Taxation without commitment

This paper considers a Ramsey model of linear capital and labor income taxation in which a benevolent government cannot commit ex-ante to a sequence of policies for the future. In this setup, if the government is forced to keep budget balance in every period, then it may not be able to sustain zero capital taxes in the long run, as shown in Benhabib and Rustichini (J Econ Theory 77:231–259, 1997) and Phelan and Stachetti (Econometrica 69:1491–1518, 2001). However, (Dominguez in J Econ Theory 135:159–170, 2007) shows that if the government is allowed to borrow and lend to households, the optimal capital income tax still converges to zero in the long run, as long as the value of defaulting is independent of the level of government debt. This paper provides a game theoretic setup with government debt where the value of the worst equilibrium only depends on the initial level of capital and can be determined in advance. This implies that under our assumptions the best sustainable equilibrium has zero capital taxes in the long run, even in the absence of government commitment.