INTRODUCTION

In the policy analyses of previous chapters it was invariably assumed that the government revenue requirement was pre-determined and the policy instruments were chosen to maximise welfare given this fixed requirement. The satisfaction of the revenue constraint implicitly prevented the government issuing any debt. In a static setting there is some sense in this procedure since, by its very nature, the static setting prevents a comprehensive analysis of the effects of the borrowing and repayment process. Introducing time and considering the intertemporal maximisation of welfare permits the endogenisation of government debt and allows the determination of its optimal level to become part of the overall policy formulation process. It also allows the interaction between debt and taxation to be explored. The employment of both debt and taxation as instruments of government policy will affect the capital market and, through this, the dynamic evolution of the economy and the eventual steady state.

The content of this chapter will reflect these intertemporal issues. Section 2 is concerned with the effects of the maintenance of a constant stock of debt upon the long-run equilibrium of the economy. Section 3 then analyses the relation between lump-sum taxation and debt and characterises the optimal combination of the two instruments. The focus of section 4 is upon debt neutrality and the circumstances in which this does, and does not, hold. Section 5 of the chapter is more concerned with tax policy than debt and it studies the optimisation of income and interest taxation in an economy with an heterogeneous population.