Working Paper: NBER ID: w17457
Authors: Mark A. Aguiar; Manuel Amador
Abstract: We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk. The SOE's government uses linear taxation to fund exogenous expenditures and uses public debt to inter-temporally allocate tax distortions. We characterize a class of environments in which the tax on labor goes to zero in the long run, while the tax on capital income may be non-zero, reversing the standard prediction of the Ramsey tax literature. The zero labor tax is an optimal long run outcome if the private agents are impatient relative to the international interest rate and the economy is subject to sovereign debt constraints. The front loading of labor taxes allows the economy to build a large (aggregate) debt position in the presence of limited commitment. We show that a similar result holds in a closed economy with imperfect inter-generational altruism.
Keywords: Fiscal Policy; Debt Constraints; Sovereign Default
JEL Codes: E62; F41; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Labor taxation (H29) | Consumption (E21) |
| Sovereign debt constraints (H63) | Labor taxation (H29) |
| Sovereign debt constraints (H63) | Optimal fiscal policy (E62) |
| Impatience relative to world interest rate (E43) | Front-loading of labor taxes (H31) |
| Front-loading of labor taxes (H31) | Consumption and leisure maximization (D10) |
| Divergence between MRS and MRT (D00) | Optimal fiscal policy (E62) |
| Sovereign debt constraints (H63) | Tax on labor converging to zero (H31) |
| Observed fiscal crises (H12) | Misalignment in fiscal practices (E62) |