Time-Consistent public policy

Paul Klein, Per Krusell, Victor Rios-Rull

Research output: Contribution to journalArticlepeer-review

101 Scopus citations

Abstract

In this paper we study how a benevolent government that cannot commit to future policy should trade off the costs and benefits of public expenditure. We characterize and solve for Markov-perfect equilibria of the dynamic game between successive governments. The characterization consists of an inter-temporal first-order condition (a "generalized Euler equation") for the government, and we use it both to gain insight into the nature of the equilibrium and as a basis for computations. For a calibrated economy, we find that when the only tax base available to the government is capital income - an inelastic source of funds at any point in time - the government still refrains from taxing at confiscatory rates. We also find that when the only tax base is labour income the Markov equilibrium features less public expenditure and lower tax rates than the Ramsey equilibrium.

Original languageEnglish (US)
Pages (from-to)789-808
Number of pages20
JournalReview of Economic Studies
Volume75
Issue number3
DOIs
StatePublished - Jul 2008

Bibliographical note

Funding Information:
Acknowledgements. Krusell thanks the National Science Foundation, Ríos-Rull thanks the National Science Foundation (Grant SES–0079504) and the University of Pennsylvania Research Foundation, and Klein thanks the Social Science and Humanities Research Council of Canada for support. The authors thank Harald Uhlig, the editor, and two anonymous referees for very useful comments.

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