Time-Consistent Public Policy

In this paper we study how a benevolent government that cannot commit to future policy should trade off the costs and benefits of public expenditure. We characterize and solve for Markov-perfect equilibria of the dynamic game between successive governments. The characterization consists of an inter-temporal first-order condition (a “generalized Euler equation”) for the government, and we use it both to gain insight into the nature of the equilibrium and as a basis for computations. For a calibrated economy, we find that when the only tax base available to the government is capital income—an inelastic source of funds at any point in time—the government still refrains from taxing at confiscatory rates. We also find that when the only tax base is labour income the Markov equilibrium features less public expenditure and lower tax rates than the Ramsey equilibrium.