The Incidence of Deficit Finance with Imperfect Capital Markets

Abstract

The purpose of this paper is to examine the possible differential welfare implications of deficit finance using a portfolio allocation model. To analyze the incidence of changing the time path of taxation in an economy with heterogeneous agents, I develop a two‐period, general equilibrium extension of work done previously to analyze the effects of taxation on risk‐taking at the individual level. Constraints on short sales of assets are introduced, and fiscal policy, changing the timing of taxation, will indirectly determine which of these constraints bind as well as alter relative tax burdens. Changes in the timing of a flat‐rate tax will also alter equilibrium asset returns, and because preferences are such that agents differ in their tolerance of risk, a Pareto frontier can be derived over a range of different levels of deficit finance.