An Argument for Paying Down Public Debt

IMF Blog, August 26, 2016

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An Argument for Paying Down Public Debt

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Bibliographic details

• Authors: Vitor Gaspar, Julio Escolano
• Published: August 26, 2016

Overview

• Authors: Vitor Gaspar, Julio Escolano
• Publication date: August 26, 2016
• Question addressed: What should governments do about high public debt-to-GDP ratios when viewed from an optimal tax smoothing perspective (abstracting from macroeconomic/business cycle considerations)?

Context and motivation

• In advanced economies, the debt-to-GDP ratio has reached the highest level on record since 1950.
• The increase in debt was particularly pronounced since the beginning of the Great Recession due to government rescues of the financial system and stimulus measures, resulting in a substantial increase in general government’s liabilities.
• Characteristics of the era noted: low inflation, low growth, and bond yields at historical lows.
• Trade-off emphasized: deleveraging is difficult in this environment, but fiscal policy has been called upon to play a more active role to head off a new mediocre of subpar growth and extremely low inflation.

Literature connection

• Reference to IMF colleagues Ostry, Ghosh, and Espinoza:
  • Their argument: countries can live with high debt under certain assumptions (for example, continuous access to financing).
  • They analyze interaction between tax smoothing and productive public investment in determining optimal policy.
  • Main result: high public debt ratios imply higher tax rates and are bad for standards of living (or growth), but after a sharp debt increase taxes should be raised only to stabilize the debt ratio; pushing taxation further to reduce debt is not optimal because the excess burden of taxation increases more than proportionally to the tax rate.
  • Policy note: governments should be opportunistic in reducing public debt (e.g., with privatization receipts, licensing royalties, or economic booms yielding exceptionally high revenues).

Extension in the authors’ working paper

• Simplifications and extensions:
  • Disregard public investment.
  • Directly postulate the normative goal of minimizing the excess burden of taxation.
  • Incorporate empirical fact that financial crises, natural disasters, and wars are repeated events with sizable implications for public finances.
  • Account for asymmetry in risks to public finances: large, positive disturbances to the public debt ratio are much more likely than negative shocks of similar magnitude (IMF, 2016).
  • Key intuition: sudden surges in debt ratios (wars, bank bailouts) are more common than sudden drops (privatizations, licenses).

Empirical documentation of asymmetry (U.S. and U.K., long-run)

• Data examined: historical time series for the United States and the United Kingdom covering the long term (charts referenced for U.S.: Chart 2; for U.K.: Chart 3).
• Observed pattern (1790 to 2014):
  • Long periods of persistent, gradual declines punctuated by occasional sharp increases in the debt ratio.
  • Histograms of changes in the debt ratio suggest the distribution is skewed to the right.
  • The paper confirms rejection of symmetry via a battery of statistical tests.

Frequency and scale of debt surges (empirical averages)

• United Kingdom:
  • On average, a (positive) outlier year every 28 years.
  • Average increase in the debt ratio during outlier year: 30.8 percentage points of GDP.
  • Average decline in the debt-to-GDP ratio in normal years: 1.3 percentage points of GDP.
  • Corresponding model normative benchmark: 1.1 percentage points.
• United States:
  • On average, a (positive) outlier year every 32 years.
  • Average increase in the debt ratio during outlier year: 15.4 percentage points of GDP.
  • Average decline in the debt-to-GDP ratio in normal years: 0.3 percentage points of GDP.
  • Corresponding model normative benchmark: 0.5 percentage points.

Key findings and policy implications

• Asymmetric risk of large debt-increasing shocks implies a rationale for reducing debt in normal times as insurance against future surges.
• Optimal tax smoothing requires small but enduring public debt reductions in normal years.
• Empirical behavior of public debt in the U.S. and U.K. over the last 200 years is close to the normative implications of the model.

Source: "An Argument for Paying Down Public Debt", Vitor Gaspar and Julio Escolano, August 26, 2016.

Content in this bundle

• Analyzing and Managing Fiscal Risks Best Practices; IMF Policy Paper; May 4, 2016
  • Analyzing and Managing Fiscal Risks Best Practices; IMF Policy Paper; May 4, 2016 (Markdown version)
  • Analyzing and Managing Fiscal Risks Best Practices; IMF Policy Paper; May 4, 2016 (PDF)
• Staff Discussion Note
  • Staff Discussion Note (Markdown version)
  • Staff Discussion Note (PDF)

References

• recent working paper