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Fiscal Policy in Debt Constrained Economies

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  • 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17457.

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Date of creation: Sep 2011
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Handle: RePEc:nbr:nberwo:17457

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  1. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
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Cited by:
  1. Gabrielle Demange, 2012. "Contagion in financial networks: a threat index," PSE Working Papers halshs-00662513, HAL.
  2. Das, Debasish Kumar, 2012. "Determinants of current account imbalances in the global economy: A dynamic panel analysis," MPRA Paper 42419, University Library of Munich, Germany.
  3. repec:hal:wpaper:halshs-00662513 is not listed on IDEAS

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