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Distortionary Taxation, Debt, and the Price Level

30 Pages Posted: 18 Jan 2006  

Leopold von Thadden

European Central Bank (ECB)

Andreas Schabert

University of Cologne - Department of Economics; University of Dortmund; University of Amsterdam - Faculty of Economics and Business

Date Written: January 2006

Abstract

This paper considers the nominal and real determinacy of equilibria under an exogenously specified path of interest rates in an economy in which taxation is either lump-sum or distortionary. Under lump-sum taxation, we confirm the well-known finding that equilibria display nominal (in) determinacy if the primary surplus is exogenous (endogenous). Under distortionary taxation, this classification is no longer relevant. Nominal determinacy is always ensured since distortionary taxes establish a link between the allocation and the sequences of taxes and debt and, hence, the price level, regardless of whether the primary surplus is exogenous or endogenous. Distortionary taxation, however, increases the scope for real indeterminacy. As a general feature, the real (in) determinacy of equilibria depends on the interaction of fiscal and monetary policies, i.e. on the sequences of taxes, debt, and interest rates. If, for example, fiscal policy runs a balanced budget the central bank should set the nominal interest rate in a way consistent with long-run deflation in order to ensure real determinacy. This finding is different from a balanced-budget policy under lump-sum taxes where no such qualification with respect to the interest rate needs to be made.

Keywords: Monetary and fiscal policy, distortionary taxes, price level determination, balanced budget policy

JEL Classification: E31, E63

Suggested Citation

von Thadden, Leopold and Schabert, Andreas, Distortionary Taxation, Debt, and the Price Level (January 2006). ECB Working Paper No. 577. Available at SSRN: https://ssrn.com/abstract=873589

Leopold Von Thadden (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Andreas Schabert

University of Cologne - Department of Economics ( email )

Cologne, 50923
Germany

University of Dortmund ( email )

Vogelpothsweg 87
Dortmund, 44227
Germany
+49 231 755 3288 (Phone)

University of Amsterdam - Faculty of Economics and Business ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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