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Ramsey monetary and fiscal policy: the role of consumption taxation

Research output: Working paper

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Abstract

We study Ramsey monetary and fiscal policy in a small scale New Keynesian
model where government spending has intrinsic value, public debt is
state-noncontingent and the fiscal authority is constrained by using
distortive taxation. We show that Ramsey policy is remarkably altered when
consumption taxation is considered as a source of government revenues
alongside or as an alternative to labour income taxes. First, we show that
the optimal steady-state size of the public spending is, ceteris paribus,
greater under consumption taxation than under labour income tax. We further
show that adopting consumption taxation has enormous long run welfare gains
and that these gains are increasing in the level of outstanding public debt.
These welfare gains are not limited to the steady-state, but they are also
present in the dynamic stochastic equilibrium. The reason is that the
dynamic nature of consumption taxation enables the policy-maker to affect
the stochastic discount factor via modifications of the marginal utility of
consumption. This extra wedge impacts on the pricing decisions of firms, and
hence on inflation stabilization, and greatly improves welfare in the
stochastic equilibrium.

Bibliographic note

2013-14