Chapter_4_on the needed quantity of government debt

Chapter_4_on the needed quantity of government debt -...

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Federal Reserve Bank of Minneapolis Quarterly Review Vol. 31, No. 1, November 2007, pp. 2 –15 On the Needed Quantity of Government Debt Kathryn Birkeland Edward C. Prescott Assistant Professor of Economics Senior Monetary Advisor University of Wisconsin La Crosse Research Department Federal Reserve Bank of Minneapolis and W. P. Carey Chair of Economics Arizona State University Abstract People are enjoying longer retirement periods, and population growth is slowing and, in some countries, falling. In this article, we determine the implications of these demographic changes for the needed amount of government debt. If tax rates and the transfer share of gross national income (GNI) are both high, the needed debt is near zero. With such a system, however, huge deadweight losses are incurred as a result of the high tax rate on labor income. With a savings system, a large government debt to annual GNI ratio is needed. In a country with early retirement and no population growth, the needed government debt is as large as F ve times GNI, and welfare is as much as 24 percent higher in terms of lifetime consumption equivalents in the savings system relative to the tax-and-transfer system. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
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FEDERAL RESERVE BANK OF MINNEAPOLIS QR 2 We need to change our way of thinking regarding gov- ernment debt. First, the government debt that a country owes to its citizens is not debt in the usual sense of the word. This form of government debt is a mechanism that facilitates intergenerational borrowing and lending, and is an integral part of a welfare-improving saving- for-retirement system. Second, because of changing demographics, the quantity of government debt needed in a saving-for- retirement system is becoming large. The number of retired workers is growing because people are living longer and population growth has slowed in most of the advanced industrial countries. With these demograph- ics, large government debt is a feature of the retirement ±nancing system that maximizes the lifetime welfare of all, including our grandchildren —namely, the saving- for-retirement system. The alternative tax-and-transfer system, in which the government taxes workers’ labor income or consumption (or both) to ±nance the con- sumption of retirees, has little or no government debt. However, the welfare for all , including our grandchil- dren, is much lower in the tax-and-transfer system. Unlike the pure consumption loan model of Sam- uelson (1958), taxing the income of people when young and making lump-sum transfers to them when old is not equivalent to there being large quantities of explicit gov- ernment debt, which people buy during their working life and sell during their retirement life. Because people value their nonmarket time, taxing labor income or con- sumption (or both) lowers labor supply. The welfare of a saving-for-retirement system is much higher than the
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This note was uploaded on 04/13/2011 for the course ECON 509 taught by Professor Villamil during the Fall '08 term at University of Illinois, Urbana Champaign.

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Chapter_4_on the needed quantity of government debt -...

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