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Markov-Perfect Optimal Fiscal Policy: The Case of Unbalanced Budgets

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  • Salvador Ortigueira
  • Joana Pereira

Abstract

We study optimal income taxation and public debt policy in a neoclassical economy populated by infinitely-lived households and a benevolent government. The government makes sequential decisions on the provision of a valued public good, on income taxation and the issue of public debt. We characterize and compute Markov-perfect optimal fiscal policy in this economy with two payoff-relevant state variables: physical capital and public debt. We find two stable, steady-state equilibria: one with no income taxation and positive government asset holdings, and another with positive taxation and public debt issuances. We prove that the two steady states are associated with different policy rules, which implies a multiplicity of (expectation-driven) Markov-perfect equilibria.

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Bibliographic Info

Paper provided by European University Institute in its series Economics Working Papers with number ECO2007/41.

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Date of creation: 2007
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Handle: RePEc:eui:euiwps:eco2007/41

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Keywords: Optimal taxation; optimal public debt; Markov-perfect equilibrium; Time-consistent policy;

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  1. Blake, Andrew P. & Kirsanova, Tatiana, 2006. "Discretionary Policy and Multiple Equilibria in LQ RE Models," MPRA Paper 21901, University Library of Munich, Germany, revised 01 Apr 2010.
  2. Dominguez, Begona, 2007. "Public debt and optimal taxes without commitment," Journal of Economic Theory, Elsevier, vol. 135(1), pages 159-170, July.
  3. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 0343, European Central Bank.
  4. Song, Zheng & Storesletten, Kjetil & Zilibotti, Fabrizio, 2007. "Rotten Parents and Disciplined Children: A Politico-Economic Theory of Public Expenditure and Debt," Memorandum 05/2008, Oslo University, Department of Economics.
  5. Davide Debortoli & Ricardo Nunes, 2013. "Lack Of Commitment And The Level Of Debt," Journal of the European Economic Association, European Economic Association, vol. 11(5), pages 1053-1078, October.
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  7. Díaz-Giménez, Javier & Giovannetti, Giorgia & Marimon, Ramon & Teles, Pedro, 2007. "Nominal Debt as a Burden on Monetary Policy," CEPR Discussion Papers 6595, C.E.P.R. Discussion Papers.
  8. repec:bla:restud:v:75:y:2008:i:3:p:789-808 is not listed on IDEAS
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  10. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, December.
  11. Catarina Reis, 2013. "Taxation without commitment," Economic Theory, Springer, vol. 52(2), pages 565-588, March.
  12. Paul Klein & Per Krusell & José-V�ctor R�os-Rull, 2008. "Time-Consistent Public Policy," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 789-808.
  13. Judd, Kenneth L., 1985. "Redistributive taxation in a simple perfect foresight model," Journal of Public Economics, Elsevier, vol. 28(1), pages 59-83, October.
  14. Persson, Mats & Persson, Torsten & Svensson, Lars E O, 1987. "Time Consistency of Fiscal and Monetary Policy," Econometrica, Econometric Society, vol. 55(6), pages 1419-31, November.
  15. Stefania Albanesi & V. V. Chari & Lawrence J. Christiano, 2003. "Expectation Traps and Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 715-741, October.
  16. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  17. Per Krusell & Fernando M. Martin & Jose-Victor Rios-Rull, 2006. "Time Consistent Debt," 2006 Meeting Papers 210, Society for Economic Dynamics.
  18. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  19. Salvador Ortigueira, 2006. "Markov-Perfect Optimal Taxation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(1), pages 153-178, January.
  20. Paul Klein & JosÈ-VÌctor RÌos-Rull, 2003. "Time-consistent optimal fiscal policy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(4), pages 1217-1245, November.
  21. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
  22. Jorge Soares, Marina Azzimonti, Pierre-Daniel Sarte & Pierre-Daniel Sarte & Jorge Soares, 2006. "Optimal Policy and (the Lack of) Time Inconsistency: Insights from Simple Models," Working Papers 06-08, University of Delaware, Department of Economics.
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Citations

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Cited by:
  1. Dennis, Richard & Kirsanova, Tatiana, 2010. "Expectations Traps and Coordination Failures: Selecting among Multiple Discretionary Equilibria," MPRA Paper 24616, University Library of Munich, Germany.
  2. Richard Dennis, 2013. "Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive," Working Papers 2013_15, Business School - Economics, University of Glasgow.
  3. Stefan Niemann & Paul Pichler, 2013. "Collateral, Liquidity and Debt Sustainability," Working Papers 187, Oesterreichische Nationalbank (Austrian Central Bank).
  4. Stefan Niemann, 2009. "Dynamic Monetary-Fiscal Interactions and the Role of Monetary Conservatism," Economics Discussion Papers 667, University of Essex, Department of Economics.
  5. Ricardo Nunes & Davide Debortoli, 2011. "Political Disagreement, Lack of Commitment and the Level of Debt," 2011 Meeting Papers 127, Society for Economic Dynamics.
  6. Fernando M. Martin, 2011. "Policy and welfare effects of within-period commitment," Working Papers 2011-031, Federal Reserve Bank of St. Louis.
  7. Stefan Niemann & Paul Pichler & Gerhard Sorger, 2008. "Optimal Fiscal and Monetary Policy Without Commitment," Economics Discussion Papers 654, University of Essex, Department of Economics.
  8. Azzimonti, Marina & Sarte, Pierre-Daniel & Soares, Jorge, 2009. "Distortionary taxes and public investment when government promises are not enforceable," Journal of Economic Dynamics and Control, Elsevier, vol. 33(9), pages 1662-1681, September.

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