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Heterogeneous Beliefs and Optimal Taxation

(Job market paper - joint with Anderson Schneider) DOWNLOAD

(Last update: December 31, 2008)

Abstract

Although time consistency problems play an important role in public policy, game theoretical models in macroeconomics seem to indicate the opposite. Due to the complexity of this kind of models, it is commonly assumed that the information is complete and perfect. In turn, this assumption becomes the key element that allows agents to coordinate perfectly to punish the government if it deviates. As a result, a wide range of feasible payoffs can be sustained as equilibrium, including the best payoff under commitment. Since this approach is widely used for normative purposes a natural question emerges: are the above results robust to small variations in information? This paper analyzes an investment taxation problem in an economy with incomplete information. Specifically, we study an environment with the following main characteristics: 1) the aggregate productivity (fundamental) is stochastic, 2) only the government observes it and; 3) every agent privately receives a noisy signal about the fundamental. The first characteristic implies that the best policy (tax on investment) with commitment is state contingent. The second and third characteristics make the information incomplete. In particular, agents have different information sets, and therefore different beliefs, about the true state of the economy. As a result, independently of the accuracy of the signal, incomplete information reduces the set of equilibrium payoffs. First, we show that any policy that depends solely on the fundamental cannot be an equilibrium. Second, the best equilibrium policy is independent of the fundamental. Finally, for any discount factor strictly smaller than one and for any size of the noise, the best equilibrium is inefficient.

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"Heterogeneous Labor Skills, The Median Voter and Labor Taxes".

Working paper. November 2008. (with Anderson Schneider) DOWNLOAD

(Last update: November 19, 2008)

Abstract

In this paper we explore the relationship between changes in labor income inequality and movements in labor taxes over the last decades in the US. In order to do so, we model this relation through a political economy channel by developing a median voter result over sequence of taxes. We consider an infinite horizon economy in which agents are heterogeneous with respect to both initial wealth and labor skills. We study indirect preferences over redistributive fiscal policies - sequences of affine taxes on labor and capital income - that can be supported as a competitive equilibrium. The paper assumes balanced growth preferences and full commitment. The first result is the following: if initial capital holdings are an affine function of skills, then the best fiscal policy for the agent with the median labor skill is preferred to any other policy by at least half of the individuals in the economy. The second result provides the characterization of the most preferred tax sequence by the median agent: marginal taxes on labor depend directly on the absolute value of the distance between the median and the mean value of the skill distribution. We extend the above results to an economy in which the distribution of skills evolves stochastically over time. A temporary increase in inequality could imply either higher or lower labor taxes, depending on the sign of the correlation between inequality and aggregate labor. The calibrated model does a good job on fitting both the increasing trend and the levels of labor taxes in the last decades, and also on matching some short run co-movements. Regarding capital taxation, the bang-bang result holds as in Bassetto and Benhabib (2006). We also generalize the median voter theorem when there is no commitment by adopting the same equilibrium definition as in Bernheim and Slavov (2008).

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Sequential Voting and Time-Consistent Redistribution

Working paper. December 2008. (with Anderson Schneider) DOWNLOAD

(Last update: December 31, 2008)

Abstract

This paper analyzes the role of reputation in influencing political outcomes about fiscal policy. We consider a class of dynamic economies populated by agents that are heterogeneous with respect to initial wealth and vote sequentially over possible fiscal policies. This fiscal policy is restricted to redistributive linear taxes on accumulated wealth and labor income. In each period society decides the current fiscal policy according to a variation of the majority voting concept in Bernheim and Slavov (2008). The basic feature of this equilibrium concept is that current choices of both taxes and individual decisions imply different continuation policies. The first result is the existence of a Dynamic Condorcet Winner which coincides with the preferences of the median voter, the agent holding the median wealth at time zero. When agents have balanced growth preferences one can replace the majority voting criterion by the following condition about the equilibrium candidate: after any history of taxes, the median voter should prefer the outcome path generated by the candidate equilibrium to any other possible path, holding individual’s decisions fixed. The second result is a characterization of equilibrium outcomes when preferences are logarithm, production function is Cobb-Douglas and there is full depreciation of capital. The most preferred competitive equilibrium for the median type with commitment can be sustained as an equilibrium outcome for high enough discounting.

Other Research

“Intermediated Quantities and Returns”.

Federal Reserve Bank of Minneapolis Working paper 655. September 2007

(with Rajnish Mehra and Edward Prescott) DOWNLOAD

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"Labor Market Distortions, Employment, and Growth: The Recent Chilean Experience".

General Equilibrium Models of the Chilean Economy, R. Chumacero and K. Schmidt-Hebbel, eds.,