Essays on Time-Consistent Fiscal Policy

Abstract

This thesis consists of an analysis of different aspects of optimal fiscal policy in dynamic economies, with a special emphasis on the consequences of dropping the assumption of full commitment to future policies: the Third Best environment. As is now well known in the dynamic optimal taxation literature - namely after the seminal contributions by Kydland and Prescott (1977) and Fisher (1980) - the fact that governments choose their fiscal policy sequentially means that they cannot credibly make promises on future taxes that fall on investments made today. When the future arrives, previous choices are bygones and namely the previous investment decisions will have been translated into inelastically supplied factors of production [such as physical and human capital]. It will then be optimal to revise past promises and tax heavily such inputs so as to lower the remaining distortions. As such, each government should set its policy as a best response to the expected, time-consistent, future policy rules. This generally represents also deviating from the second best solution for the first period. The aim of my dissertation is to provide new insights on how should benevolent governments optimally set their fiscal plan in scenarios where policy is chosen sequentially [as it is done in real economies] and to contrast the obtained results both to what we observe in developed economies and to the Second Best. Furthermore, special emphasis will be put on the design of the fiscal constitutions and its role in alleviating the burden of policy discretion over social welfare. For that, I will focus on two particular examples of the time-inconsistency problem in intertemporal policy making, hoping that the lessons derived therefrom can be extended easily to qualitatively similar problems.