Time-consistent institutional design

Abstract

We propose a new normative approach to designing institutional commitments in environments that are subject to a time inconsistency problem, à la Kydland and Prescott (1977). This approach captures the idea that institutions should be chosen in a way that is time consistent: if a commitment is found to be best in some sense today, it should remain best in the same sense tomorrow. This property is not satisfied by the usual Ramsey plan, but it can be achieved by placing appropriate restrictions on the choice set of possible commitments. Using a canonical capital tax problem as a laboratory, we consider the implications for institutional design of restricting choice to sets that exhibit this form of time consistency. We show that any optimal plan within a time-consistent choice set must converge to a steady state that differs from the long-run outcome under Ramsey policy. In particular, this outcome exhibits positive long-run capital taxes. This occurs because a time-consistent policy cannot have both high initial capital taxes and zero long-term rates. A policymaker who discounts the future will always be willing to accept long-run distortions in order to tax the inelastic initial capital stock.