Self-fulfilling recessions at the zero lower bound (joint with Matthias Paustian and Tony Yates)

This paper draws attention to a general channel through which self-fulfilling recessions can occur in rational expectations economies that are subject to a zero lower bound on nominal interest rates. The issue arises whenever there is a strong endogenous link between depressed contemporary economic conditions and low future output and inflation. In these circumstances, a current recession can itself generate expectations that future income will be low and the future real interest rate will be high. This in turn can ensure that low current output is an equilibrium outcome. We present the mechanism heuristically 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 occurs only in regions of the parameter space where persistence is strong enough. We take two ‘off the shelf’ DSGE models to estimate the likelihood attached to the multiplicity region. We find that 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.

Time-consistent institutional design (joint with Martin Ellison)

Recent Slides

Many policy environments in macroeconomics are characterised by a 'Kydland and Prescott' time inconsistency problem: the best future policy to promise today will no longer be optimal once the future comes around. This results in a dynamic tension between the interests of policymakers at different points in time - a tension which is generally resolved in the literature either by assuming that the first policymaker has the unmatched privilege of being able to design and implement a full Ramsey plan, or by treating the policy process as a Stackelberg leadership game. In this paper we argue that neither of these approaches is particularly appealing from a normative perspective, and propose a novel choice procedure based on the recursive application of a Pareto criterion, taken with respect to the preferences of policymakers at different points in time. The dynamic plans that follow from this approach are appealing as a basis for designing practical policy rules. Importantly, they do not coincide with the steady-state outcomes of Ramsey policy. In a version of the classic Judd (1985) capital tax problem, one of three examples that we use to illustrate our approach, there is a mild positive capital tax in steady state.

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.