Time Inconsistency, Capital Mobility and Debt Restructuring in a Small Open Economy

Abstract

Honest government announcements may not be credible. Governments may have incentives to change their plans when it is time to carry them out; or in technical terms, the plans may be time inconsistent. A dramatic example is the reaction to a hostage crisis. Governments should announce they will never negotiate with kidnappers to prevent future abductions. After the fact, however, there are strong incentives to break this promise to save the lives of hostages. Of course, intelligent people understand this. So, without commitment, no one expects time inconsistent policies to be undertaken. And, in general, this represents a welfare loss: hostage crises occur. As shown by Kydland and Prescott (1977) and Calvo (1978), credibility is a problem in tax policy. In general, governments have an incentive to change tax rates unexpectedly, for example, to exploit differences between ex-ante and ex-post elasticities. Take the taxation of capital. Ex ante, optimal taxes are low to promote elastically supplied investment. Ex post, the supply of capital is inelastic, so optimal taxes are high. Of course, if governments can change tax rates at any time, then in order to be credible, tax plans should be consistent with future incentives. As with a hostage crisis, this constraint, in general, represents a welfare loss. In a more subtle way, the taxation of labor and consumption is also in general time inconsistent. Optimal tax rates depend on endowments (initial plus acquired). For example, as a rule, tax rates should be high on complements to leisure and other endowments that can be directly consumed. In a dynamic economy, endowments change when assets are accumulated,