National income taxation and the geographic distribution of population

We study how different national taxation schemes interact with geographic variation in productivity and consumption amenities in determining regional populations. A neoclassical migration equilibrium model is used to analyze the current nominal income tax system in Norway. The analysis is based on estimated regional income differences accounting for both observable and unobservable individual characteristics and the value of experience. Given regional differences in incomes and housing prices, quality of life and productivity are calibrated to model equilibrium. Compared to an undistorted equilibrium with lump-sum taxation, nominal income taxation creates a disincentive to locate in productive high-income regions. The deadweight loss due to locational inefficiencies is 0.18% of gross domestic product (GDP). We study real income taxation and equal real taxes as alternative tax systems. Both alternatives generate a geographic distribution of the population closer to the undistorted equilibrium, and hence with lower deadweight loss. In an extension of the analysis, we take into account payroll taxes. The existing regionally differentiated payroll taxes to the disadvantage of cities generate a deadweight loss of 0.22% of GDP in an economy with lump-sum income taxation. The two distortionary taxes interact and strengthen each other and the combined distortionary effect of income and payroll taxation in the Norwegian system is 0.46% of GDP.     

Fiscal Externalities and Efficient Transfers in a Federation

This paper investigates properties of the second best allocation in a fiscal federal system in which both federal tax and intergovernmental grants are involved and the taxation is distortionary. Also, optimal federal grants and tax policies in a decentralized fiscal system are examined. Our major findings are: (i) the second best does not require the equalization of marginal cost of public funds across regions in a conventional form; (ii) matching grants based on either the local tax rates or tax revenues should be introduced to internalize the tax externality; and (iii) once lump-sum and matching grants are optimized, federal tax policy becomes redundant so the optimal fiscal gap is indeterminate.     

Fiscal hedging with nominal assets

We analyze optimal fiscal and monetary policy in an economy with distortionary labor income taxes, nominal rigidities, nominal debt of various maturities and short-selling constraints. Optimal policy prescribes the almost exclusive use of long term debt. Such debt mitigates the distortions associated with hedging fiscal shocks by allowing the government to allocate them efficiently across states and periods.     

Optimal fiscal and monetary policy with sticky prices

In this paper I consider the role of state-contingent inflation as a fiscal shock absorber in an economy with nominal rigidities. I study the Ramsey equilibrium in a monetary model with distortionary taxation, nominal non-state-contingent debt, and sticky prices. With sticky prices, the Ramsey planner must balance the shock absorbing benefits of state-contingent inflation against the associated resource misallocation costs. For government spending processes resembling post-war experience, introducing sticky prices generates striking departures in optimal policy from the case with flexible prices. For even small degrees of price rigidity, optimal policy displays very little volatility in inflation. Tax rates display greater volatility compared to the model with flexible prices. With sticky prices, tax rates and real government debt exhibit behavior similar to a random walk. For government spending processes resembling periods of intermittent war and peace, optimal policy displays extreme inflation volatility even when the degree of price rigidity is large. As the variability in government spending increases, smoothing tax distortions across states of nature becomes increasingly important, and the shock absorber role of inflation is accentuated.     

Optimal Fiscal Policy with Consumption Taxation

We characterize optimal fiscal policies in a general equilibrium model with monopolistic competition and endogenous public spending. The government can tax consumption, as alternative to labor income taxes. Consumption taxation acts as indirect taxation of profits (intratemporal gains of taxing consumption) and enables the policymaker to manage the burden of public debt more efficiently (intertemporal gains of taxing consumption). We show analytically that these two gains imply that the optimal share of government spending is higher under consumption taxation than with labor income taxation. Then, we quantify numerically each of these gains by calibrating the model on the U.S. economy.     

Taxes and stabilization in contemporary macroeconomic models

The role of proportional and procyclic labor income taxes for automatic stabilization with stochastic productivity is analyzed in a contemporary macroeconomic model based on imperfect competition. The importance of short-run nominal wage rigidity for the effectiveness of progressive taxes on labor income for stabilizing output and raising household welfare is examined in a model that yields complete analytical solutions with stochastic output shocks. Increasing the procyclicity of labor income tax rates raises welfare with and without rigid nominal wages in the model economy. With fully flexible prices and wages, a positive covariance between the distortionary tax rate and productivity reduces the volatility of production and employment. This effect disappears under nominal wage rigidity, although progressive taxation can still raise welfare by reducing the distortion caused by a proportional labor tax. With rigid nominal wages and flexible consumer goods prices, payroll taxes levied at rates that rise with output can serve as automatic stabilizers. JEL Code E62 · H20     

