On December 12, 2019, Fed in Print will introduce its new platform for discovering content. Please direct your questions to Anna Oates
Federal Reserve Bank of Minneapolis
Fiscal Policy in Debt Constrained Economies
We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk and limited commitment to tax plans. 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 economy is subject to sovereign debt constraints and the domestic households are impatient relative to the international interest rate. The front loading of tax distortions 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, providing a link with the closed-economy literature that has explored disagreement between the government and its citizens regarding inter-temporal tradeoffs.
Cite this item
Manuel Amador & Mark Aguiar, Fiscal Policy in Debt Constrained Economies, Federal Reserve Bank of Minneapolis, Staff Report 518, 16 Oct 2015.
- E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
- F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
Keywords: Fiscal policy; Sovereign debt; Limited commitment
This item with handle RePEc:fip:fedmsr:518
is also listed on EconPapers
For corrections, contact Jannelle Ruswick ()