Fiscal insurance and debt management in OECD economies

Assuming the role of debt management is to provide hedging against fiscal shocks we consider three questions: i) what indicators can be used to assess the performance of debt management? ii) how well have historical debt management policies performed? and iii) how is that performance affected by variations in debt issuance? We consider these questions using OECD data on the market value of government debt between 1970 and 2000. Motivated by both the optimal taxation literature and broad considerations of debt stability we propose a range of performance indicators for debt management. We evaluate these using Monte Carlo analysis and find that those based on the relative persistence of debt perform best. Calculating these measures for OECD data provides only limited evidence that debt management has helped insulate policy against unexpected fiscal shocks. We also find that the degree of fiscal insurance achieved is not well connected to cross country variations in debt issuance patterns. Given the limited volatility observed in the yield curve the relatively small dispersion of debt management practices across countries makes little difference to the realised degree of fiscal insurance.

Stock market volatility and learning

Introducing bounded rationality in a standard consumption-based asset pricing model with time separable preferences strongly improves empirical performance. Learning causes momentum and mean reversion of returns and thereby excess volatility, persistence of price-dividend ratios, long-horizon return predictability and a risk premium, as in the habit model of Campbell and Cochrane (1999), but for lower risk aversion. This is obtained, even though our learning scheme introduces just one free parameter and we only consider learning schemes that imply small deviations from full rationality. The findings are robust to the learning rule used and other model features. What is key is that agents forecast future stock prices using past information on prices.

Multinational Firms’ Heterogeneity in Tax Responsiveness: the Role of Transfer Pricing

In this paper we show that the ability of multinational firms to manipulate transfer prices affects the tax sensitivity of foreign direct investment (FDI). We offer a model of international capital allocation where firms are heterogeneous in their ability to manipulate transfer prices. Perhaps paradoxically, we show that the ability to shift profits can make parent companies' investment more sensitive to host-country tax rates, as long as investors expect fisscal authorities to use price and profit detection methods. We then offer a comprehensive empirical study to test our predictions in the case of Japanese FDI. We exploit the finding that the unobservable ability to manipulate transfer prices is correlated with whole ownership of a±liates and R&D expenditure. Based on country, parent firm and sector characteristics, we estimate an investment equation on a sample of 3614 Japanese affiliates in 49 emerging countries. We obtain a greater semi-elasticity of investment to the statutory tax rate in a±liates that are wholly-owned and that have R&D intensive parents. We interpret these results as indirect evidence that abusive transfer pricing is one of the determinants of FDI activity.

Do political incentives matter for tax policies? Ideology, opportunism and the tax structure

This paper investigates the importance of political ideology and opportunism in the choice of the tax structure. In particular, we examine the effects of cabinet ideology and elections on the distribution of the tax burden across factors of production and consumption for 21 OECD countries over the period 1970-2000 by employing four alternative cabinet ideology measures and by using the methodology of effective tax rates. There is evidence of both opportunistic and partisan effects on tax policies. More precisely, we find that left-wing governments rely more on capital relative to labor income taxation and that they tend to increase consumption taxes. Moreover, we find that income tax rates (but not consumption taxes) tend to be reduced in preelectoral periods and that capital effective tax rates (defined broadly to include taxes on selfemployed income) are reduced by more than effective labor tax rates.

On Public Inefficiencies in a Mixed Duopoly

The aim of this paper is to investigate the welfare effect of a change in the public firms objective function in oligopoly when the government takes into account the distortionary effect of rising funds by taxation (shadow cost of public funds). We analyze the impact of a shift from welfare- to profit-maximizing behaviour of the public firm on the timing of competition by endogenizing the determination of simultaneous (Nash-Cournot) versus sequential (Stackelberg) games using the game with observable delay proposed by Hamilton and Slutsky (1990). Differently from previous work that assumed the timing of competition, we show that, absent efficiency gains, instructing the public firm to play as a private one never increases welfare. Moreover, even when large efficiency gains result from the shift in public firm's objective, an inefficient public firm that maximizes welfare may be preferred.

Does Ricardian Equivalence Hold When Expectations are not Rational?

This paper considers the Ricardian Equivalence proposition when expectations are not rational and are instead formed using adaptive learning rules. We show that Ricardian Equivalence continues to hold provided suitable additional conditions on learning dynamics are satisfied. However, new cases of failure can also emerge under learning. In particular, for Ricardian Equivalence to obtain, agents’ expectations must not depend on government’s financial variables under deficit financing.

The Distributional Consequences of Supply-Side Reforms in General Equilibrium

This paper addresses the issue on whether tax reforms consisten with lower public debt-to-GDP in the long-run can lead to a more efficient and equitable economy. To this end we solve a heterogeneous agent model comprised of a government, a representative capitalist and representative skilled and unskilled workers, under both rational expectations and adaptive learning. Our main ndings are that (i) reductions in capital taxation, while bene cial at the aggregate level, lead to increased inequality mainly due to the substitutability of un- skilled labour and capital; (ii) a fall in taxation for skilled labour is Pareto improving, which is largely explained by its complementarity with the other factor inputs; (iii) all agents would prefer increasing the tax rate on capital to increasing the tax rate on skilled and un- skilled labour since it leads to relatively lower welfare losses; and (iv) heterogeneity in initial beliefs under adaptive learning quantitatively matters for welfare.

