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Politically Optimal Fiscal Policy

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Author Info
Michael Kumhof
Irina Yakadina

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Abstract

Why do governments issue large amounts of debt? In what sense and for whom is such a policy optimal? We show that twisting the optimal taxation paradigm produces very reasonable predictions for debt and real interest rates. Adding an extra dimension of uncertainty about the political planning horizon gives rise to a positive and very plausible government debt-to-GDP ratio of about 55 percent in a model that otherwise predicts negative government debt. We quantify the impact of political uncertainty on steady state and business cycle dynamics. We illustrate how populist tax cuts can cause business cycle fluctuations.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/68.

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Length: 26 pages
Date of creation: 29 Mar 2007
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Handle: RePEc:imf:imfwpa:07/68

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Related research
Keywords: Optimal Fiscal Policy Incomplete Asset Markets Political economy government debt bias Fiscal policy Public debt Gross domestic product Political economy Tax changes Business cycles

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