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  • The Tax Smoothing Implications of the Federal Debt Paydown
  • George J. Hall and Stefan Krieger

After nearly thirty straight years of deficit spending, the fiscal position of the U.S. government has experienced a dramatic turnaround. In fiscal years 1998 and 1999, for the first time since the 1950s, the federal government ran back-to-back budget surpluses. With the government no longer a net borrower, the Treasury has started paying down the federal debt: debt held by the public fell from $3.5 trillion in March 1998 to $3.0 trillion in July 2000. And both the Office of Management and Budget (OMB) and the Congressional Budget Office (CBO) are forecasting that these surpluses will continue over the next decade,1 in amounts large enough that the public debt will be fully redeemed in 2012. Although these official forecasts may prove too optimistic, it is reasonable to expect that the quantity of publicly held debt will shrink considerably over the next decade.2

The pending debt paydown has several implications for macroeconomic policy. This paper focuses on only one of these. All types of debt allow [End Page 253] the government to smooth taxes through time, but when debt is denominated in nominal dollars, it also allows the government to hedge against fiscal shocks. As the federal debt shrinks, the government’s ability to shift the risk of adverse fiscal outcomes onto debt holders will be reduced considerably. To see this, consider the choices faced by a fiscal authority when an unexpected increase in spending occurs. To satisfy the government’s net-present-value budget constraint, the fiscal authority can either raise taxes, now or in the future; cut spending in other areas, now or in the future; or impose a capital loss on existing bondholders, through inflation, higher interest rates, or explicit indexation to fiscal shocks. As the public debt falls, the government’s ability to use this third option is diminished; hence either taxes or spending, or both, will become more variable. This paper illustrates this idea theoretically and document it empirically using data from the late 1800s and from the post–World War II period.

The insight that debt can be used to hedge fiscal shocks is not new; indeed, it has been developed in a series of papers over the last quarter century. For example, Robert Barro concluded that tax rates should change only when unanticipated shocks change the discounted present value of the stream of primary surpluses.3 Thus, in an economy containing government debt and subject to stochastic shocks, the optimal path of tax rates follows a random walk regardless of the persistence properties of those shocks. Barro’s partial-equilibrium model assumes a constant, non-state-contingent rate of return on debt and an objective function for the government that depends directly on tax rates rather than on consumption and output.

Robert Lucas and Nancy Stokey formulated a general-equilibrium model in which the government sets fiscal and monetary policy to maximize households’ objective function.4 Debt plays two roles in their model. First, as in the Barro model, debt allows the government to smooth distorting tax rates over time.5 But in an important departure from the Barro model, optimal policy in Lucas and Stokey’s framework involves the government issuing and retiring bonds with a state-contingent payoff: the amount paid these bondholders in a given period would depend on what unexpected changes to government expenditure had occurred this period. [End Page 254] Through these state-contingent payoffs, the government effectively purchases “insurance” from the public against these fiscal shocks. Second, debt acts as a commitment device. The government cannot precommit itself to follow a given tax rate policy in the future; by modifying the current maturity structure of government debt, however, today’s government can manipulate the incentives of future governments to alter tax rates. Under a rich enough and properly chosen debt structure, the government today can set the debt structure such that future governments will select the same future tax rate sequence that the present government would have chosen.

V. V. Chari, Lawrence Christiano, and Patrick Kehoe extend Lucas and Stokey’s work by analyzing optimal...


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