Debt and Deficit Fluctuations and the Structure of Bond Markets
We analyse the implications of optimal taxation for the stochastic behaviour of debt. We show that when a government pursues an optimal fiscal policy under complete markets, the value of debt has the same or less persistence than other variables in the economy and it declines in response to shocks that cause the deficit to increase. By contrast, under incomplete markets debt shows more persistence than other variables and it increases in response to shocks that cause a higher deficit. Data for US government debt reveals diametrically opposite results from those of complete markets and is much more supportive of bond market incompleteness.
Complete vs incomplete markets, Debt Management, Fiscal
This paper tests for the market environment within which US fiscal policy operates, that is we test for the incompleteness of the US government bond market. We document the stochastic properties of US debt and deficits and then consider the ability of competing optimal tax models to account for this behaviour. We show that when a government pursues an optimal tax policy and issues a full set of contingent claims, the value of debt has the same or less persistence than other variables in the economy and declines in response to higher deficit shocks. By contrast, if governments only issue one-period risk free bonds (incomplete markets), debt shows more persistence than other variables and it increases in response to expenditure shocks. Maintaining the hypothesis of Ramsey behavior, US data conflicts.
Optimal fiscal policy, complete vs incomlete markets, tax smoothing, government debt, persistence of debt
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