Optimal fiscal policy with low interest rates for government debt

Keywords Optimal fiscal policy; Distortionary taxes; Government investment; Interest rate; Safe rate; Risky rate; Secular stagnation Abstract This paper analyzes optimal fiscal policy when the rate at which governments can borrow changes persistently. To analyze trade-offs, we allow for fiscal distortions and productive government spending and characterize the optimal mix between spending and revenue measures in a low rate environment. We find that low interest rates on government bonds can be welfare-enhancing if used by the government for fiscal measures that reduce the level of distortion, notably the labor tax, permanently. In the case of a general 'flight-to-quality', where households ask for a premium for holding physical (private) capital, the optimal policy is to increase the public-to-private capital ratio for as long as the shock persists. The associated financing needs should be met by a small increase in government debt and a temporary capital tax. Author Affiliation: (a) DG ECFIN, European Commission, Belgium (b) DIW, EIIW, Germany, and VIVES, KU Leuven, Belgium (c) IRES, UC Louvain, Belgium * Corresponding author. (footnote) We thank Guenter Coenen, Thomas Lubik and participants at the conference on 'Secular Stagnation, Low Interest Rates and Low Inflation: Causes and Implications for Policy' organized by the European Commission, the CEPR and the JEDC for very helpful comments and suggestions. The views expressed in this paper are those of the authors and should not be attributed to the European Commission. Byline: Philipp Pfeiffer (a), Werner Roeger [w.roeger@web.de] (b,*), Lukas Vogel (a,c)