We study public debt in competitive equilibria in which a government chooses transfers and taxes optimally and in addition decides how thoroughly to enforce debt contracts. If the government enforces perfectly, asset inequality is determined in an optimum competitive equilibrium but the level of government debt is not. Welfare increases if private debt contracts are not enforced. Borrowing frictions let the government gather monopoly rents that come from issuing public debt without facing competing private borrowers. Regardless of whether the government chooses to enforce private debt contracts, the level of initial government debt does not affect an optimal allocation.
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A key observation about these conditions is that there exist equilibrium q t that are higher than the discount factor β when the assets chosen by agent 1 are zero. We show in the online appendix 2 that for any ϱ ≥ β we can construct an equilibrium in which τ t = τ ¯ and b 1 , t = 0 for all t and an (inverse of) gross interest rate sequence q ( ϱ ) = ( ϱ , β , ϱ , β , … ) . This equilibrium is supported by transfer and debt sequences ( T (ϱ), B (ϱ)) that satisfies
- Distorting tax
- Government debt
- Ricardian equivalence