How can states benefit from the equity premium puzzle? Debt as revenue source for Swiss cantons

Abstract

This paper addresses the question of the optimal debt level of a state (canton) that issues new bonds and subsequently invests the borrowed capital. For that purpose, we first estimate the effect of the debt level on the interest rate and then we contrast the predicted interest rate with potential revenue from the capital markets. The estimation is based on panel data from the 26 Swiss cantons between 1980 and 2015. The median performance of Swiss pension funds serves as a reference value for the revenue achieved in the capital market. The results show an exponential relationship between the debt and its interest rate; raising indebtedness by 1000 Swiss francs per capita makes the spread between the risk-free rate and the interest rate on the debt increase by 5%. Given this small effect, the inherent optimal debt level equals more than twice the initial levels and the reinvested uncommitted funds provide a return potential of nearly 5% of the total cantonal receipts, on average.