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On the economics of fiscal populism in an open economy

  • Jess Benhabib
  • Andres Velasco

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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Paper provided by Federal Reserve Bank of Minneapolis in its series Discussion Paper / Institute for Empirical Macroeconomics with number 97.

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Date of creation: 1995
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Handle: RePEc:fip:fedmem:97
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  1. 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 S103-26, October.
  2. Dornbusch, Rudiger & Edwards, Sebastian, 1989. "The macroeconomics of populism in Latin America," Policy Research Working Paper Series 316, The World Bank.
  3. 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.
  4. 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.
  5. Benhabib, Jess & Rustichini, Aldo, 1991. "Social Conflict, Growth and Inequality," Working Papers 91-46, C.V. Starr Center for Applied Economics, New York University.
  6. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  7. Maurice Obstfeld and ., 1997. "Dynamic Seigniorage Theory: An Exploration," Center for International and Development Economics Research (CIDER) Working Papers C97-085, University of California at Berkeley.
  8. Jeffrey D. Sachs, 1989. "Social Conflict and Populist Policies in Latin America," NBER Working Papers 2897, National Bureau of Economic Research, Inc.
  9. 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 473-91, June.
  10. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
  11. V.V. Chari & Harold Cole, 1993. "A contribution to the theory of pork barrel spending," Staff Report 156, Federal Reserve Bank of Minneapolis.
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