Journal Article

Time-Consistent Public Policy

Paul Klein, Per Krusell and José-Víctor Ríos-Rull

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 75, issue 3, pages 789-808
Published in print July 2008 | ISSN: 0034-6527
Published online July 2008 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2008.00491.x
Time-Consistent Public Policy

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  • National Government Expenditures and Related Policies
  • Mathematical Methods; Programming Methods; Mathematical and Simulation Modelling
  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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In this paper we study how a benevolent government that cannot commit to future policy should trade off the costs and benefits of public expenditure. We characterize and solve for Markov-perfect equilibria of the dynamic game between successive governments. The characterization consists of an inter-temporal first-order condition (a “generalized Euler equation”) for the government, and we use it both to gain insight into the nature of the equilibrium and as a basis for computations. For a calibrated economy, we find that when the only tax base available to the government is capital income—an inelastic source of funds at any point in time—the government still refrains from taxing at confiscatory rates. We also find that when the only tax base is labour income the Markov equilibrium features less public expenditure and lower tax rates than the Ramsey equilibrium.

Keywords: C62; E62; H50

Journal Article.  10015 words.  Illustrated.

Subjects: National Government Expenditures and Related Policies ; Mathematical Methods; Programming Methods; Mathematical and Simulation Modelling ; Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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