Working Paper: CEPR ID: DP3438
Authors: Stephanie Schmittgroh; Martin Uribe
Abstract: This Paper studies the role of asset-market completeness for the properties of optimal policy. A suitable framework for this purpose is the small open economy with complete international asset markets. For in this environment changes in policy represent country-specific risk diversifiable in world markets. Our main finding is that the fundamental public finance principle whereby when taxes on all final goods are available, it is optimal to tax final goods uniformly fails to obtain. In general, uniform taxation is optimal because it amounts to a non-distorting tax on fixed factors of production. In the open economy this principle fails because when households can insure against the risk of a policy reform, initial private asset holdings are contingent on actual policy and thus no longer represent an inelastically supplied source of income. Two further differences between optimal policy in the closed and open economies with complete markets are: (a) In the open economy, optimal consumption and income tax rates are unchanged in response to government purchases shocks. By contrast, in the closed economy tax rates do respond to innovations in public spending. (b) In the open economy, the Friedman rule is optimal only if the Ramsey planner has access to consumption taxes. In the absence of consumption taxes, deviations from the Friedman rule are large. On the other hand, in the closed economy, the availability of either consumption or income taxes suffices to render the Friedman rule optimal.
Keywords: anticipated ramsey policy; open economies; optimal monetary and fiscal policy
JEL Codes: E52; E61; E63; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset market completeness (D52) | optimal policy outcomes (D78) |
| Initial wealth of private agents contingent on tax policies (H39) | asset market conditions (G19) |
| Small open economy with complete asset markets (F41) | failure of uniform taxation principle (H29) |
| Households can insure against risk of policy reform (G52) | initial asset holdings contingent on actual policy (G19) |
| Ramsey planner's trade-off (H21) | tax structure deviating from uniform taxation (H20) |
| Volatility in inflation (E31) | optimal policy in open economy (F41) |
| Asset market completeness (D52) | high volatility in inflation (E31) |