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Discussion Paper

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We study how the government’s ability to borrow depends on its capacity to tax. Using a two-period OLG growth model, we establish the following. When lump-sum taxes are unrestricted, Ponzi finance is possible, regardless of whether the economy is dynamically inefficient and regardless of the relationship between the interest rate and the growth rate. Ponzi finance, and government debt generally, is unessential or redundant: it does not enlarge the set of allocations that can be supported as competitive equilibria. When lump-sum taxes are restricted, Ponzi finance (public debt) may be essential . Central to the paper is our characterization of feasible government fiscal-financial plans for an infinite-lived government facing a sequence of finite-lived overlapping private generations. The central idea is that the government does not bankrupt private agents. We contrast our criterion with the conventional government solvency constraint. The conventional solvency constraint (the present value of future government debt is non-positive in the infinitely distant future) is neither necessary nor sufficient for our feasibility criterion. When the government must use distortionary taxes and the long-run interest rate exceeds the long-run growth rate, our feasibility criterion implies the conventional solvency constraint.

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