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On the Economics of Fiscal Populism in an Open Economy

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  • Benhabib, Jess
  • Velasco, Andres

Abstract

We study a representative agent, open economy in which government-provided services that enter the domestic production function must be financed with distortionary taxes, and focus on the optimal size of government and the associated optimal tax rate. If the government can precommit its actions, it maximizes individual welfare by announcing and implementing a constant tax rate, which we label the “orthodox” tax rate. This tax rate is time inconsistent, and under discretion the government implements a tax that maximizes each period’s output. We label this the “populist” tax rate. It may be higher or lower than the “orthodox” rate, depending on whether the elasticity of substitution in production between private and public inputs is below or above one. We also characterize the second-best tax rate that can be sustained through trigger strategies. This best sustainable tax rate is constant and lies between the “orthodox” and “populist” extremes.
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Suggested Citation

  • Benhabib, Jess & Velasco, Andres, 1994. "On the Economics of Fiscal Populism in an Open Economy," Working Papers 94-22, C.V. Starr Center for Applied Economics, New York University.
  • Handle: RePEc:cvs:starer:94-22
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    References listed on IDEAS

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    1. Benhabib, Jess & Rustichini, Aldo, 1991. "Social Conflict, Growth and Inequality," Working Papers 91-46, C.V. Starr Center for Applied Economics, New York University.
    2. V. V. Chari & Harold L. Cole, 1993. "A contribution to the theory of pork barrel spending," Staff Report 156, Federal Reserve Bank of Minneapolis.
    3. Rudiger Dornbusch & Sebastian Edwards, 1991. "The Macroeconomics of Populism in Latin America," NBER Books, National Bureau of Economic Research, Inc, number dorn91-1, January.
    4. Maurice Obstfeld, 1989. "Dynamic Seigniorage Theory: An Exploration," NBER Working Papers 2869, National Bureau of Economic Research, Inc.
    5. Chari, V V & Kehoe, Patrick J, 1990. "Sustainable Plans," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 783-802, August.
    6. Barro, Robert J, 1990. "Government Spending in a Simple Model of Endogenous Growth," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages 103-126, October.
    7. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
    8. Fischer, Stanley, 1980. "Dynamic inconsistency, cooperation and the benevolent dissembling government," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 93-107, May.
    9. Velasco, A., 1993. "A Model of Endogenous Fiscal Deficits and Delayed Fiscal Reforms," Working Papers 93-04, C.V. Starr Center for Applied Economics, New York University.
    10. Jeffrey D. Sachs, 1989. "Social Conflict and Populist Policies in Latin America," NBER Working Papers 2897, National Bureau of Economic Research, Inc.
    11. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-491, June.
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    Cited by:

    1. Nouriel Roubini & Gian Maria Milesi-Ferrett, 1994. "Optimal Taxation of Human and Physical Capital in Endogenous Capital Models," NBER Working Papers 4882, National Bureau of Economic Research, Inc.

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