Optimal taxation and debt composition: Is Monetary Policy Too Costly?

Gerardo Licandro

No 2000007, Documentos de trabajo from Banco Central del Uruguay

Abstract: Using an optimal taxation model, in which inflation and inflation variability are tied together, we are able to determine that the incentives to generate inflationary surprise backfire, increasing the cost of debt. When we require plans to be time consistent, we find that, although the policymaker would rather set inflation to international standards, this target is not part of any time consistent equilibrium. In order to achieve the Pareto-improving zero-inflation outcome the government needs to resort to commitment mechanisms. It is shown that an optimal selection of the debt-portfolio results in better outcomes by reducing the base of the inflation tax, but some inflationary bias persists as long as the national currency exists. With a debt portfolio in which nominal debt is incorporated, in order to achieve the zero-inflation Stackelberg equilibrium the country needs to commit to zero inflation.

Pages: 13 pages
Date: 2000-05
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