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A Ramsey Theory of Financial Distortions

Author

Listed:
  • Marco Bassetto

    (Federal Reserve Bank of Minneapolis)

  • Wei Cui

    (University College London
    Centre for Macroeconomics (CFM))

Abstract
We study optimal taxation in an economy with financial frictions, in which the government cannot directly redistribute towards the agents in need of liquidity but otherwise has access to a complete set of linear tax instruments. We establish a stark result. Provided this is feasible, optimal policy calls for the government to increase its debt, up to the point at which it provides sufficient liquidity to avoid financial constraints. In this case, capital-income taxes are zero in the long run, and the returns on government debt and capital are equalized. However, if the fiscal space is insufficient, a wedge opens between the rates of return on government debt and capital. In this case, optimal long-run tax policy is driven by a trade-off between the desire to mitigate financial frictions by subsidizing capital and the incentive to exploit the quasi-rents accruing to producers of capital by taxing capital instead. This latter incentive magnifies the wedge between rates of return on government debt and capital. It also makes it optimal to distort downward the interest rate on government debt in periods of high government spending.

Suggested Citation

  • Marco Bassetto & Wei Cui, 2021. "A Ramsey Theory of Financial Distortions," Discussion Papers 2107, Centre for Macroeconomics (CFM).
    • Handle: RePEc:cfm:wpaper:2107
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    3. Cao, Qingqing, 2024. "Optimal fiscal and monetary policy with collateral constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 161(C).
    4. Chien, YiLi & Wen, Yi, 2021. "Time-inconsistent optimal quantity of debt," European Economic Review, Elsevier, vol. 140(C).
    5. Ricardo Reis, 2022. "Debt Revenue and the Sustainability of Public Debt," Journal of Economic Perspectives, American Economic Association, vol. 36(4), pages 103-124, Fall.
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    7. Chien, YiLi & Wen, Yi, 2022. "The determination of public debt under both aggregate and idiosyncratic uncertainty," Journal of Economic Theory, Elsevier, vol. 203(C).
    8. Chien, YiLi & Wen, Yi, 2024. "The Ramsey steady-state conundrum in heterogeneous-agent economies," Journal of Economic Theory, Elsevier, vol. 220(C).

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    More about this item

    Keywords

    Financing Constraints; Asset Directed Search; Capital Tax; Low Interest Rates; Optimal Level of Government Debt;
    All these keywords.

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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