Intertemporal Distortions Research Articles

Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Income Risk

AbstractWe study optimal fiscal policy in a standard incomplete-markets model with uninsurable idiosyncratic income risk, where a Ramsey planner chooses time-varying paths of proportional capital and labour income taxes, lump-sum transfers (or taxes), and government debt. We find that (1) short-run capital income taxes are effective in providing redistribution since the tax base is relatively unequal and inelastic; (2) an increasing pattern of labour income taxes over time mitigates intertemporal distortions from capital income taxes; (3) the optimal policy increases overall transfers, calibrated initially to the US welfare system, by roughly $50\%$; (4) two-thirds of the welfare gains come from redistribution and the remaining third come mostly from insurance; and (5) redistribution also leads to a more efficient allocation of labour via wealth effects on labour supply—lower productivity households can afford to work relatively less.

A brief note on economic recessions, banking reform and the future of capitalism

In my book «Money, Bank Credit, and Economic Cycles» (1st Spanish Edition 1992, 2nd English Edition 2009) I present a detailed analysis of the Austrian Business Cycle Theory. Now I will concentrate on the financial crisis and the current worldwide economic recession as one of the most challenging problems we must now cope with and the way in which the Austrian Business Cycle Theory can help us to understand its causes and the best approach to economic recovery.
 Having witnessed the intellectual and practical defeat of socialism specially during the last decades of the twentieth century, in my opinion one of the main challenges that still remains for the future of Capitalism is the urgent need to privatize money by dismantling the organ of central monetary planning: the Central Bank. In other words, real Socialism, represented by state money, Central banks and financial administrative regulations, is still in force in the monetary and credit sectors of the so called free market economies.
 As a result of this fact we experience regularly in the area of money and credit all the negative consequences established by the Theorem of the Impossibility of Socialism discovered by those distinguished members of the Austrian School of Economics Ludwig von Mises and Friedrich Hayek.
 Specifically, the central planners of state money are unable to know, to follow and to control the changes in both the demand and supply of money. Furthermore, the whole financial system is based on the legal privilege given by the state to private bankers to act with a fractional reserve ratio in relation with the demand deposits they receive from their clients. As a result of this privilege, private bankers are not true financial intermediaries, but are mainly creators of deposits materializing in credit expansions. These credit expansions are artificial and do not correspond to any previous increases in the voluntary savings of the citizens. In this way the current fractional reserve banking system, tends to worsen and amplify the systemic intertemporal distortions and investment misallocations that the macroeconomic planners working for central banks induce in the production structure of the whole real economy. These distortions manifest themselves in the stages of financial bubbles, economic boom, overall malinvestment and afterwards in the stages of financial crisis, deep economic recession and unemployment.

Positional Preferences and Efficiency in a Dynamic Economy

Based on an endogenous growth model, this paper characterizes the conditions under which positional preferences do not give rise to intertemporal distortions as well as derives an optimal tax policy response in cases where these conditions are not satisfied. In our model, individuals can be positional both in terms of their consumption and wealth, the relative concerns partly reflect comparisons with people in other countries, and we distinguish between a (conventional) welfarist government and a paternalist government that does not respect positional preferences. We also extend the analysis to a multi-country framework and show that Nash-competition among local paternalist governments leads to a global social optimum, whereas Nash-competition among local welfarist governments does not.

Optimal capital taxation revisited

We revisit the question of how capital should be taxed. We allow for a rich set of tax instruments that consists of taxes widely used in practice, including consumption, dividend, capital, and labor income taxes. We restrict policies to those that respect pre-existing promises regarding the current value of wealth. We show that capital should not be taxed (i.e. there should be no intertemporal distortions), if households have preferences that are standard in the macroeconomics literature. We show that Ramsey outcomes that must respect such promises are time consistent. We show that the presumption in the literature that capital should be taxed for some length of time arises because the tax system is restricted.

