Dynamic Optimal Fiscal and Monetary Policy in a Business Cycle Model with Income Redistribution

An optimal program of distortionary taxes, money growth, and borrowing to finance a stream of expenditures is computed in a monetary real business cycle model for which distribution issues between the rich and poor play a fundamental role in policy decisions. Specifically, a simple feedback rule links public spending on goods and services to a measure of income inequality, and the government is required to provide poor households with some minimum level of transfers. The stationary equilibrium policy displays positive capital taxation, progressive labor taxes, and moderate (6 percent) inflation. The capital tax and the inflation tax fluctuate over time to absorb budget shocks, while the labor tax remains relatively constant. Model simulations compare favorably in many respects with postwar U.S. time series on tax rates, money growth, and aggregate business cycle variables. The solution method employs the recursive algorithm developed by Kydland and Prescott (1980) to compute optimal policy rules under the assumption of commitment.