On a Missing Constraint

We revisit, in a general equilibrium framework, the canonical issue of optimal public debt management when taxes are distortionary. Specifically, we modify the standard formulation of the problem by making an obvious observation and recognizing that, ultimately, any tax policy impacts the entire allocation - both prices and quantities - and puts the government in a unique position to control the equilibrium interest rate. We show that the optimal debt policy involves equilibrium interest rates that are a nonmonotone function of public debt or level of expenditure. In particular, we show that the equilibrium level of interest rate is decreasing for high levels of government debt or public expenditure. Furthermore, we invalidate tax smoothing and show that at the optimum distinct marginal tax rates should be used to deal with unexpected spikes in expenditures or debt repayment. Finally, we show that with an additional instrument - the interest rate - the government can manage expenditure or debt levels inaccessible - exceeding Laffer’s maximum - under the standard approach of price taking in the bond market. In summary, our theoretical results suggest that existing debt levels are consistent with low equilibrium interest rates and do not pose as significant threats as implied by the standard macroeconomic theory