Fiscal sustainability under entitlement spending

We develop a simple theoretical framework that can be used not only to assess the stability of debt, but also to evaluate the sustainability of the commitments of the public sector in the presence of entitlement spending. We model the optimal intertemporal path of fiscal variables and the optimal policy responses in this environment, which requires a dynamic framework. Our analysis suggests that even with near-zero interest rates the stability of debt is not guaranteed and that the sustainability of public finances depends on the level of taxes and the persistence of expenditure, as much as on the level of debt. We estimate the model with panel data techniques, finding that our modelling strategy is supported by the empirical evidence and we use calibrated versions of our model to compare different countries.