Optimal contract theory with time-inconsistent preferences

This paper incorporates managers' time-inconsistent preferences into the classical DeMarzo and Sannikov (2006) contract model to study corresponding impacts on the optimal contract, corporate financial policies, and the optimal capital structure. The extended model shows that the impatience of the time-inconsistent agent has positive effects on the optimal payout decision which is opposite to DeMarzo and Sannikov (2006) and consequently provides a guideline to tailor the contract between investors and the agent. It also shows in the optimal capital structure, the total debt capacity shrinks with the degree of the agent's time inconsistency, and the long-term one shrinks more. In addition, our model predicts that the agent's time inconsistency not only imposes significant limits on the use of long-term debt but also has great effects on firms' capital structures. Thus our finding can potentially explain observed cross-sectional differences in firms' capital structures.     

Pyramidal structure,risk‐taking and firm value

This article investigates the relationship among pyramidal layers, risk‐taking and firm value using a sample of local state‐owned enterprises (SOEs) in China. We find that state‐pyramidal layers have a positive and significant impact on firm risk‐taking and firm value, suggesting that the pyramidal structure formed by the state protects SOEs from political intervention. Risk‐taking is conducive to enhancing firm value and is one of the important channels through which state‐pyramidal layers increase firm value. By exploring the role of state‐pyramidal organizational structures in improving SOEs' risk‐taking, our results contribute to both corporate governance and corporate finance literature.     

A note on Kuhn’s Theorem with ambiguity averse players

Kuhn’s Theorem shows that extensive games with perfect recall can equivalently be analyzed using mixed or behavioral strategies, as long as players are expected utility maximizers. This note constructs an example that illustrates the limits of Kuhn’s Theorem in an environment with ambiguity averse players who use a maxmin decision rule and full Bayesian updating.     

Optimal Incentives with State‐Dependent Preferences

In both experimental and natural settings, incentives sometimes underperform, generating smaller effects on the targeted behaviors than would be predicted for entirely self‐regarding agents. A parsimonious explanation is that incentives that appeal to self‐regarding economic motives may crowd out noneconomic motives such as altruism, reciprocity, intrinsic motivation, ethical values, and other social preferences, leading to disappointing and sometimes even counterproductive incentive effects. We present evidence from behavioral experiments that crowding may take two forms: categorical (the effect on preferences depends only on the presence or absence of the incentive) or marginal (the effect depends on the extent of the incentive). We extend an earlier contribution (Bowles and Hwang, 2008 ) to include categorical crowding, thus providing a more general framework for the study of optimal incentives and as a result, an expanded range of situations for which the sophisticated planner will (surprisingly) make greater use of incentives when incentives crowd out social preferences than when motivational crowding is absent.     

International risk‐sharing in the short run and in the long run

Abstract International risk‐sharing has far‐reaching implications both for economic policy and for basic research in economics. When countries do not share consumption risk, individuals experience consumption fluctuations that are undesirable and possibly unnecessary. We investigate bilateral risk‐sharing at short vs. long horizons. We find substantial cross‐country consumption correlations at trend and business‐cycle frequencies. Correlations are particularly high within Europe. Prior research focused on first‐difference correlations, which are typically quite low. We argue that this reflects measurement error. At all horizons, we find that consumption correlations are not significantly different from output correlations, implying a lack of deliberate consumption risk‐sharing.     

Optimal contract mechanisms for principal-agent problems with moral hazard and adverse selection

Summary We examine the problem of incentive compatibility and mechanism design for incomplete information principal-agent problems. Allowing for risk aversion on the part of the principal and agent, we show the existence of an optimal, incentive compatible contract selection mechanism for the principal under conditions of moral hazard and adverse selection. Since we assume that the contract set is a function space of state contingent contracts, and that the set of agent types is uncountable, the set of contract selection mechanisms becomes infinite dimensional. Hence, novel existence arguments are required. Our existence result extends those of Grossman and Hart [10] and Page [23] to an infinite dimensional setting with incomplete information.     

