Are Government Bonds Net Wealth or a Liability? ---Optimal Debt and Taxes in an OLG Model with Uninsurable Income Risk

A positive national debt is often rationalized either by the assumption of dynamic inefficiency in an overlapping-generations (OLG) model, or by the hypothesis of heterogeneous-agents and incomplete-markets (HAIM) in an infinite horizon model. Both assumptions imply insufficient private liquidity to support private saving and investment, thus calling for a positive level of public debt to improve social welfare. However, since public debt is financed often by distortionary future taxes, optimal debt and tax policies ought to be studied jointly in a single framework. In this paper we use a primal Ramsey approach to analytically characterize optimal debt and tax policy in an OLG-HAIM model. We show that (i) public debt can be a liability instead of net wealth, despite insufficient private liquidity to support private saving and investment, and (ii) such a debt policy can dramatically change the government's optimal tax scheme since the sign and magnitude of the optimal quantity of debt dictate the sign and magnitude of optimal taxes as well as the priority order of tax tools (such as a labor tax vs. a capital tax) in financing the public debt.