A Positive Theory of Government Debt∗

This paper proposes a theory of government debt which, as opposed to previous theories, delivers an interior steady state that is independent of initial debt. The key elements are nominal public debt and a benevolent government that cannot commit to future policy choices. Governments face a trade-off. On the one hand, they would like to increase the 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. The sign and size of long-run debt will depend on how these two effects play against each other. The critical determinant of long-run debt is how easy or difficult it is for households to substitute away from goods being taxed by inflation. Under reasonable parameter assumptions, the model is calibrated to fit certain US facts, most importantly its debt-to-GDP ratio. A comparative statics exercise shows that fundamentals —other than the substitutability of the good being taxed by inflation— have a second-order effect on long-run debt. The model is extended to include stochastic government expenditure. In line with the tax-smoothing theory, the model predicts that governments would increase debt when expenditure temporarily rises. However, labor taxes are not smoothed.