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Fiscal Policy in Debt Constrained Economies

  • Mark A. Aguiar
  • Manuel Amador

We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk. The SOE's government uses linear taxation to fund exogenous expenditures and uses public debt to inter-temporally allocate tax distortions. We characterize a class of environments in which the tax on labor goes to zero in the long run, while the tax on capital income may be non-zero, reversing the standard prediction of the Ramsey tax literature. The zero labor tax is an optimal long run outcome if the private agents are impatient relative to the international interest rate and the economy is subject to sovereign debt constraints. The front loading of labor taxes allows the economy to build a large (aggregate) debt position in the presence of limited commitment. We show that a similar result holds in a closed economy with imperfect inter-generational altruism.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17457.

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Date of creation: Sep 2011
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Handle: RePEc:nbr:nberwo:17457
Note: EFG IFM
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  1. Mark Aguiar & Manuel Amador, 2010. "Growth in the Shadow of Expropriation," 2010 Meeting Papers 1194, Society for Economic Dynamics.
  2. Rustichini, A., 1998. "Lagrange multipliers in incentive-constrained problems," Journal of Mathematical Economics, Elsevier, vol. 29(4), pages 365-380, May.
  3. Acemoglu, Daron & Golosov, Mikhail & Tsyvinski, Aleh, 2011. "Political economy of Ramsey taxation," Journal of Public Economics, Elsevier, vol. 95(7-8), pages 467-475, August.
  4. Dominguez, Begona, 2007. "Public debt and optimal taxes without commitment," Journal of Economic Theory, Elsevier, vol. 135(1), pages 159-170, July.
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  7. Benhabib, J. & Rustichini, A., 1996. "Optimal Taxes Without Commitment," Working Papers 96-18, C.V. Starr Center for Applied Economics, New York University.
  8. Werning, Ivan & Farhi, Emmanuel, 2007. "Inequality and Social Discounting," Scholarly Articles 3451391, Harvard University Department of Economics.
  9. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  10. Ricardo J. Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2006. "An Equilibrium Model of "Global Imbalances" and Low Interest Rates," NBER Working Papers 11996, National Bureau of Economic Research, Inc.
  11. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  12. Jones, Larry E. & Manuelli, Rodolfo E. & Rossi, Peter E., 1997. "On the Optimal Taxation of Capital Income," Journal of Economic Theory, Elsevier, vol. 73(1), pages 93-117, March.
  13. Judd, Kenneth L., 1985. "Redistributive taxation in a simple perfect foresight model," Journal of Public Economics, Elsevier, vol. 28(1), pages 59-83, October.
  14. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  15. Mark Aguiar & Manuel Amador & Gita Gopinath, 2009. "Investment Cycles and Sovereign Debt Overhang," Review of Economic Studies, Oxford University Press, vol. 76(1), pages 1-31.
  16. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  17. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
  18. Debraj Ray, 2002. "The Time Structure of Self-Enforcing Agreements," Econometrica, Econometric Society, vol. 70(2), pages 547-582, March.
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