Managing the Public Debt: The Optimal Taxation Approach

Abstract

This paper examines research on public debt management, focusing on debt structure by denomination, indexation features, and maturity. The optimal taxation approach is reviewed and its policy implications are related to the trade‐off between minimization of the expected cost of debt servicing and minimization of budgetary risk. Strong arguments are provided for debt instruments which yield low returns when output and hence revenues are lower and public spending higher than expected. This debt design minimizes tax distortions and provides flexibility in conducting fiscal policy. The exact characterization of the debt composition which supports efficient taxation depends on the stochastic structure of the economy. Long‐term nominal debt is a hedge against supply shocks affecting revenues and inflation and makes the government budget insensitive to interest‐rate risk. However, at high levels of debt, the extent of insurance or flexibility that governments can obtain by issuing long‐term nominal debt is limited by the need to maintain the credibility of the anti‐inflation stance.