Fiscal and Monetary Policy Coordination,Macroeconomic Stability,and Sovereign Risk Premia

In standard macroeconomic models, equilibrium stability and uniqueness require monetary policy to actively target inflation and fiscal policy to ensure long‐run debt sustainability. We show analytically that these requirements change, and depend on the cyclicality of fiscal policy, when government debt is risky. In that case, budget deficits raise interest rates and crowd out consumption. Consequently, countercyclical fiscal policies reduce the parameter space supporting stable and unique equilibria and are feasible only if complemented with more aggressive debt consolidation and/or active monetary policy. Stability is more easily achieved, however, under procyclical fiscal policies.     

Optimal simple and implementable monetary and fiscal rules

Welfare-maximizing monetary- and fiscal-policy rules are studied in a model with sticky prices, money, and distortionary taxation. The Ramsey-optimal policy is used as a point of comparison. The main findings are: the size of the inflation coefficient in the interest-rate rule plays a minor role for welfare. It matters only insofar as it affects the determinacy of equilibrium. Optimal monetary policy features a muted response to output. Interest-rate rules that feature a positive response to output can lead to significant welfare losses. The welfare gains from interest-rate smoothing are negligible. Optimal fiscal policy is passive. The optimal monetary and fiscal rule combination attains virtually the same level of welfare as the Ramsey-optimal policy.     

The Advantage of Flexible Targeting Rules

This paper investigates the consequences of debt stabilization for inflation targeting. If the fiscal authority holds constant the real value of debt at maturity under strict inflation targeting, the equilibrium dynamics are indeterminate for a wide range of parameters and steady‐state fiscal stances. “Flexible” targeting rules that include a concern for stabilization of the output gap can restore determinacy of the equilibrium. Flexible inflation targeting appears to be more robust than flexible debt targeting to alternative parameterizations. The fiscal authority can prevent indeterminacy under strict targeting rules by committing to hold constant debt net of interest rate spending.     

Financing Public Goods with Income Taxation: Provision Rules vs. Provision Level

Due to the use of distortionary taxation, many believe that real-world economies should attain a lower level of public expenditures than in a situation where lump-sum taxes are available. The present paper examines this hypothesis by means of the two-type self-selection model of income taxation. Based on the findings of Boadway and Keen (1993), I provide sufficient conditions for both a lower and a higher level of public expenditures in second best than in first best. In particular, it is shown that the separability assumption of Christiansen (1981) leads to under-provision of the public good in the income tax optimum.     

Optimal Simple Monetary and Fiscal Rules under Limited Asset Market Participation

The combination of limited asset market participation and consumption habits generates indeterminacy for empirically plausible calibrations of a business cycle model characterized by price and nominal wage rigidities. Equilibrium determinacy is restored by demand management policies based on simple fiscal rules. In this regard, fiscal control of nominal income growth is particularly effective. In addition the complementarity between the Taylor rule and the fiscal feedback on nominal income growth produces relatively large welfare gains, limiting both aggregate and intragroup volatilities.     

The Friedman rule: Old and new

In overlapping generations models, money growth creates intergenerational wealth effects and leads to the breakdown of the Friedman rule; the rule can be restored via lump-sum tax and transfers that neutralize these wealth transfers. Additionally, and in contrast to money-in-the-utility-function models, the Friedman rule is not the unique first-best solution in cash-in-advance-constraint models of money: a continuum of combinations of money growth rates and consumption taxes implement the first-best allocation. This paper traces through the intellectual origins of the first (old) result, which was recently restated in Bhattacharya, et al. [2005. Monetary policy, fiscal policy, and the inflation tax: equivalence results. Macroeconomic Dynamics 7, 647-669.] and formally demonstrates the second (new) result.     

Keynesian Inefficiency and Optimal Policy: A New Monetarist Approach

A simple model of monetary/labor search is constructed to study Keynesian indeterminacy and optimal policy. In the model, economic agents have trouble splitting the surplus from exchange appropriately, and we consider monetary and fiscal policies that correct this Keynesian inefficiency. A Taylor rule neither implies determinacy, nor does it support an efficient outcome. An optimal policy yields an efficient and determinate allocation of resources, but equilibrium policy actions, wages, and prices are indeterminate at the optimum.     

