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Optimal Fiscal Policy over the Business Cycle

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  • Filippo Occhino

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Abstract

How should taxes, government expenditures, the primary and fiscal surpluses and government liabilities be set over the business cycle? We assume that the government chooses expenditures and taxes to maximize the utility of a representative household, utility is increasing in government expenditures, only distortionary labor income taxes are available, and the cycle is driven by exogenous technology shocks. We first consider the commitment case, and characterize the Ramsey equilibrium. In the case that the utility function is constant elasticity of substitution between private and public consumption and separable between the composite consumption good and leisure, taxes, government expenditures and the primary surplus should all be constant positive fractions of production, and both government liabilities and the fiscal surplus should be positively correlated with production. Then, we relax the commitment assumption, and we show how to determine numerically whether the Ramsey equilibrium can be sustained by the threat to revert to a Markov perfect equilibrium. We find that, for realistic values of the preferences discount factor, the Ramsey equilibrium is sustainable.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 608.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:608

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Keywords: Fiscal policy; Commitment; Time-consistency; Ramsey equilibrium; Markov perfect equilibria; Sustainable equilibria.;

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  1. Benhabib, J. & Rustichini, A., 1996. "Optimal Taxes Without Commitment," Working Papers 96-18, C.V. Starr Center for Applied Economics, New York University.
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  14. Kenneth L. Judd, 1982. "Redistributive Taxation in a Simple Perfect Foresight Model," Discussion Papers 572, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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