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We thank Olivier Blanchard, Vitor Gaspar, Jun Il Kim, and Thomas Sargent for helpful comments and discussions and Anne Lalramnghakhleli Moses for assistance.
The discussion of fiscal space in Ostry and others (2010) has since been adopted by Moody’s in their assessment of fiscal risks in advanced economies. Both analyses highlight the existence of wide gaps (margins of maneuver) between current debt ratios and public debt limits (points at which market access is likely to be curtailed or sharp rises in sovereign borrowing costs take place) in a number of advanced and emerging market economies.
In an open economy, paying down external debt involves a costly transfer of resources abroad, so the closed-economy assumption actually stacks the argument against “living with the debt.” Note that, since the analysis here pertains solely to sovereigns that are firmly in the “green zone” of ample fiscal space, crisis risk is ruled out regardless of whether the economy is open or closed: inasmuch as the government may be less willing to make an extraordinary fiscal effort to honor its debt if held by foreigners rather than domestic residents, the size of the green zone could conceivably be narrower in the open economy context. As to tax incidence, in an open economy in which capital is mobile, it would be very difficult to tax that capital, but this is economically very similar to the closed-economy case in which the optimal capital tax rate falls to zero after the initial period (as in Chamley ). Essentially, in the closed economy, capital is intertemporally mobile (investment will not materialize if capital is taxed), while in the open economy, it is mobile across borders, with the same result (it is very difficult to tax). Thus, we do not see sharply different messages as far as tax incidence is concerned.
In practice, of course, it makes a great deal of difference who is the “we” and who is the “ourselves.” The assumption that debt is held by domestic residents is plausible for advanced economies where, on average, more than two-thirds of public debt is held by residents (ranging from about 30 percent in France and Germany to 70 percent in the United Kingdom and the United States, and more than 90 percent in the advanced economy with the highest debt ratio, Japan). On the transfer problem, see Keynes (1929).
This result, originally due to Chamley (1986) for the long-run and to Chari, Christiano, and Kehoe (1994) in the short run for a CES (constant elasticity of substitution) utility function, is akin to Little and Mirrlees’ (1974) argument that, even in countries with highly distorted capital markets, world interest rates can be used for discounting returns in project evaluation.
Output declines slightly as the steady state is approached because leisure is a normal good, so the representative agent works less as the economy becomes richer.
In this simple heuristic explanation, the interest rate is treated as constant; in the actual optimization in Box 2, the government takes into account the endogeneity of the interest rate to the private sector’s saving decision and its own fiscal policies. Since there is no possibility of default here, there is no risk premium. In a fuller model, the government would also need to consider that, as debt rises and the debt limit is approached, so will the risk premium; the government would in this fuller setup take this into account in solving for its optimal fiscal program (consumption, investment, borrowing, taxation). The theoretical analysis in Ostry and others (2010) and Ghosh and others (2013) suggests that the risk premium only rises appreciably close to the debt limit, and the empirical analysis in Acharya, Drechsler, and Schnabl (2014) implies only modest increases in the risk premium with higher debt. Since the analysis in this paper is solely for countries with ample fiscal space, these considerations are not incorporated here.
Paying down less incurs a smaller cost, but of course would contribute to correspondingly smaller crisis-reduction benefits.
Of course, if we were thinking in terms of an open economy and external debt, the welfare cost of paying down 5 percent of GDP in external debt would be this distortionary cost (1 percent of GDP) plus the 5 percent transferred to foreigners (so 6 percent). The cost of paying down the debt would thus be much larger in an open-economy setting than in the one here. In that sense, the closed-economy setting actually stacks the argument against living with the debt (since the cost of repaying the debt is much lower in the closed-economy setting).
The output cost is calculated as the undiscounted sum over the three years subsequent to the event of the difference between actual and precrisis trend GDP. This estimate is in line with other studies—for example, Sturzenegger (2004); Borensztein and Panizza (2008); Levy-Yeyati and Panizza (2011), although a few papers—for example, Furceri and Zdzienicka (2011); De Paoli, Hoggarth, and Saparta (2009) suggest a permanently lower GDP level and thus larger costs.
An alternative approach to estimating the likelihood of crisis is to use the probability implied by market spreads. Simple regressions of government bond yields on debt (with country-fixed effects and time effects) for a panel of advanced economies suggests that an increase in debt of 10 percent of GDP would be associated with 20 basis point higher spreads, so reducing debt from 120 percent of GDP to 100 percent of GDP would be associated with 0.4 percentage points lower spreads. Acharya, Drechsler, and Schnabl (2014) obtain very similar estimates: in their study, 20 percent of GDP higher debt would be associated with 40 basis points higher CDS (credit default swap) spreads.
A slightly different way of calculating the benefit (in terms of reducing the expected cost of crises) of lower debt is to consider the probability that at least one crisis occurs over the planning horizon (say, 20 years). At debt of 120 percent of GDP, this probability is 41 percent (= 100×(1−(1−0.026)^20)), whereas at 100 percent of GDP, the corresponding probability is 38.5 percent; again, therefore, the estimated benefit is small (0.37 percent of GDP (=100×((0.41−0.38)×0.15)).
As argued by Chamley (1986), models of optimal taxation generally imply zero taxation of private capital in the long run because private capital becomes a fully elastic source of revenue.
We are not claiming that the mechanism emphasized by our model is the only factor at play here: political constraints, for example, would likely have played a role in determining the cutbacks in public investment.
Our results are very similar when estimating a cross-section regression of growth over the period 1978–2007. In such regressions, contemporaneous tax revenues are significant, whereas lagged tax revenues and lagged debt are not significant variables. However, the literature on the effect of taxes on growth has been less conclusive, as underlined by Easterly and Rebelo (1993). Mendoza, Milesi-Ferretti, and Asea (1997) also found that although taxes affect investment, the effect on growth is not robust.