Without Commitment, governments concerned about efficient taxation normally face a credibility problem. The taxation of capital illustrates this problem sharply. Governments should promise low future taxes on capital to encourage investment. But once investment has taken place, capital is inelastically supplied. So governments in need of revenue should tax it heavily. Since investors are aware of that, the promise of low future taxes on accumulated capital is not credible. As a result, if governments cannot commit their plans, there is a welfare loss: investment is inefficiently low. (See Kydland and Prescott 1977.) More generally, tax plans which are optimal today are likely to be suboptimal when reconsidered in the future. So, without commitment, they cannot be implemented because they lack credibility. In technical terms, they are time inconsistent.
This paper focuses on a subtle time consistency problem in the taxation of consumption and labor. A government concerned about efficiency should, if possible, tax all final goods at the same rate. In reality, however, the government can only tax market transactions. Endowments which am consumed without being traded, for example, leisure, escape taxation. In this case, the optimal policy is more complex: the government should, for example, tax more heavily the complements of leisure and the complements of any other endowments consumed without being traded. Different endowment vectors imply different goods consumed without being traded, so optimal tax plans depend on the endowment vectors held by the private sector.
In a dynamic economy, the endowments at some point in time include the assets acquired while saving. Therefore, borrowing and lending between the private and the public sectors change the private endowments over time. Since different endowment vectors call for different tax plans, the government has in general an incentive to change the tax rates by surprise after endowment vectors have changed. Consequently, the optimal tax plan today with full commitment will not be optimal tomorrow if replanning is possible: The optimal tax policy is time inconsistent.(1)
Lucas and Stokey (1983) pointed out that the government can use the maturity structure of the public debt to solve this time consistency problem. By carefully restructuring the maturity of the public debt, the government has some control over how the vector of private endowments changes over time. In a closed economy without capital and with fixed amounts of public spending, this control is sufficient to ensure time consistency.
In recent years, the robustness of the Lucas and Stokey result has been seriously challenged: Some contributions to the literature have shown that debt restructuring cannot ensure time consistency under slightly more general and realistic conditions. For example, Rogers (1989) showed that the Lucas and Stokey scheme is unable to ensure time consistency if the government chooses public consumption and taxes simultaneously. In this case, both taxes and public consumption depend on the vector of private endowments, which changes over time. As a result, debt restructuring would have to influence private endowments with two goals: avoid future incentives to deviate from tax plans and avoid future incentives to deviate from public consumption plans. Unfortunately, it can achieve only one goal at a time. Consequently, the Lucas and Stokey result appears to break down in this context.
Likewise, the Lucas and Stokey scheme apparently disappears in an economy with capital,(2) even if this is held exclusively by the government. Similar to taxes and public consumption, the optimal amounts of public investment depend on the vector of private endowments. Again, the maturity structure of the public debt has two goals, but it can achieve only one at a time.
The purpose of this paper is to give new life to the Lucas and Stokey result. It shows that debt restructuring can achieve time consistency of optimal fiscal plans in a closed economy(3) when the government chooses public consumption, public investment, and consumption taxes. …