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Financial Markets as a Commitment Device for the Government

  • Jenny Simon

    (Massachusetts Institute of Technology)

How does the presence of financial markets shape the government's ability to implement social redistribution? Individuals typically do not constrain consumption to equal their net-of-tax income every period, but instead use financial markets to allocate their resources over time. Optimal redistributive policy ought to take agents' involvement in financial markets into account. I study a two period endowment economy with heterogeneous income types that are private information where a government without commitment cannot provide any social redistribution. I show how agents' involvement in a financial market can improve the government's ability to commit at least to a partially separating allocation in the second period, enabling it to provide some redistribution across agents. In this world, agents borrow against their promised income and enter long-term consumption commitments. Changing these contracts is costly. This changes the government's ex-post incentives to renege on the promised tax schedule and fully redistribute, because some agents would have to default on their loans. I show that whenever this default cost is positive, the government is able to commit to a schedule that only pools some agents of similar type together. In other words, it serves as a commitment device in the sense that it enables the government to commit to not exploit a limited amount of information. As the default costs increase, the government is able to commit to a higher degree of separation, eventually reaching full commitment. Thus, the presence of well-functioning financial markets may in fact facilitate rather than hinder redistribution.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 447.

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Date of creation: 2011
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Handle: RePEc:red:sed011:447
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  1. Nick Netzer & Florian Scheuer, 2010. "Competitive Markets without Commitment," Journal of Political Economy, University of Chicago Press, vol. 118(6), pages 1079 - 1109.
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