Politically Optimal Fiscal Policy
28 Pages Posted: 12 Apr 2007
Date Written: March 2007
Abstract
Why do governments issue large amounts of debt? In what sense and for whom is such a policy optimal? We show that twisting the optimal taxation paradigm produces very reasonable predictions for debt and real interest rates. Adding an extra dimension of uncertainty about the political planning horizon gives rise to a positive and very plausible government debt-to-GDP ratio of about 55 percent in a model that otherwise predicts negative government debt. We quantify the impact of political uncertainty on steady state and business cycle dynamics. We illustrate how populist tax cuts can cause business cycle fluctuations.
JEL Classification: E62, H21, H39, H63
Suggested Citation: Suggested Citation
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