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.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
13353.
Length: Date of creation: Aug 2007 Date of revision: Handle: RePEc:nbr:nberwo:13353
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Find related papers by JEL classification: F3 - International Economics - - International Finance H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation H6 - Public Economics - - National Budget, Deficit, and Debt
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Aaron Tornell & Philip R. Lane, 1999.
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[Downloadable!] (restricted)
Serkan Arslanalp & Peter Blair Henry, 2006.
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NBER Working Papers
12187, National Bureau of Economic Research, Inc.
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