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Optimal taxation with restrictions on the governmemnt budget deficit

By Karl Shell and Christian Ghiglino

Abstract

In this paper we investigate the effects of government budget deficit restrictions in a finite horizon model with imperfect consumer credit market. When financial markets are perfect anonymous lump-sum taxes are sufficient to achieve irrelevance of government budget deficit restrictions in the sense that the timing of the taxation is completely indifferent. With imperfect consumer credit markets strong irrelevance does not hold. We consider a weaker form of irrelevance in which the government is able to change its budget deficit in all periods but the magnitude of this change is limited. We show that weak irrelevance holds in the presence of endogenous credit constraints provided there exists a sufficiently large number of anonymous consumption taxes. We use this result to characterize the optimal tax scheme needed to finance the production of a public good. We show that for an open set of economies the inclusion of an anonymous consumption tax in a purely anonymous lump-sum scheme increases social welfarConsumption taxes, deficit irrelevance, optimal taxation

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