New dynamic public finance.

• Author: Golosov, Mikhail
• Position: Research Summaries

Many problems in public finance and macroeconomics, such as the taxation of capital or the provision of Social Security and disability insurance, are dynamic in nature. The individuals who pay taxes or claim benefits are long-lived. The tax and benefit policies in place in one period can affect their behavior in other periods. For example, increasing retirement benefits may affect individuals' behavior and savings in earlier years.

The New Dynamic Public Finance literature extends the traditional literature on optimal income tax and optimal program design, much of which focused on settings in which individuals made decisions in a single period, to focus on such dynamic settings. (1) While the same efficiency-equity tradeoffs that apply in single-period settings also arise in dynamic settings, there are additional tradeoffs between providing insurance and preserving incentives. When individuals live for many periods, they may experience both favorable and unfavorable "shocks" as they age: unexpected increases in their wages, or the early onset of a disability, for example. Public policy can provide insurance against adverse shocks, but it may do so at some cost in incentives. Much of the research in New Dynamic Public Finance is directed at understanding how one can design social insurance or redistribution systems that achieve distributional objectives while ensuring necessary incentives to provide effort or work throughout individuals' lives.

When designing policy in dynamic settings, it is important to take account of the random shocks that confront individuals over time. These may be shocks to earnings capacity, or health status, or financial market returns. In each case, individual taxpayers or program beneficiaries are likely to have more information on their circumstances than the government does. The government cannot easily observe health status or hourly wage rates, and it cannot condition its tax or social insurance rules on them. The policy challenge is to preserve incentives for individual work and saving while still raising the necessary funds for redistribution or government revenue.

Consider a simple example of a dynamic social insurance problem: an able young worker may become disabled later in life. It may be possible to claim to be disabled even if one is able to work. For example, one can pretend to be suffering from back pain which is very difficult to verify. The fundamental challenge in designing a disability insurance system is to provide adequate transfers to truly disabled workers while discouraging fake disability applications. What a worker believes about his future decisions...