Optimal Fiscal Policy with Heterogeneous Agents

Marco Bassetto, Federal Reserve Bank of Chicago

Abstract

The aim of this paper is to study how the intertemporal behaviour of taxes affects the distribution of wealth among heterogeneous agents. The optimal-taxation literature has often concentrated on representative-agent models, in which it is typically optimal to smooth taxes over time. The purpose of my analysis is to show that this conclusion hides important distributional conflicts: if tax liabilities are unevenly spread in the population, deviations from tax smoothing will lead to interest rate changes that redistribute wealth among the agents. When a ``bad shock'' hits the economy, the optimal fiscal policy will then call for smaller or larger deficits depending on the political power of different groups of agents in the economy. The model is applied to war financing and the introduction of a balanced-budget policy.