Optimal Public Debt Consolidation with Distributional Conflicts

Abstract

In this paper, we adopt a Ramsey-optimal approach to the identification of debt reduction strategies, that is, the optimal policy mix for labor and capital income taxes, public expenditures and inflation designed to achieve an exogenous debt reduction path. Our model accounts for monopoly profits, limited asset market participation and asset holders' infrequent optimization of their portfolio composition between money holdings and other financial assets. The optimal policy envisages persistent reductions in public consumption and increases in taxes and inflation. Distributional conflicts arise between asset owners and the rest of the population. When asset holders interests are relatively less important in the planner's objective function, labor income taxes are drastically reduced whereas capital income taxes and inflation are increased. Just in this case the consolidation has short term expansionary effects.