Policy and Welfare Effects of Within-Period Commitment
FRB of St. Louis Working Paper No. 2011-031C
28 Pages Posted: 15 Apr 2012 Last revised: 10 Jul 2013
Date Written: July 8, 2013
Consider the problem of a benevolent government that needs to finance the provision of a public good with distortionary taxes and cannot commit to policies beyond the current period. In such a case, public expenditure is inefficiently low. If the government further loses the ability to set tax rates before production in the period takes place, then it will not internalize how its policy choices distort current factor markets. Thus, to counterbalance the costs of future distortions, it increases public good provision. For a calibrated economy, removing within-period commitment implies a welfare gain worth half-a-percent of yearly consumption. A similar gain can be obtained, if instead, capital depreciation were allowed to be fully deducted from taxable income.
Keywords: Fiscal policy, time-consistency, lack of commitment, Markov-perfect equilibrium
JEL Classification: E61, E62
Suggested Citation: Suggested Citation