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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. 

We use discounted cash flow analysis to measure the projected fiscal capacity of the US federal government. We apply our valuation method to the Congressional Budget Office (CBO) projections for the US federal government’s primary deficits between 2022 and 2052 and projected debt outstanding in 2052. The discount rate for projected cash flows and future debt must include a GDP or market risk premium in recognition of the risk associated with future surpluses. Despite current low interest rates, we find that US fiscal capacity is more limited than commonly thought. Because of the back-loading of projected primary surpluses, the duration of the surplus claim far exceeds the duration of the outstanding Treasury portfolio. This duration mismatch exposes the government to the risk of rising interest rates, which would trigger the need for higher tax revenue or lower spending. Reducing this risk by front-loading primary surpluses requires a major fiscal adjustment.