This study exploits the trade-off between government debt as an asset that can be used for self- insurance against idiosyncratic income shocks and the distortions on labor and capital supply created by taxes needed to finance debt.
In deriving optimal debt level, the paper explicitly considers a trade-off between the pain of fiscal adjustment (assuming that the current debt ratio is above the steady state optimal one) and the gain from reaching the ideal steady state level. To determine the optimal quantity of public debt the study uses a heterogeneous agent closed-economy model with incomplete insurance markets and endogenous labour supply. Furthermore, the model is enriched by welfare-increasing government activity via by productive government investment and provision of public goods.
The modelling framework with uninsurable idiosyncratic productivity shocks, the degree of inequality implied by the model and restricted borrowing give rise to non-trivial effects of public debt on the economy. On the one hand, higher public debt can relax borrowing constraints of households by increasing liquidity and thus facilitating consumption-smoothing. On the other hand, rising public debt crowds out private investments and therefore lowers wages and consumption in equilibrium. Therefore, a priori it is not clear which effect is stronger. The optimal public debt is determined based on welfare comparison between stationary equilibria when transitional dynamics are either ignored or accounted for.
The paper shows that public investments play an important role as they generate positive spillover effects in the private sector by boosting the productivity of labor and capital. This reduces the precautionary savings motives for households, as they can rely more on labor income. Transitionary welfare effects work differently. Reduction in public debt leads to a reduction of the tax rate in the long run. However, debt reduction requires an increase in the tax rate in the short run, which has a negative effect on welfare. Therefore, ignoring these adjustment costs, optimal debt levels would be very large and negative (government accumulates assets of 130 percent of GDP) accompanied with large welfare gains (more than 20 percent) which is fully consistent with the literature on optimal public debt (Chatterjee et al. (2017), Rohrs and Winter (2017), Aiyagari and McGrattan (1998)). However, with transitional dynamics considered, the optimal debt ratio remains positive but lower than the current level of debt (27-30 percent of GDP). The corresponding consumption-equivalent welfare gains are low, between 1.91 and 2.27 percent depending on the presence of public investment. Relatively low optimal debt level is due to low level of idiosyncratic labor income volatility as a result of low empirical wealth inequality. Hence self-insurance via private capital is more than enough and higher provision of government insurance via sovereign bonds is not necessary.
Furthermore, from the perspective of rapid population ageing expected in Slovakia, calls for even more prudent levels of public debt gain relevancy. The only reason why Slovakia should have public debt at all in this model is that it is painful to get rid of the existing debt. The validity of results is supported by numerous robustness check exercises: change to model calibration, different policy rule, modified tax system, impact of public goods provision on household social welfare.
Keywords: Infrastructure, public investment, heterogeneous agents, public debt, welfare, transitional dynamics.
JEL Classification: E2, E6, H3, H4, H6