Optimal Capital Income Taxation with Means‐tested Benefits

This paper studies the interaction between capital income taxation and a means‐tested age pension. Our results document that the existence of a social insurance program financed from general revenue puts an upward pressure on the optimal tax rate. We also show that there is a negative relation between taper (benefit‐reduction) and optimal capital income tax rates. The potential welfare gain from optimizing capital taxation in the presence of a universal retirement transfer system is relatively higher. However, when the transfer is substantially means tested, the gain is lower, because the means test effectively operates as a tax on retirement capital.     

Real exchange rate dynamics: Relative importance of Taylor‐rule fundamentals,monetary policy shocks,and risk‐premium shocks

We first show that the solution to the real exchange rate under the Taylor rule with interest rate smoothing can have two alternative representations—one based on a first‐order difference equation and the other based on a second‐order difference equation. Then, by comparing error terms from these two alternative representations and analyzing their second moments, we evaluate the relative importance of Taylor‐rule fundamentals, monetary policy shocks, and risk‐premium shocks in the dynamics of the real exchange rate. Empirical results suggest that the risk‐premium shock is the largest contributor to real exchange rate movements for all the countries examined, with the Taylor‐rule fundamentals and monetary policy shocks playing a limited role. These results are robust to various alternative sets of parameter values considered for the Taylor rule with interest rate smoothing.     

Optimal Subsidization of Business Start‐Ups

This paper studies efficient allocation of resources in an economy in which agents are initially heterogeneous with regard to their wealth levels and whether they have productive ideas or not. An agent with an idea can start a business that generates random returns. Agents have private information about (1) their initial types, (2) how they allocate their resources between consumption and investment, and (3) the realized returns. I show that, under informational frictions, a society that targets productive efficiency should subsidize poor agents with ideas, and choose the amount and timing of subsidies carefully in order to ensure that other agents do not mimic poor agents with ideas and receive subsidies. Then, I provide an implementation of the start‐up subsidies in a market framework that resembles the U.S. Small Business Administration's Business Loan Program.     

Age‐related Optimal Income Taxation*

In most countries, average income varies with age. In this paper we investigate if and how it is possible to enhance the redistributive mechanism by relating tax payments to age. Using an OLG model where some individuals are low skilled all their life while others are low skilled when young but high skilled when old, we first show how an age dependent optimal income tax can Pareto improve upon an age independent income tax. We then characterize the optimal age dependent income tax. A tax on interest income is part of the optimal tax structure.     

Optimal credit rationing in not‐for‐profit financial institutions*

We examine the dynamic optimization problem for not‐for‐profit financial institutions (NFPs) that maximize consumer surplus, not profits. We characterize the optimal dynamic policy and find that it involves credit rationing. Interest rates set by mature NFPs will typically be more favorable to customers than market rates, as any surplus is distributed in the form of interest rate subsidies, with credit rationing being required to prevent these subsidies from distorting loan volumes from their optimal levels. Rationing overcomes a fundamental problem in NFPs; it allows them to distribute the surplus without distorting the volume of activity from the efficient level.     

Optimal Drug Policy in Low‐Income Neighborhoods

The control of drug activity currently favors supply‐side policies: drug suppliers in the United States face a higher arrest rate and longer sentences than demanders. We construct a simple model of drug activity with search and entry frictions in labor and drug markets. Our calibration analysis suggests a strong “dealer replacement effect.”  As a result, given a variety of community objectives, it is beneficial to lower supplier arrests and raise the demand arrest rate from current values. A 10% shift from supply‐side to demand‐side arrests can reduce the population of potential drug dealers by 22–25,000 and raise aggregate local income by $380–$400 million, at 2002 prices.     

