New Dynamic Public Finance
Mikhail Golosov (Yale, New Economic School, and NBER)
Aleh Tsyvinski (Yale, New Economic School, and NBER)
New Dynamic Public Finance is a recent literature that analyzes taxation and social insurance policy in
dynamic settings. Many of public finance and macroeconomics problems such as taxation of capital or
Social Security and disability insurance are dynamic.
When a taxation or insurance environment is static, a large body of Mirrlees taxation literaturei showed
how to design social insurance and taxation programs. The New Dynamic Public Finance literature
extends the static Mirrlees framework to dynamic settingsii. The key tradeoff in such environments is
the insurance-incentives tradeoff: how to design social insurance or redistribution systems while
ensuring necessary incentives to provide effort or work. In dynamic settings, the primary focus is the
stochastic shocks that agents receive over time. There is an informational frictions -- these shocks are
not directly observed by the government.
Consider a simple example of such dynamic social insurance problem. An able worker can become
disabled with some probability later in life. Moreover, it is relatively easy to claim disability. For
example, one can pretend to be suffering from back pain which is very difficult to verify. A government
wants to create an optimal disability insurance system. Such a system would provide adequate transfers
to the truly disabled workers while discouraging fake disability applications. The decision of the worker
whether to claim disability in the future is necessarily dynamic and will affect his choices today. For
example, an able worker faced with a given transfer scheme can increase or decrease his savings. Such
savings choices may increase or decrease his willingness to fake disability and claim disability benefits in
the future.
Intertemporal wedge and implicit tax on savings
In our work with Narayana Kocherlakota we have shown one of the key general insights that holds in
these dynamic settings -- when agents’ skills stochastically change it is optimal to introduce a positive
distortion (an implicit tax) that implicitly discourages savingsiii. This result holds for any stochastic
process for skills (for example, for any persistence of the shocks) as long as there is some uncertainty
about future individual shocks.
A somewhat loose intuition for the implicit savings tax using the disability example above is as follows.
Consider a system of disability transfers that gives a disabled worker, say, $1000. An able worker
contemplates whether to work or to claim disability next period. If he fakes disability, he will for sure
receive $1000. If he does not fake and claims disability only if he is truly disabled, he gets $1000 if he is
disabled (with some probability) and a higher amount from work if he is able. The faker will then have
higher savings, given this transfer system – he knows that he will receive $1000 for sure and will not
work. A disability insurance scheme that introduces a tax on savings (for example, by asset-testing, i.e.,
paying benefits only to those with assets low enough) will then help discourage fake applicants.
The result on the positive intertemporal wedge or implicit tax does not necessarily mean that there has
to be a positive capital tax, or that wedges are necessarily equal to taxes. Rather, the main point is that
an optimal dynamic taxation or social insurance system has to necessarily take into account agents’
ability to save. In general, such accounting for agents’ savings implies that savings have to be
discouraged. This contrasts with the Chamley-Judd resultiv, obtained in macroeconomic Ramsey
settings, that capital should go untaxed in the long run. In the economy with heterogeneous
unobservable skills that do not stochastically change over time, it is optimal to have a zero capital tax.v
Implementation and Taxation of Savings.
What kind of taxes does the optimal program imply? There are several papers studying implementation
of the optimal programs. Our work on disability insurance shows that the optimum can be implemented
by an asset-tested program in which disability (or more, generally, retirement) benefits are paid only to
agents who have assets below a specified limitvi. A possible implementation in general environments is
one in which capital taxes are regressivevii. In a special case of the i.i.d. process for individual shocks, a
non-linear tax on wealth and income implements the optimumviii. In some models with habit formation
the optimal allocation resembles a social security system in which taxes on wealth are linear, and
taxes/transfers are history-dependent only at retirementix.
All of these implementations have two key features: (1) taxes or transfers have to be conditioned on the
amount of savings that agent accumulates, and (2) there is some degree of history dependency.
