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Ramsey monetary and fiscal policy: the role of consumption taxation

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  • Giorgio Motta
  • Raffaele Rossi

Abstract

We study Ramsey monetary and fiscal policy in a small scale New Keynesian model where government spending has intrinsic value, public debt is state-noncontingent and the fiscal authority is constrained by using distortive taxation. We show that Ramsey policy is remarkably altered when consumption taxation is considered as a source of government revenues alongside or as an alternative to labour income taxes. First, we show that the optimal steady-state size of the public spending is, ceteris paribus, greater under consumption taxation than under labour income tax. We further show that adopting consumption taxation has enormous long run welfare gains and that these gains are increasing in the level of outstanding public debt. These welfare gains are not limited to the steady-state, but they are also present in the dynamic stochastic equilibrium. The reason is that the dynamic nature of consumption taxation enables the policy-maker to affect the stochastic discount factor via modifications of the marginal utility of consumption. This extra wedge impacts on the pricing decisions of firms, and hence on inflation stabilization, and greatly improves welfare in the stochastic equilibrium.

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Paper provided by Lancaster University Management School, Economics Department in its series Working Papers with number 44449031.

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Date of creation: 2013
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Handle: RePEc:lan:wpaper:44449031

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  1. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2002. "Optimal fiscal and monetary policy: equivalence results," Working Paper Series WP-02-16, Federal Reserve Bank of Chicago.
  2. Tommaso Monacelli & Jordi Galí, 2005. "Optimal Monetary and Fiscal Policy in a Currency Union," Working Papers 300, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  3. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 861-886.
  4. Stephen Turnovsky, 1998. "Fiscal Policy, Elastic Labor Supply, and Endogenous Growth," Discussion Papers in Economics at the University of Washington 0068, Department of Economics at the University of Washington.
  5. Niemann, Stefan & Pichler, Paul, 2011. "Optimal fiscal and monetary policies in the face of rare disasters," European Economic Review, Elsevier, vol. 55(1), pages 75-92, January.
  6. Adam, Klaus, 2010. "Government Debt and Optimal Monetary and Fiscal Policy," CEPR Discussion Papers 8064, C.E.P.R. Discussion Papers.
  7. Argia M. Sbordone, 2001. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Departmental Working Papers 199822, Rutgers University, Department of Economics.
  8. Roger Gordon & Wei Li, 2005. "Tax Structure in Developing Countries: Many Puzzles and a Possible Explanation," NBER Working Papers 11267, National Bureau of Economic Research, Inc.
  9. ColemanII, Wilbur John, 2000. "Welfare and optimum dynamic taxation of consumption and income," Journal of Public Economics, Elsevier, vol. 76(1), pages 1-39, April.
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