The Theory of Optimum Deficits and Debt

This paper deals with some of the issues that arise in connection with the optimal financing of a given program of "exhaustive" public spending on goods and services. The determination of the size and composition of this real spending program is not considered. A more general view would encompass the optimal joint determination of the public sector’s consumption and investment program and its method of financing, but even the tess ambitious approach adopted here raises a very wide range of issues and considerations. Government financial policy is about the management of the public sector balance sheet, broadly defined. It includes the choice of taxation versus borrowing. It also concerns the composition or structure of taxes (lump sum, direct, indirect, degree of progression, etc.) and the characteristics of the debt instruments issued by the government (interest-bearing or noninterestbearing, legal tender, maturity, degree of indexing, etc.). Monetary policy, exchange rate management and foreign exchange market intervention therefore belong to financial policy as much as open market operations or bond issues "to finance the deficit." It should be obvious that questions concerning the distribution of income (intragenerational as well as intergenerational) are inextricably intertwined with questions relating to the financing of a given real spending program. Stiglitz (1983a,b) has emphasized the inevitable intertemporal and intergenerational risk-sharing attributes of financial policy, something I shall return to in Section II. Like any other kind of government intervention in the economy, government financial policy can be rationalized in one of two ways. The first is intervention for purely distributional reasons. While they are of major importance, I shall not pay much attention in what follows to the distributional objectives of the government. The distributional consequences of alternative financing rules will, however, be central. Indeed financial policy influences real economic variables largely by affecting the intertemporal and interpersonal (including intergenerational) distribution of income and wealth. The second justification for financial policy is the identification of instance(s) of market failure together with the attribution to the government of the ability to undertake remedial welfare-improving actions that private