw (on average) 4% of fund annually for general government expenditure –The fund started in 1990’s and will reach maximum size in 2030 –Fund is small (large) when dependency ratio is small (large) => smooth taxes during population ageing Rule 2: larger withdrawal in recessions –Difficult to discipline because “recession” is ambigous Simple rules, easy to communicate to voters

Oil-fund portfolio rules Huge fund: $400 billion, two times GDP 60% stocks, 40% bonds No domestic stocks No more than 5% stake in any single stock Unfortunately no short-selling of oil-related stocks Tempting for politicians to meddle with investments (ethical concerns, etc.)