A Test of Steady-State Government Debt Neutrality

A TEST OF STEADY-STATE GOVERNMENT-DEBT NEUTRALITY This paper investigates whether in the steady state the real interest rate is an increasing function of both the government debt and government spending. Using data from the period between January 1981 and March 1986, the paper finds no evidence of such a relationship. These data afford an especially powerful test because the ratio of federal debt to trend output, which had fallen from 93 to 33 percent between January 1948 and December 1980, reversed course after the enactment of the Economic Recovery Tax Act, reaching 47 percent in March 1986. I. INTRODUCTION In conventional macroeconomic analysis, government debt is not neutral because households view it as contributing to their net wealth. As a result, the larger the government debt is, the wealthier households feel and the more they consume. More consumption in turn spells less investment over time and thus a lower steady-state capital stock. As a result, output is ultimately lower and the real interest rate higher. In principle, however, households need not view government debt as net wealth.(1) If households accurately foresee the future taxes that will service the government debt, if they face perfect capital markets, if taxes do not distort their decisions, and if they internalize future generations, then they treat the future taxes servicing the government debt as an exact offset. Consequently, government debt is neutral since it does not make households feel wealthier and hence affects nothing.(2) Nevertheless, because most macroeconomists doubt that households accurately foresee future servicing taxes, have access to perfect capital markets, and internalize future generations, they do not model government debt as neutral. Like perfect competition, however, government-debt neutrality may be a good approximation in many applications even if the assumptions underlying it are unrealistic. Therefore, empirical analysis rather than introspection should determine how one models government debt. This paper provides such an empirical analysis. The empirical analysis focuses on the steady-state relationship between government debt and the real interest rate.(3) In the steady state, a larger government debt leads to a smaller capital stock and hence a higher marginal product of capital if households view government debt as net wealth. Consequently, the real interest rate is also higher. If instead government debt is neutral, nothing should happen to the real interest rate. U.S. data from the period between January 1981 and March 1986 have been used here to investigate whether a larger government debt leads to a higher real interest rate in the steady state and hence whether government debt is neutral. These data afford an especially powerful test because the ratio of federal debt to trend output, which had fallen from 94 to 33 percent between January 1948 and December 1980, reversed course after the enactment of the Economic Recovery Tax Act, reaching 47 percent by March 1986. Moreover, this upward trend is likely to continue well beyond 1986. Such an enormous increase in federal debt should have raised by steady-state real interest rate appreciably if households view government debt as net wealth to any important extent. In the absence of evidence that the steady-state real interest rate did rise, government debt is judged to be neutral in the steady state. Section II formulates the model, which is estimated in sections III and IV. Section V summarizes the paper and then briefly reviews an extensive literature consistent with government-debt neutrality. II. FORMULATION OF THE ECONOMETRIC MODEL The appendix demonstrates that if households view government debt as net wealth, the real interest rate should be an increasing function of both the government debt and government spending in the steady state (see also Evans [1988] for this analysis). …