A P Theory of Taxes and Debt Management

Abstract

Distortions induce a benevolent government that must finance an exogenous expenditure process to smooth taxes. An optimal fiscal plan determines the marginal cost —p’ of servicing government debt and makes government debt risk-free. A convenience yield tilts debts forward and taxes backward. An option to default determines debt capacity. Debt-GDP ratio dynamics are driven by 1) a primary deficit, 2) interest payments, 3) GDP growth, and 4) hedging costs. We provide quantitative comparative dynamic statements about debt capacity, debt-GDP ratio transition dynamics, and time to exhaust debt capacity.