Liquidity constraints, international trade, and optimal monetary policy

Abstract The availability of liquidity matters for an economy’s production and trade as firms need working capital to finance their operations. This paper studies the interaction between trade and capital flows operating through the liquidity allocations in the financial markets using a small-open-economy, overlapping-generations model. Working capital requirements distort the intratemporal consumption allocations. International capital inflows help easing liquidity in the domestic credit market, facilitating trade and improving the intratemporal allocation, while distorting the intertemporal allocation of the economy. We show how the government can use the Friedman rule and differentiated consumption taxes to address the tradeoff between the intratemporal and intertemporal distortions and achieve the second best optimum. Imposing a higher tax rate on imports can reduce the international borrowing to imports ratio and enhance the efficiency in using capital inflows to facilitate trade flows.

Positional Preferences: Efficiency and Distortions Under Welfarist- and Paternalistic Governments

This paper analyzes the distortionary effects of positional preferences when labor supply is exogenous under both a welfarist and a paternalistic government. Extending the prior literature, reference levels may be partially exogenous to the government (e.g., determined by consumption choices in a foreign country), and individuals may be positional with respect to wealth in addition to consumption. Neither consumption- nor consumption-cum-wealth positionality needs to cause inter-temporal distortions under either welfare criterion. We derive necessary and sufficient conditions for non-distortion of positional preferences. If those conditions are not satisfied, the same reference levels of consumption and wealth can give rise to under-saving or to over-saving -- depending on the extend to which the reference levels are exogenous to the government. Moreover, we provide conditions for which positional preferences for wealth and consumption imply over-consumption with respect to the welfarist criterion but, at the same time, over-saving with respect to the paternalistic criterion.

A solvable continuous time dynamic principal–agent model

I study the provision of incentives in a continuous time dynamic moral hazard model with hidden actions and hidden states. I consider a principal–agent model with linear production and exponential utility, whose explicit solution allows me to show how allocations are distorted for incentive reasons, and how access to hidden savings further alters allocations. I solve the model by applying a stochastic maximum principle, where the co-state variables from the agent's optimization problem become state variables for the principal's problem of choosing an optimal contract. I show that the main effect of moral hazard is a distortion on the effort margin, with a smaller effect on the intertemporal consumption allocation. Access to hidden savings shuts down the intertemporal distortions and increases the effort distortion. I also show how the optimal contracts can be implemented via a constant equity share, a constant flow payment, and a constant tax on savings.

Do Positional Preferences for Wealth and Consumption Cause Inter-Temporal Distortions?

This paper derives necessary and sufficient conditions under which positional preferences do not induce inter-temporal distortions. When labor supply is exogenous, positional preferences for consumption have been shown to be non-distortionary for a class of models. However, it has not been explored whether the same holds when households also exhibit positional preferences for wealth. The analysis identifies a restricted homogeneity-property which, when not satisfied, induces positional preferences to be distortionary, despite inelastic labor supply. Without positional preferences for wealth, a constant marginal rate of substitution-property is necessary and sufficient for a consumption positionality to be non-distortionary. Once a household also has positional preferences for wealth in addition, the consumption positionality almost always becomes distortionary, as the implied effects of the positional concerns induce opposing effects on a household's saving behavior. Under a constant marginal rates of substitution-property, these opposing effects exactly offset each other.

Optimal disability insurance with unobservable skill heterogeneity

This paper studies the U.S. income tax and disability insurance systems in a unified framework with relevant private information and a general social welfare function. To that end, I develop a dynamic model in which agents differ in labor productivity and disability status, which are both private information. The optimal allocation can exhibit negative marginal labor income tax rates for high-skilled individuals but zero for low-skilled individuals, which is contrary to standard results. Also, I find that a reform to the optimal system in the calibrated model would significantly improve the U.S. system. The welfare gains amount to a 3.48 percent increase in consumption with a utilitarian social welfare function, which might be larger with a non-utilitarian function. Better insurance for people in bad states and reduced intratemporal distortions account for almost all the welfare gains. However, intertemporal distortions do not appear to play a major role.

Required reserves as a credit policy tool

This paper quantitatively investigates the role of reserve requirements as a credit policy tool. We build a monetary dynamic stochastic general equilibrium (DSGE) model with a banking sector in which an agency problem between households and banks leads to endogenous capital constraints for the latter. In this setup, a countercyclical required reserves ratio (RRR) rule that responds to expected credit growth is found to countervail the negative effects of the financial accelerator mechanism triggered by productivity and bank capital shocks. Furthermore, it reduces the procyclicality of the financial system compared to a fixed RRR policy regime. The credit policy is most effective when the economy is hit by a financial shock. A time-varying RRR policy reduces the intertemporal distortions created by the fluctuations in credit spreads at the expense of generating higher inflation volatility, indicating an interesting trade-off between price stability and financial stability.

