Too big to fail, but a lot to bail: Optimal financing of large bailouts
The termination of a representative financial firm due to excess leverage may lead to substantial bankruptcy costs. A benevolent government in the tradition of Ramsey (1927) may be inclined to provide transfers to the firm so as to prevent its liquidation and the associated deadweight costs. The paper studies the optimal way to finance such a “bailout” with distortionary taxes and obtains two results. First, some degree of “fiscal stimulus” through procyclical taxation (low taxes in bad times, high taxes in good times) is always optimal. This is true even when markets are complete and government expenditure is set to zero. Second, taxes exhibit history dependence, even in a complete market. These results are in contrast with pre-existing results in the literature on optimal fiscal policy, and are driven by the endogeneity of the transfer payments that are required to salvage the financial firm. The paper also considers extensions whereby bailouts are financed partly by diluting existing shareholders, or by obtaining a fraction of the capital of the underlying company, and discusses the relative merits of these alternatives.
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