Other taxes and social insurance problems
This general framework allowed a variety of analyses of other dynamic taxes and social insurance
problems. In an environment in which the utility of consumption is linear, labor taxes of all agents
asymptotically converge to zerox. Optimal taxation of entrepreneurs has been studiedxi. In that setup, an
entrepreneur exerts unobservable effort that affects the rate of return of the project. The optimal
implicit savings tax for the entrepreneurs can be either positive or negative. In a monetary model with
heterogeneous agents with privately observed skills, the optimality of Friedman rule was proven, that is,
the optimal inflationary tax is zeroxii. In the economy in which all the skills do not stochastically change
over time and in which there is aggregate uncertainty a labor-tax smoothing result holdsxiii. The analysis
of estate taxation in an intergenerational dynastic model with dynamic private information shows that
estate taxes should be progressivexiv. In a model of endogenous fertility with private information on
productivity estate taxes are positive, and there are positive taxes on family sizexv. Also optimal taxes on
human capital have been studied.xvi
Quantitative work
In step with theoretical advances, several authors have carried out quantitative analyses on the size of
wedges, taxes, and welfare gains from improving tax policy. The sizes and shapes of the optimal capital
and labor taxes were computed in a dynamic economy in the case of i.i.d. shocks to skillsxvii. Moving to
the other side of the spectrum, with permanent disability shocks, we showed that the welfare gains
from improving disability insurance system might be largexviii. In a lifecycle version of a dynamic Mirrlees
economy with publicly and privately observable shocks to individual labor productivity, a recent study
estimates the fraction of labor productivity that is private informationxix. It finds that for the model and
data to be consistent, a large fraction of shocks to labor productivities must be private information.
Another quantitative route is considering partial reforms. Rather than finding the full optimum, a variety
of papers considered changes in the taxes or insurance systems that can improve upon the current
system. One example is to consider the welfare gains from partial reforms that introduce optimal
savings distortions but leave the labor allocations unchangedxx. Another important route of a partial tax
reform in a dynamic setting is to compute the optimal tax schedule in a model where the tax function is
restricted to a specific functional form but flexibly parameterized to allow for wide range of shapes,
including progressive taxation, non-discriminatory lump-sum taxation, and various exemptions.xxi An
interesting partial reform study determines welfare gains and optimal taxes in a calibrated model with
age-dependent taxesxxii.
Private and public insurance
An important aspect of designing optimal dynamic taxation and insurance is to allow for the possibility
of private insurance and other frictions beyond unobservability of skills. We study an environment in
which agents can trade unobservably on private marketsxxiii. An example of this in the environment of
the disability insurance considered above is that workers are able to borrow or lend with a market
determined interest rate, and such transactions are not observable by the insurance agency. We show
that when all market transactions are publicly observed, the optimal program can be implemented
privately without any government intervention. However, if some of the financial transactions are not
observable, private insurance is not efficient and has to be supplemented with public intervention. A
recent interesting paper considers a dynamic Mirrleesian economy in which workers can sign insurance
contracts with multiple firms (i.e., another friction -- non-exclusivity of contracts – is added)xxiv. The
model endogenously divides the population into agents that are not monitored and have access to nonexclusive contracts and agents that have access to exclusive contracts. The authors use US household
data and find that high school graduates satisfy the optimality conditions implied by the non-exclusive
contracts while college graduates behave according to the second group.
Political economy and optimal taxation
Another set of issues that this literature studies is that of the effect of the political economy on social
insurance. The papers considered above assume that the policymaker is a fictitious benevolent social
planner with full commitment. But in reality the social programs and taxation are run by politicians.
In our work with Daron Acemoglu we study the optimal Mirrlees taxation problem in a dynamic
economy but, in contrast to the exisiting approach, the policy is decided in a classical electoral
accountability model of political economyxxv. Politicians are self-interested (fully or partially) and cannot
commit to promises. They can misuse the resources and the information they collect to generate rents.
