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This paper addresses the basic tradeoff between the stabilisation properties of budgets and the sustainability of long run fiscal positions. The modeling framework consists of a simple non-monetary endowment economy with overlapping generations, extended to account for stochastic endowments and borrowing constrained households. A benign government chooses the optimal degree of responsiveness of net taxes to individual incomes and an optimal measure of long-run public debt in order to smooth households' consumption across states of nature. In the presence of a deficit constraint for the government, the results point to the desire for lower debt levels than those currently prevailing in European Union countries in order to enable a more effective hedging of personal income uncertainty by means of more active automatic fiscal stabilisers. The optimal degree of automatic stabilisation and debt reduction is conditional on the characteristics of economic cycles.

A substantial buildup of public debt can erode the scope for effective counter-cyclical fiscal policy stabilisation. The experience of several advanced economies over the last decades has indicated that moving to a more sustainable fiscal policy — for example, through reducing public debt levels — may help improve the ability of fiscal policy to attenuate the effects of economic fluctuations. From a political economy standpoint, however, it may be difficult to find appetite among current taxpayers (and voters) to shoulder the burden of moving to a more sustainable fiscal position, as while a policy of debt reduction would provide a permanent improvement in fiscal stabilisation against income shortfalls, the excess burden of paying down accumulated government debt would be temporary, falling on current taxpayers. In this respect, the pursuit of a credible yet responsive fiscal policy framework can benefit from explicit policy rules, such as deficit limits. This can be illustrated by the experience of countries within the European Union over the last decade, where a strong correlation between the reduction in general government gross debt ratios in GDP and the estimated degree of automatic stabilisation (see Fig. 1) suggests that more sustainable fiscal positions yield scope for enhanced budgetary responsiveness.In this paper, we build a simple model to analyse under what conditions current taxpayers would be willing to unilaterally shoulder a higher tax burden to finance public debt reduction in order to enhance the functioning of automatic stabilisers for themselves and subsequent generations in the absence of altruism.1 The analysis is based on a dynastic overlapping generations framework `a la Weil (1989) applied to a simple endowment economy with a household and government sector, along with incomplete capital markets which prevent consumption smoothing in the presence of stochastic shocks to income. The model indicates that myopic fiscal policymaking that considers only the welfare of the current generation of taxpayers leaves plenty of room for self-insurance motivated debt reduction. Subjecting fiscal authorities to borrowing limits of some sort induces a tradeoff, whereby households with a self-insurance motive can only obtain higher automatic budgetary stabilisation by paying higher taxes. This, in turn, allows for debt reduction to obtain enhanced automatic stabilisation in the face of income shortfalls.2 The current generation of taxpayers, even in the absence of altruistic links, can be shown to optimally choose to shoulder a state-contingent excess tax designed to reduce public debt levels and thereby determine the level at which debt per capita should be stabilised for itself and future generations of taxpayers. The magnitude of such public debt reduction hinges on the characteristics of shocks hitting the economy, and in particular heterogeneity in the probability distribution for national income leads to large differences in desired long-run debt levels. In general, a higher amplitude of exogenous national shocks implies a lower optimal public debt level to provide scope for adequate consumption stabilisation. This may help explain the pace at which debt has been reduced in the course of the last decade across various European Union countries. The finding that debt reduction can give room for enhanced automatic stabilisation — and thereby help households to smooth consumption in the face of income shocks — contrasts with the literature which focuses on the liquidity-enhancing impact of government transfers on households in a closed economy with idiosyncratic shocks to income (see, for instance, Flodén, 2001, Aiyagari and McGrattan, 1998 and Woodford, 1990). The key difference lies both in the nature of uninsurable risk individual-specific risk versus aggregate risk and the treatment of fiscal sustainability issues. Taking into account the latter can imply that automatic stabilisation and debt are no longer perfect substitutes as tools to insure households against income shortfalls. The tradeoff we analyse would be consistent with the empirical findings of Gali and Perotti (2003) in which it is argued that following the fiscal consolidations of the 1990s, most industrialised countries began to experience a decline or at least a deceleration in their debt/GDP ratios in conjunction with a trend towards more countercyclical fiscal policies. 3 The rest of the paper is organised as follows. In Section 2 we present the model. Then, we move to discuss the fiscal policy problem which the government solves optimally — first in the absence of any formal deficit limit in Section 3, then in the case where deficit limits apply in Section 4. In Section 5 we briefly discuss an application of our theoretical framework to European Union countries in the context of the Stability and Growth Pact. Section 6 presents some concluding remarks.

This paper presented a model motivating a complementary relationship between enhanced debt reduction and heightened automatic stabilisation properties of government budgets. We show that when fiscal policy can cushion consumption against unfavourable aggregative income shocks, households choose a balance of automatic stabilisation and debt reduction from a self-insurance perspective. When income insurance in the form of ex-post automatic stabilisation is available at no cost, households prefer to cushion their consumption against income shortfalls using this channel rather than obtain similar insurance through a voluntary ex-ante reduction in public debt. In the more realistic case in which a public borrowing constraint applies, effective automatic stabilisation carries the price of debt reduction, thereby creating the tradeoff necessary to jointly solve for the optimal level of public debt and optimal degree of automatic stabilisation. Parameterising the model to a set of EU countries, we show that the current generation of mildly risk-averse households in an overlapping generations framework would be willing to reduce accumulated public debt considerably in order to provide more room for the functioning of automatic stabilisers both for themselves and for future generations, even in the absence of altruism. The desirability of self-insurance against adverse income shocks increases with uncertainty — whereby more pronounced output fluctuations imply less scope for automatic stabilisation in the absence of an aggressive policy of debt repayment. A key conclusion of the model calibration is that actual debt stocks in the majority of EU countries are higher than the optimal levels that would enable a more effective hedging of households' incomes. The model also points out that in countries where output volatility is high the optimal level of the debt-to-GDP ratio is much lower than the 60% limit envisaged in the EU fiscal policy framework.