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Imperfect Financial Markets as a Commitment Device for the Government

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  • Jenny Simon

Abstract

When the government lacks the ability to commit to a tax policy over time, agents’ involvement in imperfect financial markets can be welfare improving. Agents borrow against their promised income in markets that are incomplete in the sense that claims cannot be resold without loss. Taking these contractual positions into account thus changes the government’s ex-post incentives to renege on the promised tax schedule. Any increase in redistribution ex-post would lead to some agents not being able to fulfill their financial liabilities. The impending individual “default losses” add up to an effective commitment device for the government. Even a small market imperfection yields limited commitment, which leads to optimal partial pooling in the tax schedule.

Suggested Citation

  • Jenny Simon, 2014. "Imperfect Financial Markets as a Commitment Device for the Government," CESifo Working Paper Series 4902, CESifo.
    • Handle: RePEc:ces:ceswps:_4902
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    More about this item

    Keywords

    limited commitment; commitment device; financial markets; incomplete markets; revelation theorem; redistribution Mirrlees;
    All these keywords.

    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
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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