Initial Debt Research Articles

Fiscal policy reforms and dynamic Laffer effects

This paper looks at the conditions under which a dynamic Laffer effect occurs. Using a basic model, we explain and reconcile selected findings in the literature. We numerically show that a lower tax rate on capital income is the best candidate for obtaining a dynamic Laffer effect—here defined as an improvement in the long-run budget balance of the government. Moreover, ignoring the stock of initial debt and changes in labor supply lead to an overestimation and underestimation of the effect, respectively. Finally, we show that when lower taxes on factor income are financed by higher taxes on consumption, there exists a wide array of combinations for which there is an improvement in both the long-run government budget balance and lifetime welfare. These combinations, however, differ in their implications for labor supply and immediate welfare effects.

Optimal Government Spending at the Zero Lower Bound: A Non-Ricardian Analysis

This paper analyzes the implications of distortionary taxation and debt financing for optimal government spending policy in a sticky-price economy where the nominal interest rate is subject to the zero lower bound constraint. Regardless of the type of tax available and the initial debt level, optimal government spending policy in a recession is characterized by an initial increase followed by a reduction below, and an eventual return to, the steady state. The magnitude of variations in the government spending as well as their welfare implications depend importantly on the available tax instrument and the initial debt level.

Critical thresholds for budget consolidations: a semi-parametric approach

While a lot is known regarding the determinants of successful fiscal consolidations, previous studies do not allow for the possibility of nonlinearities in factors impacting budget consolidations. By using a semi-parametric modelling approach employing penalized spline regression on a data-set for 28 OECD countries for the period 1978–2007, we demonstrate the existence of critical thresholds not only for the initial debt level but also for the accompanying monetary policy. The latter result shows when monetary policy matters most and suggests, counter to previous studies, that too lax a monetary policy decreases the success probability of a fiscal adjustment episode.

First-Day Stock Returns to Issuing Initial Corporate Bond and Seasoned Equity

This paper examines the intraday return of stock price in response to announcement of initial corporate debt offerings and seasoned equity offerings. We find that the average stock price reaction to initial debt offerings is positive, in comparison to an established notion that average stock price return to regular corporate debt offerings is not significantly different from zero. Moreover, firms issuing initial debt offerings with higher price/earnings ratio are found to experience more positive stock price return. Although the stock price reaction to initial debt offerings is negatively affected by the expected post-issuance long term debt ratio, the stock price return is interestingly positively correlated with the amount of debt to be issued. These findings support the theory of quality signaling by debt financing and provide evidence to the static trade-off model of capital structure. As for seasoned equity offering, we find that average stock reaction is significantly negative, which is consistent with all existing studies. Firms issuing seasoned equity offerings experience less negative stock price return if they have higher post-issuance long-term debt ratio and lower the pre-issuance liability/assets ratio relative to the industry average, which suggest that, whenever seasoned equity is issued, valuation of the firm goes down with the decrease of leverage, and market participants instead favor higher long term leverage.

Debt Maturity Choices, Multi-Stage Investments and Financing Constraints

We develop a dynamic investment options framework with optimal capital structure and analyze the effect of debt maturity. We find that in the absence of financing constraints short-term debt maximizes firm value. In contrast with most literature results, in the absence of constraints, higher volatility may increase initial debt for firms with low initial revenues, issuing long term debt that expires after the investment option maturity. This effect, which is due to the option value of receiving the value of assets and remaining tax savings, does not hold for short term debt and firms with high profitability, where an increase in volatility reduces the firm value. The importance of short-term debt is reduced in the presence of non-negative equity net worth or debt financing constraints and firms behave more conservatively in the use of initial debt. With non-negative equity net worth, higher volatility has adverse effects on the firm value, while with debt financing constraints higher volatility may enhance firm value for firms with relatively low revenue that have out-of-the-money investment options.

Interpretation and limits of sustainability tests in public finance

Public debt is considered sustainable if discounted net repayments are expected to cover the initial debt issuance, i.e. if the government’s inter-temporal budget constraint is expected to hold. With risk-averse lenders and an uncertain economic environment, Bohn (1995) stresses that this constraint relies on a stochastic discount factor which depends on lenders’ preferences. To get round the difficulty related to the specification of private agents’ preferences in empirical analysis, Bohn (1998) suggests to estimate fiscal reaction functions describing how primary surplus reacts to indebtedness. After having solved the econometric issues arising when primary surplus and debt have a very different persistence (with a nonparametric approach) or are both integrated (with parametric tests), we estimate fiscal reaction functions for France and Greece. There remain important limitations and interpretation difficulties that are common to all econometric sustainability tests.