An important technical result of our analysis is that a version of revelation principle works despite the
commitment problems and the different interests of the government. Using this tool, we show that if
the government is as patient as the agents, the best sustainable mechanism leads in the long run to
allocation where the aggregate distortions arising from political economy disappear. In contrast, when
the government is less patient than the citizens, there are positive aggregate political economy
distortions even asymptotically. We also use this framework to compare centralized mechanisms
operated by self-interested rulers to anonymous marketsxxvi. A related environment is that of the debt
policy in dynamic settings with linear taxes and self-interested politiciansxxvii.
A recent study of efficient nonlinear taxation of labor and capital in a dynamic Mirrleesian model
incorporates political economy constraints in which policies are the outcome of democratic elections,
and there is no commitmentxxviii. Their main result is that the marginal tax on capital income is
progressive, in the sense that richer agents face higher marginal tax rates. The properties of credible
equilibria in dynamic settings with a lack of societal commitment are examined in another recent paper.
xxix
The authors isolate forces that promote and retard capital accumulation in these settings, derive the
pattern of intertemporal wedges as well as provide an implementation result.
Conclusion
The literature on dynamic Mirrlees problems has already delivered many important results on a broad
variety of social insurance and taxation issues in dynamic context. There are many interesting questions
that lie ahead. On the theoretical part it is important to create a general algorithm that will allow to
solve quantitatively a broader set of models, especially, ones with general persistent shocks which are
empirically relevant. It is also important to bridge the gap with the more standard public finance
literature much of which was done for the static frameworkxxx.
i
A seminal paper in this literature is J. Mirrlees, “An Exploration in the Theory of Optimum Income Taxes,” Review
of Economic Studies, Vol. 38, No. 114, 1971.
ii
For surveys see M. Golosov, A. Tsyvinski, and I. Werning, “New Dynamic Public Finance: A User’s Guide,” in NBER
Macroeconomics Annual, D. Acemoglu, K. Rogoff, and M. Woodford ed., NBER, 2006 and N. Kocherlakota, “The
New Dynamic Public Finance”, Princeton University Press, forthcoming 2010.
iii
The general proof is provided in M. Golosov, N. Kocherlakota and A. Tsyvinski, “Optimal Indirect and Capital
Taxation,” Review of Economic Studies, Vol. 70, No. 3, 2003. For earlier results in more limited settings see P.
Diamond and J. Mirrlees “A Model of Social Insurance with Variable Retirement”, Journal of Public Economics, Vol.
10, 1978 and W. Rogerson “Repeated Moral Hazard” Econometrica, 53, 1985.
iv
K.L. Judd, “Redistributive Taxation in a Simple Perfect Foresight Model,” Journal of Public Economics, Vol. 28, No.
1, 1985 and C. Chamley, “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives,”
Econometrica, Vol. 54, No. 3, 1986.
v
I. Werning, “Optimal Dynamic Taxation,” Ph.D. Dissertation, The University of Chicago, 2002 and M. Golosov, N.
Kocherlakota and A. Tsyvinski, “Optimal Indirect and Capital Taxation,” Review of Economic Studies, Vol. 70, No. 3,
2003.
vi
M. Golosov and A. Tsyvinski, “Designing Optimal Disability Insurance: A Case for Asset Testing,” NBER Working
Paper No. 10792, September 2004, and Journal of Political Economy, Vol. 114, No. 2, 2006.
vii
N. Kocherlakota, “Zero Expected Wealth Taxes: A Mirrlees Approach to Dynamic Optimal Taxation,”
Econometrica, Vol. 73, No. 5, 2005.
viii
S. Albanesi and C. Sleet, “Dynamic Optimal Taxation with Private Information,” Review of Economic Studies, Vol.
73, No. 1, 2006.
ix
B. Grochulski and N. Kocherlakota, “Nonseparable Preferences and Optimal Social Security Systems,” NBER
Working Paper No. 13362, September 2007.
x
M. Battaglini and S. Coate, “Pareto Efficient Taxation with Stochastic Abilities,” Journal of Public Economics, 2008,
v. 92, iss. 3-4, pp. 844-68.
xi
S. Albanesi, “Optimal Taxation of Entrepreneurial Capital with Private Information,” CEPR Discussion Paper No.
5647, 2006.
