Fiscal Policy with Limited-Time Commitment

Abstract

We consider models where the Ramsey-optimal fiscal policy under Full Commitment (FC) is time-inconsistent and define a new notion of optimal policy, Limited-Time Commitment (LTC). Successive one-period lived governments can commit to future plans over a finite horizon. We provide a sufficient condition on the mapping from finite policy sequences to allocations, such that LTC and FC lead to the same outcomes. We then show that this condition is verified in several existing models, allowing FC Ramsey plans to be supported with a finite commitment horizon (often a single period). We relate the required degree of commitment to the economic environment: in economies without capital, the minimum degree of commitment required is given by the government debt maturity; in economies with capital and government balanced-budget constraints, the required commitment is given by the horizon over which the budget has to be balanced. Finally, we solve numerically for the LTC equilibrium of an economy where the equivalence result fails and show that a single year of commitment to capital taxes provides substantial welfare gains relative to the No-Commitment time-consistent policy.

Capital and Labor Taxes with Costly State Contingency

“…A model of adjustment costs would not have this desirable property. In a similar fashion, the assumption of (noncontingent) Limited-Time Commitment that Clymo and Lanteri (2020) consider corresponds to the special case γ k = γ l = ∞.…”

“…However, because in our model the costs of state contingency depend on the realizations of the tax rates, to relate allocations to tax rates in the objective of the government, we add the intratemporal optimality condition (4) and the government budget constraint (8), combined with equilibrium factor prices ( 6) and ( 7). As Clymo and Lanteri (2020) show, these equations uniquely pin down the level of labor and consumption, given state variables (k t−1 , g t ) and a choice of contemporaneous tax rates (τ k t , τ l t ). For any level of capital and exogenous realization of government spending, a choice of current tax rates must induce this allocation, in order to respect the government budget constraint and satisfy private sector optimality.…”

“…Thus, announcements provide an anchor for future tax rates, but do not amount to actual commitments, because the future government may choose state-contingent taxes subject to the costs of state contingency. This institutional framework generalizes the Limited-Time Commitment model of Clymo and Lanteri (2020), in which future announcements are instead commitments and must coincide with ex-post realized policy. 9 Here, we allow governments to endogenously choose the degree to which they desire to stick to their predecessors' announcements.…”

“…Each government inherits its predecessor's announced plan, but may reoptimize in a statecontingent fashion subject to a cost. We refer to this setup as Limited-Time Commitment, because it builds on and generalizes the framework of Clymo and Lanteri (2020). In this case, governments use fiscal announcements strategically not only to affect private sector allocations, but also, critically, to constrain future policy decisions, partly overcoming time inconsistency.…”

A Toolkit for Computing Constrained Optimal Policy Projections (COPPs)

“…Our limited-time commitment approach is closely related withClymo and Lanteri (2020). Similar in spirit is the loose commitment approach of Debortoli and Nunes (2010) that assumes a policymaker can commit but with some exogenous probability succumbs to the temptation to re-optimize.ECB Working Paper Series No 2555 / May 2021…”