Corrigenda

MetroeconomicaVolume 64, Issue 4 p. 760-760 CORRIGENDAFree Access Corrigenda This article corrects the following: The Effect of Government Spending on the Debt-to-GDP Ratio: Some Keynesian Arithmetic Pedro Leão, Volume 64Issue 3Metroeconomica pages: 448-465 First Published online: March 27, 2013 First published: 18 September 2013 https://doi.org/10.1111/meca.12031AboutSectionsPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinked InRedditWechat In the article by Pedro Leão entitled, ‘The Effect of Government Spending on the Debt-to-GDP Ratio: Some Keynesian Arithmetic’ in Volume 64, Number 3 of Metroeconomica, there were errors in the calculation of the estimates of the ‘minimum values of the multiplier’ for the UK (but not for the other countries). In the column of the UK in Table 1 (p. 458), the correct values in rows 7 and 8 are 0.26 and 0.22 (instead of 0.18 and 0.17). In turn, this correction implies that: In the UK rows of Table 2 (p. 459), the estimates of 0.56 and 0.93 should be replaced by 0.64 and 1.01 and the minimum values of the multiplier should not be 0.68 and 0.55, but 0.65 and 0.52. The correspondent correct numbers of Table 3 (p. 460) for the UK are 0.64, 1.01 and 0.81, 0.62. Finally, the correspondent correct numbers of Table 4 (p. 461) for the UK are 0.64 and 1.01 and 0.67 and 0.54. These small corrections imply that the last sentence of Part 4 on page 457 should read as follows: ‘More precisely, multipliers can be between 0.52 and 0.79 for initial debt ratios equal to 90 per cent, between 0.62 and 1.04 for initial debt ratios equal to 60 per cent and, finally, between 0.54 and 0.80 for initial debt ratios equal to the debt ratios observed at the end of 2011.’ Note finally that this correction leads to slightly lower ‘minimum values of the multiplier’ for the UK than before and therefore, if anything, reinforces the main conclusions of the paper. The author would like to thank Vassilis Droucopoulos (University of Athens) for alerting to the errors now corrected. Reference Leão, P. (2013): ‘The Effect of Government Spending on the Debt-to-GDP Ratio: Some Keynesian Arithmetic’, Metroeconomica, 64, pp. 448– 465, doi: 10.1111/meca.12013. Wiley Online LibraryWeb of Science®Google Scholar Volume64, Issue4November 2013Pages 760-760 ReferencesRelatedInformation

The Effect of Firm’s Growth on Firm Survival in Vietnam

With the dataset of 7,962 firms in Vietnam and using the Cox proportional hazard model, the main findings are drawn that the relationship between the firm’s growth (both in employment and in assets) and the survival is positive and non-linearity, and as increasing the growth, the effect of firm’s growth on the firm survival is diminishing. In addition, we also find that the presence of the domestic private and the foreign firms can improve the survival chances, compared to the state firms; The firm size in assets and initial debt have positive relationships with firm survival; Earning before taxes over labour in year t-1 and the return on assets in year t-1 are important and have positive impacts on firm survival in year t, whereas the leverage in year t-1 has a negative impact on the probability of survival in year t for firms in Vietnam.

On the timing and optimality of capital controls: Public expenditures, debt dynamics and welfare

AbstractThis paper solves a second‐best problem where a government has to choose whether to tax financial inflows (capital controls) or not, and when. A multi‐stage optimal control technique is used to this end. First, it is shown that it is optimal to switch in finite time from capital controls to full financial liberalization whenever a measure of total wealth is above a certain threshold. In particular, a too large initial debt makes financial liberalization sub‐optimal. Second, capital controls should be used countercyclically. Third, financial liberalization is not unaffordable only for poor countries, even wealthy countries might find it optimal to implement capital controls if they aim to keep a large amount of public expenditure.

