Working Paper: CEPR ID: DP4582
Authors: Paul Klein; Per Krusell; Josvctor Rosrull
Abstract: How should aggregate public expenditures be traded off against their financing costs? We incorporate public expenditures into a standard neoclassical growth setup with model policy choice as made by a government choosing tax rates and spending so that the resulting competitive equilibrium allocation maximizes consumer welfare. An additional key restriction that the government faces in our model is that it cannot commit to future policy. This restriction binds: current income taxes influence past savings decisions as well as past work decisions, and these effects are ignored by governments without access to commitment. We solve for equilibria where ?reputational? mechanisms are not operative: we characterize Markov-perfect equilibria of the dynamic game between successive governments. We characterize equilibria in terms of an intertemporal first-order condition (a ?generalized Euler equation?, GEE) for the government and we use this condition both to gain insight into the nature of the equilibrium and as a basis for computation. The GEE reveals how the government optimally trades off tax wedges over time. For a calibrated economy, we find that when the tax base available to the government is capital income ? an inelastic source of funds at any moment in time ? the government still refrains from taxing at confiscatory rates. As a result, the economy is far from the mix of public and private goods that would be optimal in a static context; in return, steady-state savings are less distorted.
Keywords: Markov-perfect equilibrium; Optimal taxation; Time consistency
JEL Codes: E62; H21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Inability of the government to commit to future tax rates (H29) | dynamic inconsistency (C69) |
| dynamic inconsistency (C69) | current tax decisions influence past savings and work decisions (H31) |
| current tax decisions influence past savings and work decisions (H31) | suboptimal mix of public and private goods (H49) |
| government optimally trades off tax wedges over time (H21) | suboptimal mix of public and private goods (H49) |
| lower initial tax rates (H29) | higher savings (D14) |
| current government's policy choices (E60) | expectations about future taxation (H31) |
| expectations about future taxation (H31) | capital accumulation (E22) |
| current tax decisions (H29) | future government revenues (H27) |
| current tax decisions (H29) | future policies (J18) |