A Ramsey theory of financial distortions

The interest rate on government debt is significantly lower than the rates of return on other assets. From the perspective of standard models of optimal taxation, this empirical fact is puzzling: typically, the government should finance expenditures either through contingent taxes, or by previously-issued state-contingent debt, or by labor taxes, with only minor effects arising from intertemporal distortions on interest rates. We study how this answer changes in the presence of financial frictions such that the entrepreneurs’ net worth has a direct effect on their ability to invest. In a deterministic environment, a stark result emerges. Provided this is feasible, optimal policy calls for the government to increase its debt, up to the point at which it provides sufficient liquidity to avoid financial constraints. In this case, capital-income taxes are zero in the long run, and the returns on government debt and capital are equalized. However, if the fiscal space is insufficient, a wedge opens between the rate of return on government debt and capital. In this case, optimal long-run tax policy is driven by a trade-off between the desire to mitigate financial frictions by subsidizing capital and the incentive to exploit the quasi-rents accruing to producers of capital by taxing capital instead. This latter incentives magnifies the wedge between rates of return on publicly and privately-issued assets. JEL classification: E22, E44, E62;