Intertemporal Distortions in the Second best

Abstract

This paper studies the long run properties of intertemporal distortions in a broad class of second best economies. Our unified framework encompasses and extends many well known models, such as variants of the Ramsey taxation model with aggregate or idiosyncratic risk, and economies with incentive compatibility constraints due to limited commitment, political economy, self-enforcement or private information, or combinations of these. We identify a sufficient condition that rules out permanent intertemporal distortions: If there exists an allocation that satisfies all constraints and eventually converges to the limiting first best allocation, then intertemporal distortions are temporary in the second best. This result uncovers a common optimality principle linking the intertemporal allocation of resources with the ability to frontload distortions for this broad class of environments. A series of applications illustrates the significance of these findings.