In the presence of aggregate risk, governments face a trade-off between insuring taxpayers or bondholders. The literature assumes that the government can finance deficits at the risk-free rate, protecting bondholders at the expense of taxpayers. We characterize the implications of this assumption on the surplus process. Under reasonable debt dynamics, counter-cyclical debt issuance that protects taxpayers against adverse macroeconomic shocks is limited in time and scope, and comes at the expense of higher long-run risk. We find that the restrictions imposed by risk-free debt are rejected in U.S. surplus data, especially after the GFC. Taxpayers have been protected at the expense of bondholders.
