© Sanjay K. Chugh
Optimal Fiscal Policy
We now proceed to study optimal fiscal policy.
We should make clear at the outset what
we mean by this.
In general, “fiscal policy” entails the government choosing its spending
(i.e., how much to spend on building roads, bridges, wars, etc.) and some combination of
taxes that finance that spending.
The convention in most macroeconomic analysis of
fiscal policy is to
take as given
government spending; we will adopt this convention.
That is, we will not think about
the government is choosing a particular level of
spending, but rather just focus on, given some amount of spending, the optimal way for
the government to pay for that spending.
The reasons why the government chooses a
particular level of spending are surely interesting to study, but probably take us too far
afield into the realms of political economy, the provision of public goods, and political
Thus, we confine ourselves here to the narrower topic of just the
of a pre-set amount of government spending.
Even given this limitation, we still have a lot to think about.
One issue we need to take a
stand on right away is what
of tax instruments we will assume the government has
available to use in order to pay for its spending.
For example, the government may be
able to levy a labor income tax; it may be able to levy consumption taxes (sales taxes);
and it may be able to levy taxes on savings or interest income.
As our starting point, we
will consider optimal fiscal policy in the context of the one-period consumption-leisure
model; as such, a tax on savings or interest income has no meaning because, recall, the
basic consumption-leisure model abstracts from time altogether and hence abstracts from
savings and interest income.
principles of optimal fiscal policy, see to what extent the lessons learned extend to a
multi-period economy and what role, if any, taxes on savings or interest income play in
the optimal conduct of fiscal policy.
Given our starting point of the one-period consumption-leisure model, it seems we still
must decide whether we want to allow our government to have access to a labor income
tax, a consumption tax, or both. It turns out that in our simple model, it does not matter
which one we allow it to have, and in fact if allow it to have both, we run into problems
We are already being a bit loose about the elements of fiscal policy:
another component is how much
debt to issue.
In any given period of time, a government can pay for its spending by either collecting taxes
or issuing debt (bonds) – i.e., by borrowing.
For our discussion of fiscal policy, we will assume that a
government must always run a balanced budget; indeed this assumption can be justified given our
restriction (discussed immediately below) here to a one-period setting.
Debt only becomes interesting to
think about in an explicitly dynamic (multi-period) setting.
When we turn to the consideration of