The risk premium of unfunded spending
In this paper, Roberto Gomez-Cram, Howard Kung, Hanno Lustig, and David Zeke analyze how the risk of wealth redistribution from bondholders to taxpayers during unfunded fiscal expansions drives government bond risk premia and raises borrowing costs.
The authors employ a two-agent analytical model with limited asset market participation, separating asset-holding bondholders from hand-to-mouth taxpayers who cannot save. Gomez-Cram et al. distinguish between two policy regimes: a monetary-led regime where central banks target inflation and fiscal authorities fully fund spending through future taxation (creating safe debt), and a fiscally-led regime where monetary policy accommodates and fiscal policy relies on inflationary finance (creating risky debt). They use risk-adjusted log-linear approximations for analytical solutions, then extend the framework to a quantitative New Keynesian model with heterogeneous agents, calibrating it to match observed unfunded spending volatility.
Findings
- Quantitative impact: The model shows that unfunded fiscal shocks account for over 50% of the nominal term premium in government bonds (5-year minus 1-quarter yield spread), with fiscal redistribution risk being a major driver of government funding costs.
- Safe debt condition: Debt remains safe only when governments commit to fully funding spending increases through future taxation (monetary-led regime). Without Ricardian tax adjustments that offset fiscal surprises, bondholders demand higher risk premia.
- Policy implication: Governments relying on partial inflationary finance to cover unfunded obligations face significantly elevated borrowing costs due to the pricing of fiscal redistribution risk, a mechanism overlooked in standard macroeconomic models.
Fiscal Redistribution Risk in Treasury Markets
Authors: Roberto Gomez-Cram, Howard Kung, Hanno Lustig, David Zeke
From: London Business School, Stanford Graduate School of Business, Federal Reserve Board of Governors
How citizens form beliefs about fiscal policy
Francesco Bianchi, Era Dabla-Norris, and Salma Khalid employ a large-scale cross-country survey of 27,000 respondents across 13 advanced and emerging market economies, conducted from April to May 2024, to examine how knowledge, beliefs, and preferences about government debt shape expectations of fiscal policy. The survey captures respondents’ understanding of fiscal relationships (taxes, spending, deficits, debt), perceptions of current and future debt levels, and expectations of tax increases and spending cuts. The authors measure past fiscal experiences using a weighted measure of lifetime exposure to fiscal consolidation episodes, following the learning-from-experience approach. They conduct three randomized information treatments that vary how respondents learn about debt levels and fiscal relationships, and analyze treatment effects using regression analysis with demographic controls and country fixed effects.
Findings
- Knowledge gaps and misperceptions: Individuals demonstrate weak understanding of fiscal relationships and systematically underestimate debt in high-debt countries. Asymmetric framing effects appear—respondents are less likely to recognize that higher tax revenues reduce deficits compared to spending cuts. Older individuals with financial assets have significantly better fiscal understanding, identifying age and financial wealth as the strongest predictors of fiscal knowledge.
- Policy expectations and distributional concerns: Approximately 63% of respondents expect tax increases compared to 35% expecting spending cuts. Crucially, individuals across income levels expect fiscal adjustment burdens to fall disproportionately on themselves—high-income respondents expect wealth taxes, lower-income respondents expect cuts to social programs they receive. This pattern suggests people perceive themselves as bearing asymmetric adjustment costs.
- Role of past consolidation experiences: Respondents with greater lifetime exposure to fiscal consolidation episodes are significantly more pessimistic about debt trajectories, expect future tax increases, and demonstrate lower trust in government. Spending-based consolidations drive these effects, while tax-based consolidations have minimal impact.
- Information treatment effects: Providing accurate debt information produces differential effects based on country debt trajectories. In debt-stable countries, information reduces expectations of tax increases (by 1.7-3.2%), particularly among those with high initial debt priors. In high-debt countries, information increases expectations of spending cuts (by 1.7%), especially among those who initially underestimated debt levels.
Perceptions of Public Debt and Policy Expectations: Evidence from Cross Country Surveys
Authors: Francesco Bianchi, Era Dabla-Norris, Salma Khalid
From: John Hopkins University, IMF
