Optimal Fiscal Policy under Multiple Equilibria
Posted: 16 Feb 2013
Date Written: November 10, 2005
We study optimal fiscal policy in an economy where (i) search frictions create a coordination problem and generate multiple, Pareto-ranked equilibria and (ii) the government finances the provision of a public good by taxing market activity. The government must choose the tax rate before it knows which equilibrium will obtain, and therefore an important part of the problem is determining how the policy will affect the equilibrium selection process. We show that when the equilibrium selection rule is based on the concept of risk dominance, higher tax rates make coordination on the Pareto-superior outcome less likely. As a result, taking equilibrium-selection effects into account leads to a lower optimal tax rate.
Keywords: coordination problems, equilibrium selection, search and matching, taxation
JEL Classification: E61, E62, H21, H41
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