Optimal Taxation with Endogenously Incomplete Debt Markets

Empirical analyses of labour tax and public debt processes provide prima facie evidence for imperfect government insurance. This paper considers a model in which the government's inability to commit to future policies or to truthfully reporting its spending needs renders government debt markets endogenously incomplete. A method for solving for optimal fiscal policy under these constraints is developed. Such policy is found to be intermediate between that implied by the complete insurance (Ramsey) model and a model with exogenously incomplete debt markets. In contrast to optimal Ramsey policy, optimal policy in this model is consistent with a variety of stylised fiscal policy facts such as the high persistence of labour tax rates and debt levels and the positive covariance between government spending and the value of the government debt. Consideration of policy in the neighbourhood of endogenously determined debt limits provides a new perspective on the recent literature on fiscal consolidations.