Optimal Fiscal Policy without Commitment: Beyond Lucas-Stokey

By Davide Debortoli, Pierre Yared and Ricardo Nunes

http://d.repec.org/n?u=RePEc:red:sed019:926&r=dge

According to the Lucas-Stokey result, a government can structure its debt maturity to guarantee commitment to optimal fiscal policy by future governments. In this paper, we overturn this conclusion, showing that it does not generally hold in the same model and under the same definition of time-consistency as in Lucas-Stokey. Our argument rests on the existence of an overlooked commitment problem that cannot be remedied with debt maturity: a government in the future will not tax on the downward slopping side of the Laffer curve, even if it is ex-ante optimal to do so. In light of this finding, we propose a new framework to characterize time-consistent policy. We consider a Markov Perfect Competitive Equilibrium where a government reoptimizes sequentially and may deviate from the optimal commitment policy. We find that, in a deterministic economy, any stationary distribution of debt maturity must be flat, with the government owing the same amount at all future dates.

I must confess I have a hard time wrapping my head around this paper. My difficulty lies in the example that it provides: why would it ever be ever ex-ante optimal for a government to tax on the downward-sloping side of the Laffer curve? The entire point of the Laffer curve is that you do not want to be there.

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