Understanding public debt dynamics

A brief account on the dynamics of public debt is given with the intent of explaining to high school students this crucial aspect in today's economic crisis. A simple model is proposed to argue that only for high enough values of an assumed constant rate ρ of increase of taxable resources there might exist a finite number of periods (years) for repaying an initial debt b0 contracted by a government with its reference national bank.

Initial Public Debt Offerings

We analyze a sample of private firms that choose to go public through an initial public debt offering (IPDO) as an alternative to going public through equity (IPO). These IPDO firms, which have never been analyzed in the prior literature, are more likely to be sponsor backed, significantly larger, and less likely to face information asymmetry than traditional IPO firms. Their debt issues are more expensive and face more restrictive covenants than initial debt issues by publicly listed peers. When these debt-first firms eventually go public, they face lower underpricing than firms without public debt at IPO. Overall, our results are consistent with the hypotheses that ownership structure and the relative informativeness of reported financial statements in different markets drive the decision of where to go public.

Strategic Analysis of Risk-Shifting Incentives with Convertible Debt

Convertible debt eliminates asset substitution in a one-period setting (Green, 1984). But convertible debt terms are usually set before the asset substitution opportunity. This allows shareholders and convertible debtholders to play a strategic noncooperative game. Two risk-shifting Nash equilibria are attainable: pure asset substitution when, despite no conversion, shareholders benefit from shifting risk, and strategic conversion when, despite early conversion, convertible debtholders expropriate wealth from straight debtholders. Even when initial convertible debt is designed to minimize the risk-shifting likelihood, the risk of asset substitution remains economically substantial — contrasting with the agency theoretic rationale for issuing convertible debt.

Government Budget Deficits in Large Open Economies

Large and growing levels of public debt in the United States, United Kingdom, Japan and the Euro Area raise new interest in the cross-country effects of a large open economy’s deficits. We consider a dynamic optimising model with costly tax collection and exogenously given public spending and initial debt. We ask whether the externalities associated with an individual country’s deficits are positive or negative. We characterise the path of taxes in the Nash equilibrium where policy makers act nationalistically and compare this outcome to the global optimal outcome.

Creditors’ Bargaining Power and Accounting Conservatism: A Debt Contracting Perspective

We examine the implications of creditors’ bargaining power, and in particular, how creditors’ bargaining power affects the role of accounting conservatism in initial debt contracting. The relative bargaining power of creditors and borrowers in our study is proxied by exogenous factors unaffected by initial contracting terms. We hypothesize that creditors’ bargaining power affects ex post renegotiation outcomes in cases of covenant violation. We find supportive evidence that higher creditors’ bargaining power is associated with less favorable renegotiation outcomes for borrowers. In addition, our proxies of creditors’ bargaining power are positively associated with loan interest rates and covenant restrictions in initial debt contracts. Since only creditors with high bargaining power can extract benefits from renegotiations, we hypothesize and find that creditors with higher bargaining power exhibit a higher demand for accounting conservatism when entering initial debt contracts. Furthermore, the negative association between conservatism and loan spreads is stronger when creditors’ bargaining power is higher.

Cost of Capital and Value Without Circularity for Constant Growth Perpetuities

This paper presents the derivation of non-circular formulas for the calculation of the cost of equity, WACC, equity value (as a function either of initial debt or leverage), and levered firm value, using some previous results and showing their consistency with other well-known expressions. Relationships between growth, leverage, and debt level at instant zero (which must hold in all cases in order to assure consistency in the valuation process) are also deduced. In addition, a set of exact expressions to compute the impact on equity value of changes in the main variables which it depends on are shown, and conclusions regarding issues such as optimal capital structure that maximize equity value, or the nature of the interaction between cost of debt and equity value, are extracted. Finally, a set of detailed examples are presented that illustrate the proper application of the derived expressions and the steps involved in the process.

