Public Debt and the Balance Sheet of the Private Sector
This paper studies the political and welfare determinants of fiscal policy and growth. We introduce different interest groups, firms and households, into a simple growth model with incomplete markets, heterogeneous agents, and non-insurable idiosyncratic productivity shocks. Firms finance productive investments by issuing bonds but cannot issue equity. Households invest in corporate and public debt. The government selects the levels of taxes and public debt so as to maximize a weighted sum of the welfare of firms’ owners and households. More government debt reduces corporate leverage, increases the risk free rate r, and decreases the growth rate g. The weight of firms in social welfare determines whether r < g or r > g at the optimum, with different dynamics in both regimes.