Transaction Costs and Institutions

This paper proposes a simple framework for understanding endogenous transaction costs - their composition, size and implications. In a model of diversification against risk, we distinguish between investments in institutions that facilitate exchange and the costs of conducting exchange itself. Institutional quality and market size are determined by the decisions of risk averse agents and conditions are discussed under which the efficient allocation may be decentralized. We highlight a number of differences with models where transaction costs are exogenous, including the implications for taxation and measurement issues.

Time-consistent fiscal policy under heterogeneity: Conflicting or common interests?

This paper studies the aggregate and distributional implications of Markov-perfect tax-spending policy in a neoclassical growth model with capitalists and workers. Focusing on the long run, our main fi ndings are: (i) it is optimal for a benevolent government, which cares equally about its citizens, to tax capital heavily and to subsidise labour; (ii) a Pareto improving means to reduce ine¢ ciently high capital taxation under discretion is for the government to place greater weight on the welfare of capitalists; (iii) capitalists and workers preferences, regarding the optimal amount of "capitalist bias", are not aligned implying a conflict of interests.

Fiscal Policy and Learning

Using the standard real business cycle model with lump-sum taxes, we analyze the impact of fiscal policy when agents form expectations using adaptive learning rather than rational expectations (RE). The output multipliers for government purchases are significantly higher under learning, and fall within empirical bounds reported in the literature (in sharp contrast to the implausibly low values under RE). Effectiveness of fiscal policy is demonstrated during times of economic stress like the recent Great Recession. Finally it is shown how learning can lead to dynamics empirically documented during episodes of 'fiscal consolidations.'

Self-Fulfilling Price Cycles

This paper presents a model of a self-fulfilling price cycle in an asset market. Price oscillates deterministically even though the underlying environment is stationary. The mechanism that we uncover is driven by endogenous variation in the investment horizons of the different market participants, informed and uninformed. On even days, the price is high; on odd days it is low. On even days, informed traders are willing to jettison their good assets, knowing that they can buy them back the next day, when the price is low. The anticipated drop in price more than offsets any potential loss in dividend. Because of these asset sales, the informed build up their cash holdings. Understanding that the market is flooded with good assets, the uninformed traders are willing to pay a high price. But their investment horizon is longer than that of the informed traders: their intention is to hold the assets they purchase, not to resell. On odd days, the price is low because the uninformed recognise that the informed are using their cash holdings to cherry-pick good assets from the market. Now the uninformed, like the informed, are investing short-term. Rather than buy-and-hold as they do with assets purchased on even days, on odd days the uninformed are buying to sell. Notice that, at the root of the model, there lies a credit constraint. Although the informed are flush with cash on odd days, they are not deep pockets. On each cherry that they pick out of the market, they earn a high return: buying cheap, selling dear. However they don't have enough cash to strip the market of cherries and thereby bid the price up.

The Optimal Distribution of the Tax Burden over the Business Cycle

This paper analyses optimal income taxes over the business cycle under a balanced-budget restriction, for low, middle and high income households. A model incorporating capital-skill complementarity in production and differential access to capital and labour markets is developed to capture the cyclical characteristics of the US economy, as well as the empirical observations on wage (skill premium) and wealth inequality. We .nd that the tax rate for high income agents is optimally the least volatile and the tax rate for low income agents the least countercyclical. In contrast, the path of optimal taxes for the middle income group is found to be very volatile and counter-cyclical. We further find that the optimal response to output-enhancing capital equipment technology and spending cuts is to increase the progressivity of income taxes. Finally, in response to positive TFP shocks, taxation becomes more progressive after about two years.

Comparative Statics of Asset Prices: the effect of other assets' risk

Currently, financial economics is unable to predict changes in asset prices with respect to changes in the underlying risk factors, even when an asset's dividend is independent of a given factor. This paper takes steps towards addressing this issue by highlighting a crucial component of wealth effects on asset prices hitherto ignored by the literature. Changes in wealth do not only alter an agents risk aversion, but also her perceived 'riskiness' of a security. The latter enhances significantly the extent to which market- clearing leads to endogenously-generated correlation across asset prices, over and above that induced by correlation between payoffs, giving the appearance of 'contagion.'

Government information transparency

This paper studies a model of announcements by a privately informed government about the future state of the economic activity in an economy subject to recurrent shocks and with distortions due to income taxation. Although transparent communication would ex ante be desirable, we find that even a benevolent government may ex-post be non-informative, in an attempt to countervail the tax distortion with a "second best" compensating distortion in information. This result provides a rationale for independent national statistical offices, committed to truthful communication. We also find that whether inequality in income distribution favors or harms government transparency depends on labor supply elasticity.

Computing Markov-Perfect Optimal Policies in Business-Cycle Models

Time-inconsistency is an essential feature of many policy problems (Kydland and Prescott, 1977). This paper presents and compares three methods for computing Markov-perfect optimal policies in stochastic nonlinear business cycle models. The methods considered include value function iteration, generalized Euler-equations, and parameterized shadow prices. In the context of a business cycle model in which a scal authority chooses government spending and income taxation optimally, while lacking the ability to commit, we show that the solutions obtained using value function iteration and generalized Euler equations are somewhat more accurate than that obtained using parameterized shadow prices. Among these three methods, we show that value function iteration can be applied easily, even to environments that include a risk-sensitive scal authority and/or inequality constraints on government spending. We show that the risk-sensitive scal authority lowers government spending and income-taxation, reducing the disincentive households face to accumulate wealth.