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A Ramsey Theory of Financial Distortions

Author

Listed:
  • Marco Bassetto
  • Wei Cui
Abstract
The interest rate on government debt is significantly lower than the rates of return on other assets. From the perspective of standard models of optimal taxation, this empirical fact is puzzling: typically, the government should finance expenditures either through contingent taxes, or by previously-issued state-contingent debt, or by labor taxes, with only minor effects arising from intertemporal distortions on interest rates. We study how this answer changes in an economy with financial frictions, where the government cannot directly redistribute towards the agents in need of liquidity, but has otherwise 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 rate 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 publicly and privately-issued assets.

Suggested Citation

  • Marco Bassetto & Wei Cui, 2020. "A Ramsey Theory of Financial Distortions," Working Papers 775, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmwp:89242
    DOI: 10.21034/wp.775
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    3. Chien, YiLi & Wen, Yi, 2021. "Time-inconsistent optimal quantity of debt," European Economic Review, Elsevier, vol. 140(C).
    4. Chien, YiLi & Wen, Yi, 2022. "The determination of public debt under both aggregate and idiosyncratic uncertainty," Journal of Economic Theory, Elsevier, vol. 203(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. He, Ping & Liu, Zehao & Xie, Chengbo, 2023. "A fiscal theory of money and bank liquidity provision," Journal of Economic Theory, Elsevier, vol. 214(C).

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    More about this item

    Keywords

    Low interest rates; Asset directed search; Capital tax; Financial constraints; Optimal level of government debt;
    All these keywords.

    JEL classification:

    • 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
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity

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