The Time-Inconsistency Problem of Labor Taxes and Constitutional Constraints

This paper investigates the time-inconsistency problem of labor taxes in an economy with balanced-budget policies and no capital taxes. With full commitment, we show that Ramsey labor taxes change with the cost of distortionary taxation and with the cost of not being able to tax capital. We numerically show that these make labor taxes increasing over time. With limited commitment, we find that this time-inconsistency problem leads to underprovision of public consumption. For our baseline parameter values, we find that imposing carefully chosen bounds on labor taxes as constitutional constraints can be optimal. While our proposed bounds sustain the Ramsey as the best sustainable equilibrium, our lower bounds alone or, in combination with some upper bounds, induce higher public consumption and higher welfare in the worst sustainable equilibrium