Testing Public Debt Sustainability Using a Present-Value Model

The recent fiscal crisis has renewed the public policy focus on debt sustainability. To investigate debt sustainability empirically, a significant portion of the literature on public debt sustainability tests whether government revenue and expenditure are cointegrated, i.e., move together in the long-run. In this paper, we show that this approach is not conclusive when the null of cointegration is not rejected. In such a case, one cannot draw definitive conclusions about the sustainability of public debt. To overcome this problem, we propose a new approach based on Campbell and Shiller's (1987) present-value model to derive moment restrictions that can be used to test fiscal sustainability consistently. Using this new approach, we test the solvency of the U.S. fiscal situation for the post-WWII data. Our findings suggest that the U.S. fiscal situation has not been sustainable for the post-WWII period. This result is in contrast to the traditional approach where we find that the sustainability hypothesis is not rejected