The Overhang Hangover

The authors revisit the debt overhang question. They first use nonparametric techniques to isolate a panel of countries on the downward sloping section of a debt Laffer Curve. In particular, overhang countries are ones where a threshold level of debt is reached in sample, beyond which (initial) debt ends up lowering (subsequent) growth. On average, significantly negative coefficients appear when debt face value reaches 60 percent of GDP or 200 percent of exports, and when its present value reaches 40 percent of GDP or 140 percent of exports. Second, the authors depart from reduced form growth regressions and perform direct tests of the theory on the thus selected sample of overhang countries. In the spirit of event studies, they ask whether, as the overhang level of debt is reached: (1) investment falls precipitously as it should when it becomes optimal to default; (2) economic policy deteriorates observably, as it should when debt contracts become unable to elicit effort on the part of the debtor; and (3) the terms of borrowing worsen noticeably, as they should when it becomes optimal for creditors to preempt default and exact punitive interest rates. The authors find a systematic response of investment, particularly when property rights are weakly enforced, some worsening of the policy environment, and a fall in interest rates. This easing of borrowing conditions happens because lending by the private sector virtually disappears in overhang situations, and multilateral agencies step in with concessional rates. Thus, while debt relief is likely to improve economic policy (and especially investment) in overhang countries, it is doubtful that it would ease their terms of borrowing or the burden of debt.

Foreign Aid and Sovereign Credit Worthiness

International nancial markets are far from perfect. Because of problems related to contract enforcement borrowers often end up being rationed; the lenders tend to constrain the amount lent ex ante in order to motivate the borrowers to ful l their obligations and not default ex post. In this paper we take as our point of departure a relationship like this between a lender (or consortium of lenders) and the government of a poor country and ask: How is this relationship a ected by the fact that the borrowing country also receives foreign aid? The answer depends on how the aid is given. If the aid in ow is exogenous we show that some types of aid are e ective in the sense that the aid has a positive e ect on the credit obtained and aggregate welfare. Other types are directly counterproductive. If the aid in ow is endogenous, supplied by altruistic donors as part of a safety-net, serious incentive distortions arise, crowding out private credit. Such aid may actually be welfare-reducing in the recipient country. The paper also contains a discussion of how aid will in uence lenders' incentives to give relief if the initial debt is not sustainable.

Public Debt and Growth

This paper explores the impact of high public debt on long-run economic growth. The analysis, based on a panel of advanced and emerging economies over almost four decades, takes into account a broad range of determinants of growth as well as various estimation issues including reverse causality and endogeneity. In addition, threshold effects, nonlinearities, and differences between advanced and emerging market economies are examined. The empirical results suggest an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth: on average, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year, with the impact being somewhat smaller in advanced economies. There is some evidence of nonlinearity with higher levels of initial debt having a proportionately larger negative effect on subsequent growth. Analysis of the components of growth suggests that the adverse effect largely reflects a slowdown in labor productivity growth mainly due to reduced investment and slower growth of capital stock.

Resolving the Underinvestment and Asymmetric Information Problems with Target Debt Ratios

We show how target debt ratios in book value terms applied to new investment can improve alignment of investment incentives in firms with risky debt outstanding and asymmetric information. While wealth transfer from both agency conflicts can reduce the value of existing equity, new debt offsets the value loss to old shareholders. When an initial target book debt ratio is preserved following the investment, new debt set by the target debt ratio naturally reflects key factors such as the NPV and size of the new project and offsets wealth transfers. Numerical examples show that both agency conflicts can be eliminated both in structural models and in binomial models.

Optimal Capital Structure, Debt Structure, and Investment

We examine the optimal capital structure and priority structure of multiple classes of debt using a dynamic model where firms face a tradeoff between bankruptcy costs, interest tax shield benefits, and investment benefits. As a base case, we first analyze jointly optimal policies for a firm initially constrained to a single class of debt, which results in underinvestment in the growth option. Surprisingly, this standard case produces several novel predictions, such as, financial leverage ratios need not be inversely related to a firm's investment opportunities, and reliance on credit spreads to gauge agency costs of debt is inappropriate when it is hard to identify whether debt policy is endogenous or not. Relaxing the firm's constraint, we then study jointly optimal policies for initial debt and additional debt used to finance the growth option. Ironically, equityholders' optimal strategy in this unconstrained case results in overinvestment in the growth option. As a result, we obtain an interior optimum for priority structure as an important financial contracting device. One of the paper's key implications is that priority structure plays a critical and heretofore unrecognized role in helping to resolve bondholder-shareholder conflicts over investment policy. This financial contracting perspective offers other potentially fruitful insights to better understand the effects of optimal capital structure and debt structure on corporate investment policy.