Fiscal Policy with Limited-Time Commitment
59 Pages Posted: 26 Jul 2016 Last revised: 14 Mar 2017
Date Written: March 1, 2017
We consider models where the Ramsey-optimal fiscal policy under Full Commitment (FC) is time inconsistent and define a new notion of optimal policy, Limited-Time Commitment (LTC). Successive governments can commit to future plans over a finite horizon. We provide an intuitive sufficient condition on the mapping from finite policy sequences to allocations, such that LTC and FC lead to the same outcomes. We then show that this condition is verified in commonly used models of fiscal policy, allowing FC Ramsey plans to be supported with a finite commitment horizon (often a single period). The required degree of commitment depends on the economic environment. In economies without capital, the minimum degree of commitment required is given by the government debt maturity. In economies with capital, the required commitment is given by the horizon over which the budget has to be balanced. Hence, our results provide a potential rationale for balanced-budget rules, which alleviate the consequences of limited commitment. Finally, we consider an economy where the equivalence between LTC and FC fails and show numerically that a constitutional reform imposing a single year of commitment to capital taxes provides substantial welfare gains relative to the No-Commitment policy, even accounting for transitional dynamics.
Keywords: Optimal fiscal policy; time-inconsistency; limited commitment
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