Optimal Taxes without Commitment

Jess Benhabib · Aldo Rustichini C

102 citations0/0 files storedJournal of Economic Theory

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Fiscal Policy and Economic Growth Economic and Fiscal Studies Fiscal Policies and Political Economy

Abstract

In the problem of optimal taxation in an economy with labor and capital, the optimal solution when the government can commit to a sequence of tax rates entails that the tax on capital tends to zero in the limit, with all the tax burden on labor. It is well known, however, that this solution is time inconsistent; so if the commitment power is not perfect, this second best tax plan will not be sustainable. We model explicitly the trade-off between the cost of revising the tax plan, and the benefit of the revision. As a result, when commitment is not possible, both the limit tax rate and the steady state capital are different from their levels in the second best solution. Limit taxes on capital may be strictly positive; but it may also be the case that the only sustainable plan has subsidies to capital. The subsidies induce an overaccumulation of capital, which becomes a commitment device against revisions of the tax plan.Journal of Economic LiteratureClassification Numbers: H21, C73.

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References

1977Rules Rather than Discretion: The Inconsistency of Optimal Plans 1928A Mathematical Theory of Saving 1986Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives 1985Redistributive taxation in a simple perfect foresight model 1993Optimal Taxation in Models of Endogenous Growth 1993Optimal Fiscal Policy in a Business Cycle Model 2002Optimal Taxation without State‐Contingent Debt 1997On the Optimal Taxation of Capital Income

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2003Indeterminacy and fiscal policies in a growing economy 2004Policy commitment and the welfare gains from capital market liberalization 2002Taxation and Saving**I am grateful to the National Science Foundation (Grant Number SBR95-11321) for financial support. During the course of this project, I have benefitted from discussions with numerous friends and colleagues, and my intellectual debts are too numerous to list. However, I am especially grateful to Alan Auerbach, William Gale, and Kenneth Judd. I am also indebted to Sita Nataraj for catching a number of errors, and for suggesting a variety of expositional improvements.

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