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

Salvador Ortigueira () and Joana Pereira

No ECO2007/41, Economics Working Papers from European University Institute

Abstract: We study optimal income taxation and public debt policy in a neoclassical economy populated by infinitely-lived households and a benevolent government. The government makes sequential decisions on the provision of a valued public good, on income taxation and the issue of public debt. We characterize and compute Markov-perfect optimal fiscal policy in this economy with two payoff-relevant state variables: physical capital and public debt. We find two stable, steady-state equilibria: one with no income taxation and positive government asset holdings, and another with positive taxation and public debt issuances. We prove that the two steady states are associated with different policy rules, which implies a multiplicity of (expectation-driven) Markov-perfect equilibria.

Keywords: Optimal taxation; optimal public debt; Markov-perfect equilibrium; Time-consistent policy (search for similar items in EconPapers)
JEL-codes: E61 E62 H21 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-pub
Date: Written 2007
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