Optimal government bond finance

Control theory is used to analyze optimal bond and tax finance, where welfare costs of taxation increase with increases in the tax rate, interest rates increase with increases in the ratio of bonds outstanding to wealth, and the government's objective is to minimize the present value of total welfare costs of taxation. The tax rate and the bond-income ratio adjust gradually to a steady state determined by the parameters of the model, unlike the historically determined optimal bond-income ratios and constant optimal planned tax rates in Barro (1979). Comparative dynamic analysis of transitory changes shows that, as in Barro (1979), bond finance is a shock-absorber that smooths tax rate changes over time.