Fiscal Policy in Debt Constrained Economies

54 Pages Posted: 23 Sep 2011

See all articles by Mark Aguiar

Mark Aguiar

Princeton University

Manuel Amador

affiliation not provided to SSRN

Date Written: September 2011

Abstract

We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk. 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 private agents are impatient relative to the international interest rate and the economy is subject to sovereign debt constraints. The front loading of labor taxes 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.

Suggested Citation

Aguiar, Mark and Amador, Manuel, Fiscal Policy in Debt Constrained Economies (September 2011). NBER Working Paper No. w17457, Available at SSRN: https://ssrn.com/abstract=1932586

Mark Aguiar (Contact Author)

Princeton University ( email )

Princeton, NJ 08544-1021
United States

Manuel Amador

affiliation not provided to SSRN

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