Beyond Tax Smoothing

Abstract

Analyses of optimal government capital structure generally follow Bohn (1990) and Barro (1995) in assuming risk neutrality or an exogenous risk premium. These analyses usually conclude that the optimal government capital structure stabilizes tax rates over time and states of nature to the greatest extent possible, something known as "tax smoothing." In this paper, we show that when an endogenous risk premium is introduced, the optimal government capital structure will no longer smooth tax rates. Under likely conditions, the optimal structure requires a larger short position in risky assets than that implied by tax smoothing