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Increasing taxes after a financial crisis: Not a bad idea after all ..

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  • Koulovatianos, Christos
  • Mavridis, Dimitris

Abstract

Based on OECD evidence, equity/housing-price busts and credit crunches are followed by substantial increases in public consumption. These increases in unproductive public spending lead to increases in distortionary marginal taxes, a policy in sharp contrast with presumably optimal Keynesian fiscal stimulus after a crisis. Here we claim that this seemingly adverse policy selection is optimal under rational learning about the frequency of rare capital-value busts. Bayesian updating after a bust implies massive belief jumps toward pessimism, with investors and policymakers believing that busts will be arriving more frequently in the future. Lowering taxes would be as if trying to kick a sick horse in order to stand up and run, since pessimistic markets would be unwilling to invest enough under any temporarily generous tax regime.

Suggested Citation

  • Koulovatianos, Christos & Mavridis, Dimitris, 2018. "Increasing taxes after a financial crisis: Not a bad idea after all ..," CFS Working Paper Series 614, Center for Financial Studies (CFS).
  • Handle: RePEc:zbw:cfswop:614
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    References listed on IDEAS

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    More about this item

    Keywords

    Bayesian learning; controlled diffusions and jump processes; learning about jumps; Gamma distribution; rational learning;
    All these keywords.

    JEL classification:

    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • D90 - Microeconomics - - Micro-Based Behavioral Economics - - - General
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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