The Region

Optimal Taxes in a Debt-Burdened Nation

For countries that can’t borrow internationally, a zero labor tax is best policy

Douglas Clement | Editor, The Region

Published February 11, 2016

In the early 2010s, several European nations faced severe fiscal crises. Greece, Ireland and Portugal in particular had pursued fiscal policies that resulted in sustained annual deficits; international credit markets stopped lending them money at normal interest rates.

To service their growing debt loads, these countries cut government spending and raised tax rates. Public response varied, but widespread civil discord in Greece was a dramatic reminder that such outcomes are socially and politically painful and unpopular. Nonetheless, similar crises have occurred with remarkable frequency throughout modern history, as Carmen Reinhart and Kenneth Rogoff illustrate in their 2009 book This Time Is Different.

Mark Aguiar
Mark Aguiar

That these episodes happen with such regularity suggests that while moralistic scorn is a typical international response when countries can’t pay their debts, such policies shouldn’t be dismissed as the foolish choices of illogical policymakers and selfish populations. As economists Mark Aguiar of Princeton and Manuel Amador of the Minneapolis Fed argue in a recent staff report, “Fiscal Policy in Debt Constrained Economies” (SR 518), “Policies that run up debt, and eventually encounter borrowing constraints, may be the rational response of citizens (and their politicians) who face a world interest rate that is below their subjective rate of time preference.”

“Subjective rate of time preference” means a person’s wish to consume goods and leisure now instead of doing so in the future (and it’s directly tied to the labor he or she offers to firms to earn enough to pay for such consumption). If nations can finance their consumption by borrowing from international markets at interest rates that are lower than their time preference, it makes perfect sense to do so—putting off the “day of reckoning” for that growing debt until a later date.

Optimal taxation

In their paper, Aguiar and Amador focus on the question of optimal taxation in such a situation. For economies that are relatively “impatient” in that they want to consume now rather than later but are debt constrained (that is, they can’t borrow), what is the best tax policy?

Manuel Amador
Manuel Amador

The standard wisdom on optimal fiscal policy—derived from the seminal 1927 work of British economist Frank Ramsey—is that a government trying to maximize welfare for its households should aim for a long-run policy of no taxes on capital. But Aguiar and Amador find that in this economic situation, the standard Ramsey prediction is reversed: Labor, not capital, should face zero taxation in the long run.

Why such an unconventional outcome? “The zero-labor-tax result arises because the private agents wish to front load consumption and leisure.” That is, they want to postpone work and consume and relax now. A matter of lazy greed? Not necessarily. “The greater impatience may reflect higher mortality in developing economies,” note the authors, “imperfect altruism, or simple preference heterogeneity (with large/rich countries being rich because they have patient agents).” In any case, the scenario seems quite realistic.

Aguiar and Amador emphasize that their model makes another departure from the standard Ramsey analysis: an assumption that the government lacks commitment to tax, transfer and debt repayment promises. That too seems a believable premise. Pragmatic government leaders are likely to change policies to fit present-day economic reality rather than the realities that faced their nations last year or the year before.

Environment, analysis and extensions

The economists begin their work by designing a mathematical model to study optimal taxation for an economic environment populated by households, firms and the government in a small economy that interacts with other nations through product and credit markets.

They then derive the optimal fiscal policy for such an economy, finding the zero-labor-tax result. The result is “quite general,” they write. As long as certain conditions are met, labor tax is driven to zero in the long run. Somewhat surprisingly, this doesn’t mean that the government itself runs deficits year after year, thereby generating large public debt. Rather, the government uses claims against households and/or foreigners, plus net taxes on capital, to finance necessary public expenditures. “It is the household sector that is indebted in the long run, not the fiscal authority.”

Aguiar and Amador extend their benchmark model in several directions, including constraints on private as well as sovereign debt, alternative preference schemes and a closed economy (“autarky”). Each extension on the basic scheme highlights different features of the model. For instance, changing the discount rate or the sequence of politicians making fiscal policy decisions isn’t relevant to the outcome. “It is the private household’s impatience [relative to the world interest rate] that leads to zero long-run labor taxation.” The result also applies to closed economies as well as those engaged in global markets.

The economists also conclude that the insight they’ve reached is probably applicable in similar situations. “Namely, an economy that wishes to front load consumption and leisure should operate as efficiently as possible in the long run to maximize its debt servicing capacity,” they write. “This requires the fiscal authority to ‘make room’ by front loading its labor tax revenue.”