Public Debt, Distortionary Taxation, and Monetary Policy

37 Pages Posted: 7 Feb 2012  

Alessandro Piergallini

Tor Vergata University

Giorgio Rodano

SPES Development Studies at the University of Rome La Sapienza

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Date Written: February 7, 2012

Abstract

Since Leeper’s (1991, Journal of Monetary Economics 27, 129-147) seminal paper, an extensive literature has argued that if fiscal policy is passive, i.e., guarantees public debt stabilization irrespectively of the inflation path, monetary policy can independently be committed to inflation targeting. This can be pursued by following the Taylor principle, i.e., responding to upward perturbations in inflation with a more than one-for-one increase in the nominal interest rate. This paper analyzes an optimizing framework in which the government can only finance public expenditures by levying distortionary taxes. It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate.

Keywords: Public Debt, Distortionary Taxation, Monetary and Fiscal Policy Rules

JEL Classification: E63, H31, H63

Suggested Citation

Piergallini, Alessandro and Rodano, Giorgio, Public Debt, Distortionary Taxation, and Monetary Policy (February 7, 2012). CEIS Working Paper No. 220. Available at SSRN: https://ssrn.com/abstract=2000714 or http://dx.doi.org/10.2139/ssrn.2000714

Alessandro Piergallini (Contact Author)

Tor Vergata University ( email )

Via Columbia 2
Rome, Rome 00133
Italy
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HOME PAGE: http://www.economia.uniroma2.it/piergallini

Giorgio Rodano

SPES Development Studies at the University of Rome La Sapienza ( email )

Via del Castro Laurenziano, 9
Rome, RM I - 00183
Italy

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