Four Solutions First-Best Allocation maximize g households welfare subject to resource constraint o Cheating (Time-Inconsistent) Solution: government would like to deviate from her previous policy at the second period when k has been accumulated, because she always has incentive to reduce distortion by only taxing k &s Precommitment Solution: Open Loop Solution in the Stackelburghk Game Time Consistent Solution: Subgame, Perfect Equilibrium Welfare Comparison >2>3>
Four Solutions ❖ First-Best Allocation: maximize household’s welfare subject to resource constraint. ❖ Cheating (Time-Inconsistent) Solution: government would like to deviate from her previous policy at the second period when k has been accumulated, because she always has incentive to reduce distortion by only taxing k. ❖ Precommitment Solution: OpenLoop Solution in the Stackelburgh Game. ❖ Time Consistent Solution: Subgame Perfect Equilibrium. ❖ Welfare Comparison: 1 > 2 > 3 > 4
What causes Time Inconsistency insufficient Policy Instruments: One can easily find that there is no time inconsistency in the second model if the government is allowed to levy lump-sum tax (or proportional income tax? ). However, this explanation seems not satisfactory since it can't explain why time inconsistency rises in the first model Persson and Tabellini(1994)argue that Ti is due to the sequential nature of policy-making. This, again, is only partially correct Now most economists believe that TI 3 is induced by the heterogeneity of i interests, or equivalently some externality. This is first pointed out by Chari, Kehoe and Prescott(1989). Be
What Causes Time Inconsistency • Insufficient Policy Instruments: One can easily find that there is no time inconsistency in the second model if the government is allowed to levy lump-sum tax (or proportional income tax?). However, this explanation seems not satisfactory since it can’t explain why time inconsistency rises in the first model. • Persson and Tabellini (1994) argue that TI is due to the sequential nature of policy-making. This, again, is only partially correct. • Now most economists believe that TI is induced by the heterogeneity of interests, or equivalently, some externality. This is first pointed out by Chari, Kehoe and Prescott (1989)