Intertemporal Distortions in the Second Best

We consider a very general class of public …nance problems that encompasses Ramsey models of optimal taxation as well as economies with limited commitment, private information, and political economy frictions. We identify a su¢ cient condition to rule out permanent intertemporal distortions at the optimum: If there exists an admissible allocation that converges to the …rst best steady state, then all intertemporal distortions are temporary in the second best. We analyze a series of applications to illustrate the signi…cance of this result.

A Dynamic Theory of Resource War

We develop a dynamic theory of resource wars and study the conditions under which such wars can be prevented. The interaction between the scarcity of resources and the incentives for war in the presence of limited commitment is at the center of our theory. We show that a key parameter determining the incentives for war is the elasticity of demand. Our first result identifies a novel externality that can precipitate war: price-taking firms fail to internalize the impact of their extraction on military action. In the case of inelastic resource demand, war incentives increase over time and war may become inevitable. Our second result shows that in some situations, regulation of prices and quantities by the resource-rich country can prevent war, and when this is the case, there will also be intertemporal distortions. In particular, resource extraction will tend to be slower than that prescribed by the Hotelling rule, which is the rate of extraction in the competitive environment. Our third result is that, due to limited commitment, such regulation can also precipitate war in some circumstances in which war is avoided in the competitive environment.

A Dynamic Theory of Resource Wars

We develop a dynamic theory of resource wars and study the conditions under which such wars can be prevented. The interaction between the scarcity of resources and the incentives for war in the presence of limited commitment is at the center of our theory. We show that a key parameter determining the incentives for war is the elasticity of demand. Our first result identifies a novel externality that can precipitate war: price-taking firms fail to internalize the impact of their extraction on military action. In the case of inelastic resource demand, war incentives increase over time and war may become inevitable. Our second result shows that in some situations, regulation of prices and quantities by the resource-rich country can prevent war, and when this is the case, there will also be intertemporal distortions. In particular, resource extraction will tend to be slower than that prescribed by the Hotelling rule, which is the rate of extraction in the competitive environment. Our third result is that, due to limited commitment, such regulation can also precipitate war in some circumstances in which war is avoided in the competitive environment.

Tax Smoothing in Frictional Labor Markets

The optimality of tax smoothing is reexamined using frictional labor markets. In a calibrated matching model that generates empirically relevant labor market fluctuations conditional on exogenous fiscal policy, the Ramsey-optimal policy calls for extreme labor tax rate volatility. Purposeful tax volatility induces dramatically smaller, but efficient, fluctuations of labor markets by keeping distortions constant over the business cycle. We relate the results to standard Ramsey theory by developing welfare-relevant concepts of efficiency and distortions based on primitive matching frictions. Although the basic Ramsey principles of “wedge smoothing” and zero intertemporal distortions hold, tax smoothing depends on whether wages are set efficiently.

Dynamic scoring: Alternative financing schemes

Neoclassical growth models predict that reductions in capital or labor income tax rates are expansionary when lump-sum transfers are used to balance the government budget. This paper explores the consequences of bond-financed tax reductions that bring forth a range of possible offsetting policies, including future government consumption, capital tax rates, or labor tax rates. Through the resulting intertemporal distortions, current tax cuts can be expansionary or contractionary. The paper also finds that more aggressive responses of offsetting policies to debt engender less debt accumulation and less costly tax cuts.

Dynamic Scoring: Alternative Financing Schemes

Neoclassical growth models predict that reductions in capital or labor tax rates are expansionary when lump-sum transfers are used to balance the government budget. This paper explores the consequences of bond-financed tax reductions that bring forth a range of possible offsetting policies, including future government consumption, capital tax rates, or labor tax rates. Through the resulting intertemporal distortions, current tax cuts can be contractionary. The paper also finds that more aggressive responses of offsetting policies to debt engender less debt accumulation and less costly tax cuts.

