Working Paper: NBER ID: w13353
Authors: Mark Aguiar; Manuel Amador; Gita Gopinath
Abstract: We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy and seeks to insure a risk averse domestic constituency. The expected tax on capital is shown to vary with the state of the economy, generating cyclicality in investment and debt in an environment where the first best capital stock is a constant. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a "debt overhang'' effect. If the government discounts the future at a rate higher than the market, then capital oscillates indefinitely at a level strictly below the first best. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Further, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.
Keywords: optimal taxation; sovereign debt; investment cycles
JEL Codes: F3; H21; H6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government policy (F68) | investment (G31) |
| expected tax on capital (H24) | investment (G31) |
| state of the economy (E66) | expected tax on capital (H24) |
| investment (G31) | government debt (H63) |
| government discount rate > market interest rate (E43) | investment (G31) |
| government access to international debt markets (F34) | capital volatility (E22) |
| debt relief (F34) | Pareto improvements (D61) |
| balanced budget (H61) | cyclical distortions in investment (E32) |