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Ramsey monetary and fiscal policy: the role of consumption taxation

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  • Giorgio Motta
  • Raffaele Rossi

Abstract

We study Ramsey monetary and fiscal policy in a small scale New Keynesian model where government spending has intrinsic value, public debt is state-noncontingent and the fiscal authority is constrained by using distortive taxation. We show that Ramsey policy is remarkably altered when consumption taxation is considered as a source of government revenues alongside or as an alternative to labour income taxes. First, we show that the optimal steady-state size of the public spending is, ceteris paribus, greater under consumption taxation than under labour income tax. We further show that adopting consumption taxation has enormous long run welfare gains and that these gains are increasing in the level of outstanding public debt. These welfare gains are not limited to the steady-state, but they are also present in the dynamic stochastic equilibrium. The reason is that the dynamic nature of consumption taxation enables the policy-maker to affect the stochastic discount factor via modifications of the marginal utility of consumption. This extra wedge impacts on the pricing decisions of firms, and hence on inflation stabilization, and greatly improves welfare in the stochastic equilibrium.

Suggested Citation

  • Giorgio Motta & Raffaele Rossi, 2013. "Ramsey monetary and fiscal policy: the role of consumption taxation," Working Papers 44449031, Lancaster University Management School, Economics Department.
  • Handle: RePEc:lan:wpaper:44449031
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    File URL: http://www.lancaster.ac.uk/media/lancaster-university/content-assets/documents/lums/economics/working-papers/Ramsey_Monetary_and_Fiscal_Policy.pdf
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    References listed on IDEAS

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    1. Gali­, Jordi & Monacelli, Tommaso, 2008. "Optimal monetary and fiscal policy in a currency union," Journal of International Economics, Elsevier, vol. 76(1), pages 116-132, September.
    2. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2008. "Optimal Fiscal and Monetary Policy: Equivalence Results," Journal of Political Economy, University of Chicago Press, vol. 116(1), pages 141-170, February.
    3. Turnovsky, Stephen J., 2000. "Fiscal policy, elastic labor supply, and endogenous growth," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 185-210, February.
    4. ColemanII, Wilbur John, 2000. "Welfare and optimum dynamic taxation of consumption and income," Journal of Public Economics, Elsevier, vol. 76(1), pages 1-39, April.
    5. Adam, Klaus, 2011. "Government debt and optimal monetary and fiscal policy," European Economic Review, Elsevier, vol. 55(1), pages 57-74, January.
    6. Gordon, Roger & Li, Wei, 2009. "Tax structures in developing countries: Many puzzles and a possible explanation," Journal of Public Economics, Elsevier, vol. 93(7-8), pages 855-866, August.
    7. Niemann, Stefan & Pichler, Paul, 2011. "Optimal fiscal and monetary policies in the face of rare disasters," European Economic Review, Elsevier, vol. 55(1), pages 75-92, January.
    8. Sbordone, Argia M., 2002. "Prices and unit labor costs: a new test of price stickiness," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 265-292, March.
    9. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 861-886.
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    Cited by:

    1. Sarolta Laczo & Raffaele Rossi, 2014. "Time-consistent consumption taxation," Working Papers 67495267, Lancaster University Management School, Economics Department.
    2. McKnight, Stephen, 2017. "Are Consumption Taxes Preferable To Income Taxes For Preventing Macroeconomic Instability?," Macroeconomic Dynamics, Cambridge University Press, vol. 21(04), pages 1023-1058, June.
    3. Roberta, Cardani & Lorenzo, Menna & Patrizio, Tirelli, 2016. "Optimal Public Debt Consolidation with Distributional Conflicts," Working Papers 350, University of Milano-Bicocca, Department of Economics, revised 05 Oct 2016.
    4. Taisuke Nakata, 2017. "Optimal Government Spending at the Zero Lower Bound: A Non-Ricardian Analysis," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 23, pages 150-169, January.
    5. Taisuke Nakata, 2017. "Optimal Government Spending at the Zero Lower Bound: A Non-Ricardian Analysis," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 23, pages 150-169, January.

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