2.2 Conflicting targets
The three main objectives imply a range of targets could be adopted for the Crown balance sheet, some of which would be conflicting. The main conflicts are as follows (see Figure 1 below):
- the distortionary taxation and agency cost objectives tend to conflict over the setting of tax rates and hence the Operating Balance (OB) and accumulation of fungible assets. The distortionary tax objective subjugates the level of the Operating Balance and fungible assets to the needs of hedging risk (to smooth tax rates), whereas the agency cost objective implies the tax rate should adjust to limit operating surpluses and prevent any significant build up of fungible assets;
- the time-consistency and agency cost objectives tend to conflict over debt levels. The time-consistency objective implies low debt levels so that the risk premium is low or zero.[17] The agency cost objective implies high debt as a discipline on government spending; and
- the distortionary tax objective may or may not conflict with the time-consistency objective in terms of debt levels. The distortionary tax objective may reinforce the low debt target to the extent that high debt would lead to “unjustified” risk premia on sovereign debt. However, if unjustified risk premia do not occur at any level of debt then a policy aimed at smoothing tax rates may imply aggressive leveraging of the balance sheet to fund the acquisition of financial assets.
Notes
- [17]The potential for conflict is reduced if the main risk is unexpected inflation (rather than new taxes or repudiation). In this case, time-consistency arguments imply an upper bound on net local currency debt, allowing scope to issue foreign-currency debt to limit agency cost. However, the risk properties of foreign-currency debt may conflict with the tax smoothing objective.
