The Optimum Quantity of Debt for Japan

Abstract

Japan's net government debt reached 130% of GDP in 2013. The present paper analyzes the welfare implications of the large debt for Japan. We use a heterogeneousagent, incomplete-market model with idiosyncratic wage risk and endogenous labor supply. We find that under the utilitarian welfare measure, the optimal government debt for Japan is -50% of GDP and the current level of debt incurs the welfare cost that is 0.22% of consumption. Decomposing the welfare cost reveals substantial welfare effects arising from changes in the level, inequality, and uncertainty. The level and inequality costs are 0.38% and 0.52% respectively, whereas the uncertainty benefit is 0.68%. Adjusting consumption taxes instead of factor income taxes to balance the government budget reduces the welfare cost of the current debt, whereas the indivisibility of labor increases the cost.