The Growth and Welfare Consequences of Differential Tariffs

This paper analyzes the impact of differential tariffs on consumption and investment in a specific factors model of a small open economy in which capital is accumulated over time. Particular attention is devoted to the welfare aspects, highlighting the cost of the intertemporal distortions produced by protective trade policies. Several specific welfare propositions are obtained. First, tariff protection is shown to create short-run benefits but long-run costs in welfare. Second, the second-best policy for the two tariffs is characterized. Finally, several propositions summarizing the implications of our analysis for tariff reform are derived.

TAXATION OF BANKING SERVICES UNDER A CONSUMPTION TYPE, DESTINATION BASIS VAT

This paper discusses the tax treatment of banking under a credit-method consumption type destination-basis VAT. We suggest that, contrary to previous arguments, extending a credit-type VAT to include banking as usually proposed is feasible but would involve intertemporal tax distortions which a consumption-type VAT seeks to avoid. In contrast, a flow of funds type VAT retains the essential features of the credit/invoice method and does not introduce intertemporal distortions. The negative feature is its perceived impact on cash flow since deposits are taxed, with withdrawals subsequently grossed up at the tax rate. Alternative separate tax treatments for banking require an apportionment.

Welfare Effects of Capital Income Taxation under Variable and Fixed Labor Supply

Not every model of economic behavior can allow for variable labor supply. When attention is focused on other economic issues, the effect on welfare change measurement of assuming labor to be in fixed supply becomes important. The traditional view is that allowing labor supply to be variable will reduce the measured benefits of replacing an interest income tax with a payroll or consumption tax, owing to the introduction (or increase in) a static distortion between consumption and leisure. However, this view ignores two mechanisms by which variable labor supply may actually increase the benefits of relaxing the capital income tax. First, an interest income tax distorts the intertemporal path of leisure, and thus of labor supply. Second, as explained below, the interest elasticity of savings may be augmented by changes in the intertemporal labor supply path. Eliminating the labor supply path distortion and increasing capital accumulation can provide benefits which may potentially exceed the disadvantages of increased static distortion. This paper tests which effects dominate by simulation in a life cycle growth model. Previous papers have not addressed these issues. Feldstein [3] discusses welfare measurement in a two-period model in which an individual supplies labor in the first period and consumes in both periods. Feldstein's partial equilibrium efficiency measure incorporates the elasticity of labor supply with respect to the interest rate, but his single period of labor supply may be misleading. Summers [8] demonstrates that in multi-period models interest rate changes may have a large effect upon the present value of lifetime resources (human wealth) and, consequently, consumption. That finding, when applied to frameworks allowing for leisure consumption, implies that both the compensated and uncompensated elasticities of labor supply with respect to the interest rate may be markedly different for multi-period than for one period labor supply models. Summers exploits a multi-period life cycle growth model to measure numerically the steady state efficiency gains following an elimination of interest income taxation. He assumes labor to be fixed in supply at each moment. Consequently, changes in human wealth cannot affect the leisure profile and the benefits of eliminating intertemporal leisure distortions are not captured. Summers concludes that steady state consumption and welfare would increase

The Cost of the Intersectoral and Intertemporal Price Distortions of a Corporation Income Tax

By raising corporations' cost of capital above that for non-corporate firms, the corporation income tax induces an inefficient intersectoral allocation of capital.' Further, by forcing a wedge between the gross-of-tax return to savings in the corporate sector and the net return, the corporation income tax also causes an inefficient allocation of consumption over time. Harberger [12] and Shoven [18] have examined the intersectoral misallocation of capital induced by the corporation income tax.2 They both estimated the resulting efficiency loss at around five-tenths of a per cent of national income. Feldstein has recently treated the corporation income tax as a tax on all capital income (i.e., on the return to all savings) and has investigated the resulting distortion in the timing of consumption [8]. His rough estimates suggest that this distortion also induces an efficiency cost of around five-tenths of a per cent of national income. As Feldstein cautions, one cannot simply take his estimates and add them to the Harberger-Shoven estimates to get an over-all picture of the efficiency cost of the corporation income tax [8, S47 fn. 42]. Harberger and Shoven use a static model which cannot take into account distortions in future consumption. Feldstein, on the other hand, uses a one-sector