Optimal fiscal policy with low interest rates for government debt

Abstract

This paper analyzes optimal fiscal policy when the rate at which governments can borrow changes persistently. To analyze trade-offs, we allow for fiscal distortions and productive government spending and characterize the optimal mix between spending and revenue measures in a low rate environment. We find that low interest rates on government bonds can be welfare-enhancing if used by the government for fiscal measures that reduce the level of distortion, notably the labor tax, permanently. In the case of a general "flight-to-quality”, where households ask for a premium for holding physical (private) capital, the optimal policy is to increase the public-to-private capital ratio for as long as the shock persists. The associated financing needs should be met by a small increase in government debt and a temporary capital tax.