Time Consistency Of Optimal Fiscal Policy In An Endogenous Growth Model

The present paper analyses the time-consistency of optimal fiscal policies in a model with private capital and endogenous growth achieved via public capital. A benevolent government chooses both public spending and taxation plans in order to maximise the welfare of the representative individual. When a full-commitment technology is assumed, the optimal policy is obviously implementable. Nevertheless, in the absence of full-commitment, it is well known that the debt restructuring method cannot make the optimal fiscal policy time-consistent in economies with private capital. Under a zero-tax rate on capital income, we prove that debt restructuring can solve the time-inconsistency problem of fiscal policy. In order to compare this policy with the one under full-commitment, we use a numerical solution method for non-linear rational expectations models, in particular the eigenvalue-eigenvector decomposition method suggested by Novales et al. (1999), which in turn is based on Sims (1998). Both models are solved and surprisingly we find that the policy under debt-commitment is quite close to the full-commitment policy both in growth and in welfare terms.