Optimal fiscal policy in sunspot‐driven oligopolistic economies

Economies with oligopolistic markets are prone to inefficient sunspot fluctuations triggered by autonomous changes in firms equilibrium conjectures. A well‐designed taxation‐subsidization scheme can eliminate these fluctuations by coordinating firms in each sector on a single equilibrium, left unaffected. The optimal taxation scheme must select the number of active firms that makes the best trade‐off (in terms of consumer welfare) between the markup and the scale inefficiency distortions. Implementing such stabilization policy leads to significant welfare gains, attributable to an “efficient stabilization effect,” typically ignored in usual computations of the welfare costs of fluctuations.     

Optimal Reserves and Short‐Term Interest Rates in a Model of Bank Runs

A global game framework of bank runs is used to analyse a bank's choice of its reserve level and short‐term interest rate. Higher level of reserves and a lower short‐term interest rate would decrease the probability of bank runs. When the bank's reserve policy is transparent, it will hold excess reserves to discourage withdrawals by patient depositors. This inefficiency of excess reserves increases with the proportion of impatient depositors. When the bank has private information about its reserve level, it will follow a more risky strategy of choosing lower reserves and higher early return than what maximizes depositor welfare and increases the probability of bank runs.     

Optimal Monetary Policy in OLG Models with Long‐Lived Agents: A Note

This note reexamines Crettez, Michel, and Wigniolle ( 2002 ), who studied a two‐period overlapping generations model with cash‐in‐advance constraints and showed that a combination of saving tax and monetary policy involving positive nominal interest rates could achieve the first‐best allocation. The note shows that their result does not hold if agents live for three periods. The implementation of the first best requires the Friedman rule. If agents are long‐lived, saving tax cannot offset a distortion caused by the positive nominal interest rate.     

Optimal Taxation: The Design of Child‐Related Cash and In‐Kind Benefits

Abstract. In this paper, we empirically derive the welfare function that guarantees that the current German tax and transfer system for single women is optimal. In particular, we compare the welfare function conditional on the presence and age of children and assess how recent reforms of in‐kind childcare transfers affect the welfare function. Our analysis is based on a discrete model of optimal taxation. We apply this framework using microsimulation and microeconometric techniques. In general, we find that marginal welfare weights are relatively high for non‐working single women. Further, we show that the reform of in‐kind childcare transfers is only optimal if society increases the marginal welfare weights for the working single women.     

Debt Maturity: Is Long‐Term Debt Optimal?

We model and calibrate the arguments in favor and against short-term and long-term debt. These arguments broadly include: maturity premium , sustainability, and service smoothing. We use a dynamic-equilibrium model with tax distortions and government outlays uncertainty, and model maturity as the fraction of debt that needs to be rolled over every period. In the model, the benefits of defaulting are tempered by higher future interest rates. We then calibrate our artificial economy and solve for the optimal debt maturity for Brazil as an example of a developing country and the US as an example of a mature economy. We obtain that the calibrated costs from defaulting on long-term debt more than offset costs associated with short-term debt. Therefore, short-term debt implies higher welfare levels.     

Optimal Fiscal Policies,Congestion and Over‐entry*

By shedding light on market imperfections and the congestion of public goods, we show that free entry in a market equilibrium will lead to excessive entry relative to the social optimum. Moreover, by specifying a generalized congestion function, it is also shown that different fiscal policies, including labor income tax, capital income tax and government expenditure, play a distinct role in terms of remedying market distortions. Specifically, optimal income taxes decrease with the degree of market imperfections in order to remove the monopoly inefficiency, while they increase with the degree of congestion in order to remedy the adverse externality caused by congestion distortion. Since a higher degree of increasing returns to an expansion in the variety of intermediate goods is found to intensify the congestion effect of government infrastructure expenditure, the optimal rule of government expenditure proposed by Barro (1990) should be modified.     

Optimal Investment and Financial Strategies under Tax‐Rate Uncertainty

Abstract. In this paper, we apply a real‐option model to study the effects of tax‐rate uncertainty on a firm's decision. In doing so, we depart from the relevant literature, which focuses on fully equity‐financed investment projects. By letting a representative firm borrow optimally, we show that debt finance not only encourages investment activities but can also substantially mitigate the effect of tax‐rate uncertainty on investment timing.