Democracy or Optimal Policy: Income Tax Decisions without Commitment

November 27, 2021

By Youngsoo Jang

How do differences in the government’s political and commitment structure affect the aggregate economy, inequality, and welfare? I analyze this question, using a calibrated Aiyagari’s (1994) economy with wealth effects of labor supply wherein a flat tax rate and transfers are endogenously determined according to its political and commitment structure. I compare four economies: a baseline economy, an economy with the optimal tax with commitment in all steady states, an economy with the optimal tax without commitment, and a political economy with sequential voting. I obtain two main findings. First, the commitment structure shifts the government’s weighting between redistribution and efficiency. A lack of commitment leads the government to pursue a more redistributive policy at the expense of efficiency. Second, given a lack of commitment, the political economy with voting yields greater welfare than the economy with the time-consistent optimal policy. In the latter case, a lack of commitment hinders the government from implementing a more frugal policy desirable in the long run; instead, it cares more for low-income and wealth households, resulting in a substantial efficient loss. However, in the political economy with voting, the government considers only the interests of the median voter, who is middle class and reluctant to bear larger distortions from a higher tax rate and larger transfers. These findings imply that in terms of welfare, policies targeting the middle class would possibly be better than those exquisitely designed for the general public.

That institutional design matters for policy setting in nothing new, including for Aiyagari models. It easy to imagine why: you change the welfare function between a voting equilibrium and one based on average welfare, for example. This paper shows that the ability of the government to commit matters as well.

Green technology policies versus carbon pricing. An intergenerational perspective

November 22, 2021

By Sebastian Rausch and Hidemichi Yonezawa

Technology policy is the most widespread form of climate policy and is often preferred over seemingly efficient carbon pricing. We propose a new explanation for this observation: gains that predominantly accrue to households with large capital assets and that influence majority decisions in favor of technology policy. We study climate policy choices in an overlapping generations model with heterogeneous energy technologies and distortionary income taxation. Compared to carbon pricing, green technology policy leads to a pronounced capital subsidy effect that benefits most of the current generations but burdens future generations. Based on majority voting which disregards future generations, green technology policies are favored over a carbon tax. Smart “polluter-pays” financing of green technology policies enables obtaining the support of current generations while realizing efficiency gains for future generations.

Interesting explanation on why it is so difficult to convince people and politicians about carbon taxes.

An Economy of Neural Networks: Learning from Heterogeneous Experiences

November 19, 2021

By Artem Kuriksha

This paper proposes a new way to model behavioral agents in dynamic macro-financial environments. Agents are described as neural networks and learn policies from idiosyncratic past experiences. I investigate the feedback between irrationality and past outcomes in an economy with heterogeneous shocks similar to Aiyagari (1994). In the model, the rational expectations assumption is seriously violated because learning of a decision rule for savings is unstable. Agents who fall into learning traps save either excessively or save nothing, which provides a candidate explanation for several empirical puzzles about wealth distribution. Neural network agents have a higher average MPC and exhibit excess sensitivity of consumption. Learning can negatively affect intergenerational mobility.

This is an interesting approach to a old problem. There is an learning literature out there that has shown that rational expectations are not necessarily a convergence outcome, and this is another example of that. But there is also a literature that shows that markets can help a lot in getting to the “right” equilibrium. This is a field that is studied enough.

Firm Heterogeneity, Market Power and Macroeconomic Fragility

November 17, 2021

By Alessandro Ferrari and Francisco Queirós

We investigate how firm heterogeneity and market power affect macroeconomic fragility, defined as the probability of long-lasting recessions. We propose a theory in which the positive interaction between firm entry, competition and factor supply can give rise to multiple steady-states. We show that when firm heterogeneity is large, even small temporary shocks can trigger firm exit and make the economy spiral in a competition-driven poverty trap. Calibrating our model to incorporate the well-documented trends in increasing firm heterogeneity we find that, relative to 2007, an economy with the 1985 level of firm heterogeneity is 5 to 9 times less likely to experience a very persistent recession. We use our framework to study the 2008-09 recession and show that the model can rationalize the persistent deviation of output and most macroeconomic aggregates from trend, including the behavior of net entry, markups and the labor share. Post-crisis cross-industry data corroborates our proposed mechanism. Firm subsidies can be powerful in preventing quasi-permanent recessions and can lead to a 21% increase in welfare.

It is well known that market power is detrimental to the level of output and welfare. It turns out it has also adverse business cycle implications that can add to level effects.

Why does risk matter more in recessions than in expansions?

November 15, 2021

By Martin Andreasen, Giovanni Caggiano, Efrem Castelnuovo and Giovanni Pellegrino

This paper uses a nonlinear vector autoregression and a non-recursive identification strategy to show that an equal-sized uncertainty shock generates a larger contraction in real activity when growth is low (as in recessions) than when growth is high (as in expansions). An estimated New Keynesian model with recursive preferences and approximated to third order around its risky steady state replicates these state-dependent responses. The key mechanism behind this result is that firms display a stronger upward nominal pricing bias in recessions than in expansions, because recessions imply higher inflation volatility and higher marginal utility of consumption than expansions.

I would have thought that the higher marginal utility of consumption in recessions was sufficient to explain why risk matters more in those periods. It appears there is more to it on the firm side. Firms like to set (nominally rigid) prices a bit higher in the face on uncertainty, and there is more uncertainty in recessions.