Fiscal Policy with Limited-Time Commitment

We propose a theory of optimal fiscal policy consistent with the observation that governments typically inherit their predecessors’ plans and formulate their policies over a finite future horizon. We use this framework, which we call “Limited-Time Commitment” (LTC), to make two contributions. First, in a general stochastic model, we show that, under an intuitive sufficient condition, a chain of successive governments with LTC sustains the Full Commitment (FC) Ramsey equilibrium. This equivalence result clarifies in which cases existing recursive methods to solve for FC plans have a positive interpretation based on partial commitment. We apply this result in two benchmark models of optimal fiscal policy (with and without capital), in which the FC policy is time-inconsistent. Second, we investigate the implications of LTC in a model of capital taxation in which the FC outcome cannot be achieved with finite commitment. We show that the internalisation of near- future tax distortions represents a key distinction with respect to the literature on No Commitment (NC). In a calibrated version of the model, we find that a single year of fiscal commitment leads to large welfare gains (approximately a third of the difference between FC and NC). Finally, we use LTC to analyse commitment to different fiscal instruments and to study the importance of state-contingency in fiscal plans.