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Optimal policy with credibility concerns

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  • Lu, Yang K.

Abstract

This paper considers a reputation model of optimal taxation in which the public is unsure about the government type. A long-lived government can be trustworthy (meaning that it commits to its announced tax rate) or opportunistic (meaning that it retains the ability to change its tax rate after announcing it). Unlike in most prior studies, the committed strategy in this model is optimally chosen by the trustworthy type. We show that this change has significant consequences for the equilibrium dynamics. The optimal committed strategy is found to vary with the time preferences of the two government types, the initial reputation of the government, and the elasticity of household production. This formulation explains differences in policy responses across governments in the face of similar credibility problems.

Suggested Citation

  • Lu, Yang K., 2013. "Optimal policy with credibility concerns," Journal of Economic Theory, Elsevier, vol. 148(5), pages 2007-2032.
  • Handle: RePEc:eee:jetheo:v:148:y:2013:i:5:p:2007-2032
    DOI: 10.1016/j.jet.2013.04.015
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    References listed on IDEAS

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    Cited by:

    1. Yang Lu & Ernesto Pasten & Robert King, 2013. "Policy design with private sector skepticism in the textbook New Keynesian model," 2013 Meeting Papers 241, Society for Economic Dynamics.

    More about this item

    Keywords

    Imperfect credibility; Reputation game; Optimal taxation; Time inconsistency;

    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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