Optimal redistributive policy in debt constrained economies

Abstract

How should governments with a preference for redistribution design tax policies when facing limited borrowing? This paper studies optimal taxation in a small open economy with heterogeneous agents and endogenous debt constraints arising from the government's limited commitment to fiscal policies. The optimal labor tax decreases over time and is nonzero in the limit, and the optimal capital and domestic borrowing taxes are positive in the limit, deviating from the standard Ramsey tax results. The government's redistributive motive directly affects optimal tax levels, whereas binding debt constraints influence optimal tax dynamics. In the numerical analysis, a stronger redistributive preference requires greater initial tax distortions and a higher external debt level in the long run.