Abstract
Rising debt/GDP ratios have been a common feature of many developed countries since the 70s. In many cases, budget deficits have been the result of increased government spending coupled with relatively lower tax rates. In an economy where the government expenditure/GDP ratio follows a regulated Brownian motion, distortion smoothing is shown to imply a simple closed form relationship between the optimal tax rate, the process drift, and the optimal path of government debt. The paper shows that apparently ‘low’ tax rates are optimal when a future stabilization of government spending is expected, so that the debt/GDP ratio rises on the optimal path as stabilization is approached. The expectation of future stabilization gives rise to a nonlinear relationship between tax rates and expenditures, similar to that observed in the data.
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