Real Balance Effects,Timing, and Equilibrium Determination

By assuming that money balances at the beginning instead of at the end of the period provide transaction services, standard results on nominal and real determinacy in monetary models are overturned. The key is that predetermined real money balances can be a state variable. Whereas the determination of the absolute price level typically depends on fiscal policy under an exogenous interest setting, nominal determinacy is now achieved even when fiscal policy is Ricardian. Also, in contrast to the Taylor principle, the interest rate policy should respond passively to changes in inflation, thus ensuring nonoscillatory and locally stable equilibrium sequences.     

On the International Dimension of Fiscal Policy

This paper analyzes the international dimension of fiscal policy in a small open economy framework. We consider the case in which the government finances its spending by levying distortionary taxes and issuing state‐contingent debt. While in a closed economy taxes are essentially invariant, in an open economy taxes can be as volatile as output. This is because the presence of a terms of trade externality introduces efficient fluctuations in the consumption–leisure wedge driven by movements in the real exchange rate. As a result, the optimal fiscal rule suggests that taxes should be varied to replicate these fluctuations.     

Payments systems and monetary policy

A dynamic spatial model is constructed where there is a role for money and for centralized payments arrangements, and where there are aggregate fluctuations driven by fluctuations in aggregate productivity. With decentralized monetary exchange and no centralized payments arrangements, there is price level indeterminacy, and the equilibrium allocation is inefficient. A private clearinghouse arrangement improves efficiency but produces a real indeterminacy. The pricing of daylight overdrafts is irrelevant for the equilibrium allocation. Efficiency is achieved with a zero nominal interest rate on overnight central bank lending, or through private overnight interbank lending.     

Interest rate rules and price determinacy: The role of transactions services of bonds

Interest rate rules have been associated with price indeterminacy when they do not respond aggressively enough to inflation. Price indeterminacy is typically associated with indeterminacy of real bond balances, suggesting that the missing element is a meaningful role for government bonds. We assume that government bonds provide arbitrarily small transactions services and show that this can dramatically change the local and global determinacy conditions. In particular, the specification of fiscal policy affects the aggressiveness with which monetary policy must respond to inflation to deliver local determinacy—a range of passive monetary policies, even an interest rate peg, may yield determinacy.     

Monetary-fiscal policy interactions and the price level:Background and beyond

The paper presents the fiscal theory of the price level in a variety of models, including endowment economies with lump-sum taxes and production economies with proportional income taxes. We offer a microeconomic perspective on the fiscal theory by computing a Slutsky-Hicks decomposition of the effects of tax changes into substitution, wealth, and revaluation effects. Revaluation effects arise whenever tax changes alter the value of outstanding nominal government liabilities by changing the price level. Under certain assumptions on monetary and fiscal behavior, the revaluation effect reflects the fiscal theory mechanism. When taxes distort, two Laffer curves arise, implying that a tax increase can lower or raise the price level and the revaluation effect can be positive or negative, depending on which side of a particular Laffer curve the economy resides. Jel Code: E31 · E52 · E62     

The marginal cost of public funds is one at the optimal tax system

This paper develops a Mirrlees framework with skill and preference heterogeneity to analyze optimal linear and nonlinear redistributive taxes, optimal provision of public goods, and the marginal cost of public funds (MCF). It is shown that the MCF equals one at the optimal tax system, for both lump-sum and distortionary taxes, for linear and nonlinear taxes, and for both income and consumption taxes. By allowing for redistributional concerns, the marginal excess burden of distortionary taxes is shown to be equal to the marginal distributional gain at the optimal tax system. Consequently, the modified Samuelson rule should not be corrected for the marginal cost of public funds. Outside the optimum, the marginal cost of public funds for distortionary taxes can be either smaller or larger than one. The findings of this paper have potentially important implications for applied tax policy and social cost–benefit analysis.     

Fiscal policy with banks and financial frictions

We assess the role of banks to the transmission of optimal and exogenous changes in fiscal policy to the economy. We built-up a dynamic stochastic general equilibrium model with patient and impatient agents, banks and a government to find that banks and their associated capital-adequacy constraint mitigate the negative spill-over effects to the economy from higher taxes. Specifically, we confirm that labour income tax is the most distortionary fiscal instrument. The optimal choice of a housing tax is the most favorable funding source to a temporary increase in public spending. The combination of housing and labour taxes is the most preferred tax bundle to be optimally chosen under negative output shocks. Moreover, a permanent increase in housing tax is beneficial if it is welfare enhancing and the existence of banks benefits mainly impatient households under permanently higher consumption taxes. Finally, these results remain robust to various robustness checks.