xii
C. da Costa and I. Werning, “On the Optimality of the Friedman Rule with Heterogeneous Agents and Nonlinear
Income Taxation,” Journal of Political Economy, Vol. 116, No. 1, 2007.
xiii
I. Werning, Optimal Fiscal Policy with Redistribution” Quarterly Journal of Economics August 2007, Vol. 122, No.
3, Pages 925-967: 925-967.
xiv
E. Farhi and I. Werning, “Inequality, Social Discounting and Estate Taxation,” NBER Working Paper No. 11408,
June 2005 and Journal of Political Economy, Vol. 115, No. 3, 2007.
xv
R. Hosseini, L. Jones, and A. Shourideh, “Risk Sharing, Inequality and Fertility,” NBER Working Paper No. 15111,
June 2009.
xvi
R. Bohacek and M. Kapicka, “Optimal Human Capital Policies,” Journal of Monetary Economics, Vol. 55, No. 1,
2008 and B. Grochulski and T. Piskorski "Risky Human Capital and Deferred Capital Income Taxation", Journal of
Economic Theory (forthcoming).
xvii
S. Albanesi and C. Sleet, “Dynamic Optimal Taxation with Private Information,” Review of Economic Studies, Vol.
73, No. 1, 2006.
xviii
M. Golosov and A. Tsyvinski, “Designing Optimal Disability Insurance: A Case for Asset Testing,” NBER Working
Paper No. 10792, September 2004, and Journal of Political Economy, Vol. 114, No. 2, 2006.
xix
L. Ales and P. Maziero, “Accounting for private information,” Mimeo, 2008.
xx
E. Farhi and I. Werning, “Capital Taxation: Quantitative Explorations of the Inverse Euler Equation”, 2008.
xxi
J.C. Conesa, S. Kitao and D. Krueger, ‘Taxing Capital? Not a Bad Idea After All!” NBER Working Paper No. 12880,
January 2007, and American Economic Review, Vol. 99, No. 1, 2009 and J.C. Conesa and D. Krueger, “On the
Optimal Progressivity of the Income Tax Code,” NBER Working Paper No. 11044, January 2005, and Journal of
Monetary Economics, Vol. 53, No. 7, 2006.
xxii
M. Weinzierl, “The Surprising Power of Age-Dependent Taxation,” Mimeo, Harvard University, 2008.
xxiii
M. Golosov and A. Tsyvinski, “Optimal Taxation with Endogenous Insurance Markets,” NBER Working Paper No.
11185, March 2005, and The Quarterly Journal of Economics, Vol. 122, No. 2, 2007.
xxiv
L. Ales and P. Maziero, “Non-exclusive Dynamic Contracts, Competition and the Limits of Insurance,” Mimeo,
2008.
xxv
D. Acemoglu, M. Golosov, and A. Tsyvinski “Markets versus Governments: Political Economy of Mechanisms,”
NBER Working Paper No. 12224, 2006 and D. Acemoglu, M. Golosov, and A. Tsyvinski “Political Economy of
Mechanisms,” Econometrica, Vol. 76, No. 3, 2008, and “Dynamic Mirrlees Taxation under Political Economy
Constraints”, Review of Economic Studies, forthcoming, and “Political Economy of Ramsey Taxation”, NBER
Working Paper No. 15302, August 2009.
xxvi
D. Acemoglu, M. Golosov, and A. Tsyvinski “Markets versus Governments”, Journal of Monetary Economics
(2008), 55(1): 159-189.
xxvii
P. Yared "Politicians, Taxes, and Debt," 2009, forthcoming in Review of Economic Studies.
xxviii
E. Farhi and I. Werning, “The Political Economy of Non-Linear Capital Taxation”, Mimeo, 2008.
xxix
xxx
C. Sleet and S. Yeltekin “Allocation and Taxation in Uncommitted Societies”, Mimeo, 2009.
E. Saez, “The Desirability of Commodity Taxation Under Non-Linear Income Taxation and Heterogeneous
Tastes,” NBER Working Paper No. 8029, December 2000, and The Journal of Public Economics, Vol. 83, Vol. 2, 2002.