Optimal Fiscal Policy with Endogenous Time Preference

• Published date: 01 December 2015
• Author: SARANTIS KALYVITIS,EVANGELOS V. DIOIKITOPOULOS
• Date: 01 December 2015
• DOI: http://doi.org/10.1111/jpet.12110

OPTIMAL FISCAL POLICY WITH ENDOGENOUS TIME

PREFERENCE

EVANGELOS V. DIOIKITOPOULOS

Brunel University London

SARANTIS KALYVITIS

Athens University of Economics and Business

Abstract

This paper studies the role of Ramsey taxation under the

assumption that the individual rate of time preference is

determined by the publicly provided social level of edu-

cation. We show how intertemporal complementarities of

aggregate human capital can generate multiple equilibria

and we examine the role of endogenous fiscal policies in

equilibrium selection. Our analysis implies a lower optimal

government size due to the effect of human capital on time

preference.

1. Introduction

In his seminal work, Ramsey (1927) took into account agents’ equilibrium

reactions in forming optimal fiscal policy. This second-best approach has

Evangelos Dioikitopoulos, Department of Economics and Finance, Brunel University

London, Uxbridge, UB8 3PH, UK (evangelos.dioikitopoulos@brunel.ac.uk). Sarantis

Kalyvitis, Department of International and European Economic Studies, Athens University

of Economics and Business, Patision Str 76, Athens 10434, Greece (skalyvitis@aueb.gr).

We have benefited from comments and suggestions by C. Arkolakis, C. Azariadis, G.

Economides, T. Palivos, E. Pappa, A. Philippopoulos, E. Vella, A. Xepapadeas, and sem-

inar participants at the 2009 Annual Meeting of the European Public Choice Society,

PGPPE 2009 Workshop in Graz, RCEA 2009 Workshop of Recent Developments in Eco-

nomic Growth, Seventh Conference on Research on Economic Theory and Economet-

rics, Universitat Autonoma de Barcelona, University of Crete, University of Cyprus, and

Athens University of Economics and Business. Part of the project was conducted when

Dioikitopoulos was visiting Brown University, whose hospitalityis gratefully acknowledged.

Received August 1, 2013; Accepted September 5, 2013.

This is an open access article under the terms of the Creative Commons Attribution-

NonCommercial-NoDerivs License, which permits use and distribution in any medium,

provided the original work is properly cited, the use is non-commercial and no modifica-

tions or adaptations are made.

C2014 The Authors. Journal of Public Economic Theory Published by Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (6), 2015, pp. 848–873.

848

Optimal Fiscal Policy 849

been extensively revitalized in capital accumulation models of unique equi-

librium and exogenous time preference (Lucas and Stokey 1983, Judd 1985,

Chamley 1986, Lucas 1990, Jones, Manuelli, and Rossi 1993). The present

paper introduces the role of Ramsey taxation in selecting a second-best

allocation under the presence of multiple competitive equilibria generated

by intertemporal complementarities of human capital in the formation of

time preference. Our theoretical framework provides a new role for the

conduct of optimal fiscal policy under indeterminacies and poverty traps

(Ben-Gad 2003, Park and Philippopoulos 2004, Park 2009, Ag´

enor 2010).

We also analyze some interesting policy implications as the standard produc-

tive effects of optimal taxation are altered (Barro 1990, Futagami, Morita,

and Shibata 1993, Glomm and Ravikumar 1997, Turnovsky 2000).

The starting point of our analysis is an endogenous growth model in

which the rate of time preference depends positively on the economy-wide

consumption level and negatively on the publicly provided aggregate human

capital stock, which are exogenous to the agents’ decisions, and we introduce

in this setup optimal fiscal policy in the form of Ramsey taxation.1We fir st

examine the properties of the intertemporal competitive equilibrium and

we show that there can be one or two balanced growth paths (BGPs). The

central mechanism that drives these results arises from two counterbalancing

channels. First, a rise in human capital financed by an increase in the tax

rate lowers the rate of time preference, causing savings to increase and as

a result the economy can attain higher growth. This, in turn, increases the

tax base, raises public expenditures on education, and hence fuels further

growth. On the other hand, the rise in taxation decreases private savings,

which increases the rate of time preference in the economy due to the rise

in aggregate consumption and hence lowers growth. A lower growth rate, in

turn, lowers the tax base that finances aggregate human capital formation

leading to even higher time discounting. We show that these externalities

are crucial for the steady state and the dynamics of the economy, and we

establish necessary and sufficient conditions for the existence of a unique or

multiple (two) BGPs.

The selection of a second-best allocation is then addressed by endoge-

nizing fiscal policy in the context of Ramsey taxation. We demonstrate, first,

how the government’s objective can determine the available set of policy

instruments (Atkinson and Stiglitz 1980) and, second, its importance in

the implementation of additional restrictions on private decisions that can

lead the decentralized economy to a unique BGP. Typically, global and

local indeterminacy at the competitive equilibrium implies that the ra-

tional expectations equilibria involve random variables, which are unre-

lated to the economy’s fundamentals and are driven by individual beliefs.

However, in a second-best (Stackelberg) environment, the government can

1See Section 2 for a detailed review on these assumptions.