Fiscal Capacity: An Asset Pricing Perspective

Abstract

This review revisits the literature on fiscal capacity using modern tools from asset pricing. We find that properly accounting for aggregate risk substantially reduces fiscal capacity. In this environment, the gap between the risk-free rate and the expected growth rate is not a sufficient statistic for fiscal capacity. To borrow at the risk-free rate when aggregate growth is risky, governments need to ask taxpayers to insure bondholders against aggregate risk, but governments in advanced economies tend to insure taxpayers against aggregate risk. We use this asset pricing perspective to review alternative mechanisms to boost fiscal capacity that have been explored in the literature. Expected final online publication date for the Annual Review of Financial Economics, Volume 15 is November 2023. Please see http://www.annualreviews.org/page/journal/pubdates for revised estimates.