Essays on fiscal policy and government debt

This dissertation is composed of three essays aimed at further our understanding of government policy. The first essay explores how a benevolent government would tax capital and labor income, when it has no access to a commitment technology and reputational mechanisms are not operative. Since capital in the current period is supplied inelastically, the government views taxing it as non-distortionary. The incentives to tax capital are so large, that in equilibrium the government may confiscate the capital stock. If both the length of the period is sufficiently long and the provision of the public good sufficiently low, then the time-inconsistency problem is reduced and capital taxes are not confiscatory. The second essay addresses the time inconsistency of optimal real debt policy. The main result is striking: the time series of debt in the economy without commitment is extremely similar to that with commitment. The incentives that naturally arise in the dynamic game between successive governments actually help limit the time-consistency problem, leading to very limited debt accumulation. This incentive mechanism is a result of forward-looking and strategic use of debt and of non-convexities whose fundamental origin is the disagreement between consecutive governments. The third essay proposes that, governments that cannot commit to future policy choices face a trade-off that explains the level of debt. On the one hand, the government would like to increase debt and delay taxation, so as to reduce current distortions. On the other hand, inflating current prices lowers the real value of nominal debt and so there is a motive to reduce it now. This trade-off generates a level of long-run debt that is interior and independent of initial debt, a feature missing in previous theories. The sign and size of long run debt will depend on how the incentives to increase and decrease debt play out against each other. The critical determinant is how easy or difficult it is for households to substitute away from goods being taxed by inflation.