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Debt and Deficits: Fiscal Analysis with Stationary Ratios

Abstract:
We introduce a new measure of a government's fiscal position that exploits cointegrating relationships among fiscal variables. The measure is a loglinear combination of tax revenue, government spending and the market value of government debt that—unlike the debt-GDP ratio— appears stationary in the US and 15 other developed countries. A weak fiscal position must ultimately be resolved by low future returns on government debt or by fiscal adjustment, a combination of high tax growth and low spending growth. Empirically, we find that debt returns play a negligible role and fiscal adjustment predominantly consists of changes in spending growth.