4.4  Misperceptions of default risk

The risk premium paid by an issuer of debt securities depends on the degree of default risk perceived in the markets. A poor reputation due to past actions, or simply characteristics similar to those of previous defaulters, may undermine the credibility of promises to honour debt obligations. Hence, the potential exists that the financial markets may assess a probability of default on public debt even though the government may not intend to default under any circumstances. The East Asian financial crisis is a recent example where cross-country contagion was a significant risk.

In the event that a government faces an unjustified default premium on its debt, Bohn (1995) shows that the optimal portfolio policy is to reduce the level of debt until the unjustified premium reduces to zero. If the unjustified premium is exogenous with respect to the level of debt, the optimal debt target is zero.

The debt reduction may be achieved by sale of assets where this does not undermine risk diversification or other objectives. In the absence of suitable asset sales, the optimal tax policy is to “tilt” the time profile of optimal taxes towards higher current taxes to pay down debt to the target level. In terms of deadweight losses, a temporarily high tax rate is worth incurring in return for achieving a permanently lower tax rate by avoiding the unjustified default premium.[17]

The above argument may be refined in two ways:

• if the unjustified premium applies only to some types of debt (e.g. unjustified inflation risk on nominal debt), the optimal portfolio policy would place upper bounds on the particular instrument rather than debt reduction as a whole; and
• a risky security issued for hedging purposes to reduce fluctuations in the tax rate may reduce the probability of default. In this case, the optimal portfolio policy would place lower bounds on securities performing this type of role.

In addition to asset sales and temporarily higher tax rates, legislative provisions such as the Reserve Bank Act 1989 and Fiscal Responsibility Act 1994 may help to reduce unjustified default premia. Also important is a regulatory structure that underpins good corporate governance and private sector transparency, especially in the banking sector due to its central role in New Zealand of maintaining a stable financial system.

Summary for unjustified default risk

Economic objective

Minimise the expected economic value of the deadweight loss of taxation

CFP objectives

Portfolio policy

Minimise costs arising from unjustified default premia

Targets

For total debt or any instruments subject to unjustified default premia, set upper bound such that unjustified premium falls to zero

Instruments

• Sale of assets
• Tax rate
• Institutional arrangements (e.g. RBA 1989 and FRA 1994)

4.5  Non-responsive citizens

Previous subsections have assumed that citizens adjust their total wealth portfolios in response to any change in Crown financial policy. This subsection is concerned with the case where citizens do not respond to changes in Crown financial policy. Possible reasons include bounded rationality, costly information, and capital market imperfections such as liquidity constraints, short-selling restrictions and transaction costs. These are canvassed more fully in Section 8.

Consider a situation where the government’s objective is to minimise the expected value of deadweight losses (assumed to be convex in the tax rate).[18] This differs from Bohn (1990, 1995), where the government’s objective was to maximise the utility of a representative citizen. A possible motivation for the new objective could be that the government does not possess detailed information about citizens’ individual utility functions and current wealth portfolios or does not have the ability to construct a social welfare function through interpersonal comparisons. This is consistent with the view that government lacks the information necessary to engage in ‘fine tuning’ of policy.

In the context where the objective is to minimise deadweight losses, Grimes and Davis (2001) show that perfect tax smoothing is no longer optimal. Optimal Crown financial policy involves a trade-off between the level and variability of tax rates. The Crown would invest a portion of the balance sheet in risky assets with high-expected returns (but possibly with no hedging benefits). This would achieve lower deadweight losses through lower average tax rates.

The intuition for the Grimes/Davis result relative to Bohn (1990, 1995) is straight- forward. First, the assumption that citizens do not respond to changes in Crown financial policy removes the Crown’s comparative disadvantage – in effect, the government becomes the only party able to manage the impact of the Crown on citizens’ total wealth portfolio. Second, at the same time, the ‘no fine tuning’ assumption causes the government to adopt a simple expected value criterion that takes no account of the correlation between payoffs on high-return assets and citizens’ marginal utility. The combination of these two effects causes the Bohn results to break down.[19]

Summary for non-responsive citizens

Economic objective

Minimise the expected deadweight loss of taxation

CFP objectives

Tax policy

Minimise the expected value of deadweight losses

Portfolio policy

Achieve risk/return portfolio consistent with tax policy objective

Target

Specified level of systematic risk (exceeding minimum variance)

Instruments

No specific information available