Department of Economics

Optimal Policy and (the Lack of) Time Inconsistency: Insights from Simple Models

Department of Economics

University of Delaware

Working Paper #2006-08

Optimal Policy and (the Lack of) Time Inconsistency: Insights from Simple Models

Marina Azzimonti-Renzo, Pierre-Daniel Sarte, and Jorge Soares

ABSTRACT

In the standard neoclassical model with a representative agent, a benevolent planner who can commit to future policies will, if feasible, levy a single confiscatory tax on capital in the initial period and commit never to set positive taxes thereafter. We show that this policy, which allows for the disposal of distortional taxes entirely, can arise even when sequential governments are unable to credibly promise future tax rates, regardless of how public expenditures are determined.

We suggest that Markov-perfect distortional tax rates emerge more naturally in an overlapping generations setting. In that setting, an intergenerational distribution concern arises that limits the degree to which the initial old generation is taxed, in effect creating an endogenous upper limit on initial capital income taxes. Furthermore, this intergenerational objective reintroduces time inconsistency as a policy issue since, in a Markov-perfect equilibrium, taxes are set to equate marginal utilities of consumption across generations regardless of the implications for capital income tax rates. Unlike a Ramsey planner, at each date, sequential governments in a Markov-perfect equilibrium consider the past as sunk and, therefore, treat capital income taxes as non-distortionary.

 

JEL CODES: H3, H6, H21, E62

KEY WORDS: Capital Taxation, Ramsey, Commitment, Markov-Perfect equilibrium, Time consistent policy, Overlapping Generations.

The Lerner College is home to a state-of-the-art financial trading facility, the $1.4 million student-led Blue Hen Investment Fund, a student-managed restaurant and hotel, a high-technology development center of a global bank and a start-up experience for students with new business ideas.

Lerner College faculty - like Anu Sivaraman, who is among Social Media Marketing Magazine’s “Top 100 Marketing Professors on Twitter” and MBAprograms.org’s “Top 50 Marketing Professors on Twitter” - are thought leaders who command attention from influential business audiences, economists and policy makers.

All Lerner College departments offer experience-driven learning and emphasize evidence-based analytics methods to enrich the student experience. Here, finance students visit New York City’s financial districts for a first-hand look at markets trading and to meet with UD alumni.

Charles W. Horn, AS75, and wife Patricia, recently made a $3 million commitment to enhance and expand entrepreneurial studies.

  • Alfred Lerner College of Business & Economics
    303 Alfred Lerner Hall  •  Newark, DE 19716  •  USA  •  ©