Government borrowing using bonds with randomly determined returns: Welfare improving randomization in the context of deficit finance

Abstract

We study the problem of a government that wishes to share optimally the burden of deficit finance among agents with differential access to investment opportunities. In the presence of private information, it is Pareto efficient for the government to borrow in a way that amounts to non-linear taxation, and it must treat agents with access to the best investment opportunities preferentially to keep them in the bond market. In addition, with private information about access to assets, it is often desirable to randomize extraneously the return on the highest yielding government liabilities. The optimal government policy is shown to accord well with historical observations and provides insight into why explicit randomization is not often observed in private contracts.