Markov-Perfect Optimal Fiscal Policy: The Case of Unbalanced Budgets∗

In most developed economies, income tax rates and government debt levels are positive and sizable. In the US, effective income tax rates have been in the order of 20%, and outstanding public debt represents about 60% of GDP. The main question we pose in this paper is: can these numbers be accounted for as the outcome of a government’s welfare maximization program in a neoclassical economy? To address this question we adopt the standard framework in the literature of optimal fiscal policy, and drop the assumption of government’s full commitment to future policies. Instead, we assume that the government has no access to commitment devices nor to reputation mechanisms, and, therefore, we restrict our attention to Markovian optimal policies. Our answer to the above question is in the affirmative, provided that this is the policy expected by households and all successive governments. JEL Classification Numbers: E61; E62. ∗The authors thank Ken Judd, Ramon Marimon, Vladimir Petkov, Rick van der Ploeg, Debraj Ray and JoséVı́ctor Rı́os-Rull for helpfull comments and discussions. Joana Pereira is grateful for the hospitality of the Economics Department at New York University where part of this research was conducted. †Email address: [email protected] ‡Email address: [email protected]