OPTIMAL DYNAMIC PROFIT TAXATION: THE DERIVATION OF FEEDBACK STACKELBERG EQUILIBRIA

In this paper we develop a framework for determining optimal profit taxation for a welfare maximising government. We show that there is a dynamic trade off between public consumption now and in the future. Two possible solutions are derived. The first solution, which is the formal outcome of an open-loop Stackelberg equilibrium of a game between government and firms, is time-inconsistent. The second solution, which corresponds to a feedback Stackelberg equilibrium, is time-consistent, but yields a lower value of steady-state utility. The outcome of the feedback Stackelberg equilibrium depends on the number of firms in this economy. If the number of firms is large, this equilibrium coincides with the open-loop Nash equilibrium. Furthermore, we show the dynamic paths if the economy goes from its feedback to its open-loop steady-state.