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.