Time-consistently undominated policy (joint with Martin Ellison)
Abstract: This paper proposes and characterises a new normative solution concept for Kydland and Prescott problems, allowing for a commitment device. A policy choice is dominated if either (a) an alternative exists that is superior to it in a time-consistent subdomain of the constraint set, or (b) an alternative exists that Pareto-dominates it over time. Policies may be time-consistently undominated where time-consistent optimality is not possible. We derive necessary and sucient conditions for this to be true, and show that these are equivalent to a straightforward but signicant change to the rst-order conditions that apply under Ramsey policy. Time-consistently undominated policies are an order of magnitude simpler than Ramsey choice, whilst retaining normative appeal. This is illustrated across a range of examples.
Self-fulfilling recessions at the zero lower bound (joint with Matthias Paustian and Tony Yates)
Abstract: We draw attention to an overlooked channel through which purely self-fulfilling recessions can occur in monetary economies subject to a zero bound on nominal interest rates. In many environments depressed contemporary economic conditions imply lower expectations of future output and inflation. We show that if this expectations channel is sufficiently strong, a current recession followed by gradual convergence back to steady state may be a self-supporting equilibrium outcome. We present the logic behind this result heuristically in partial equilibrium, and in a nonlinear New Keynesian model, and explain why it is different from the well-known multiplicity highlighted by Benhabib, Schmitt-Grohé and Uribe (2001). Generically, multiplicity of the kind we identify occurs only in certain regions of the parameter space. We study two well-known estimated DSGE models to investigate how likely it is that multiplicity could arise. We find that purely self-fulfilling recessions are possible at 99.8 per cent of parameter draws from the posterior distribution in the Smets and Wouters (2007) model, and at over two-thirds of draws in the Iacoviello and Neri (2010) model. Alternative monetary policy strategies can play an important role in reducing these probabilities.
Efficiency, equity, and optimal income taxation
Social insurance schemes must resolve a trade-off between competing efficiency and equity considerations. Yet there are few direct statements of this trade-off that could be used for practical policymaking. To this end, this paper re-assesses optimal redistributive policy in the celebrated Mirrlees (1971) model. It provides an intuitive characterisation of the optimum, based on two newly-defined cost terms that are directly interpretable as the marginal costs of inefficiency and of inequality respectively. We show how these cost terms can be used both to describe optimal policy under a generalised utilitarian social welfare criterion, and also to state the weaker requirements of Pareto efficiency in the model. An empirical exercise then applies our characterisation to ask whether existing tax systems give too much weight to efficiency or to equity concerns, relative to a benchmark constrained optimum. Based on earnings, consumption and tax data from 2008, our results suggest that social insurance policy in the US is systematically giving insufficient weight to equality considerations when conventional assumptions are made about individual and social preference structures. This is particularly true in relation to the treatment of low-to-middle-income earners.
General efficiency-equity trade-offs in dynamic Mirrleesian tax problems
This paper develops a new approach to analysing optimal income tax decisions in 'dynamic Mirrleesian' models (in which heterogeneous agents have unobservable earnings potentials that evolve stochastically over time). In particular, it shows how to derive a set of optimality conditions that are far simpler and more general than those that have been studied in the literature to date. These conditions can easily be interpreted in terms of an 'efficiency-equity' trade-off of the type traditionally emphasised in the public economics literature.
My results have a number of novel implications relating to optimal tax distortions in economies of this type. For instance, when earnings shocks are persistent I show that it is desirable for the policymaker to tolerate growing productive inefficiency through time relative to a particular measure of cross-sectional inequality. I am also able to generalise the result that it is optimal to deter savings when labour supply and consumption are separable in the utility function to the case in which they are substitutes, but I show that the generalisation does not apply in the case of complements.