The theory of optimal taxation focuses on the combination of distortionary taxation and seigniorage required to finance a given commitment to government spending. In Discussion Paper No. 768, Research Fellow Paul Levine and Joseph Pearlman adopt a dynamic framework in which the assumption of a rational private sector implies two possible equilibria: for a government that can make binding policy commitments, a time-inconsistent policy is optimal, but the time-consistent equilibrium is optimal for a government that lacks reputation. They consider a myopic government with a far higher discount rate than the public, facing two solvency constraints. `Weak solvency' permits the debt/GDP ratio to grow no faster than the growth-adjusted real interest rate, while `strong solvency' requires a stable debt/GDP ratio.

For a simple, non-monetary model and the Obstfeld dynamic seigniorage model, they establish a necessary and sufficient condition based on the social discount and real interest rates for an optimal taxation or seigniorage policy to exist with weak solvency. For a wide class of models, however, optimization based solely on aggregate consumption and inflation, myopia and weak solvency are incompatible. This must cast doubt on either the standard model or the choice of government objectives, but including a debt/GDP ratio target in the welfare function (even with a small weight) resolves this problem under either solvency constraint.

Levine and Pearlman also examine a YaariBlanchard model which includes both capital accumulation and non-Ricardian features. In this more complex model, simulations indicate that a much higher discount rate is possible before optimization and solvency become incompatible; its qualitative properties are otherwise similar.

Optimal Tax Policy, Government Myopia and Insolvency
Paul Levine and Joseph Pearlman

Discussion Paper No. 768, February 1993 (IM)