Debt Sustainability and Welfare along an Optimal Laffer Curve

Abstract

A recent literature on sovereign debt sustainability (see Trabandt and Uhlig (2011) and Mendoza et al. (2014)) has produced Laffer curve calculations for Eurozone countries. These calculations have been carried out mainly in a quasi-static fashion by considering policy experiments where individual tax rates are permanently set at a new value while keeping all others constant. However, such fiscal policy design disregards complementarities among tax instruments as well as the potential for altering tax rates during the transition to the steady-state in a manner which exploits expectations. Our paper addresses this issue by considering policy experiments where fiscal policy is set optimally and fiscal instruments are jointly varied along the transition to steady-state. Through the Ramsey problem we map the maximum amount of tax revenues a government can further raise to the welfare costs of the associated tax distortions. We label this relation as the ‘optimal Laffer curve’. We show that tax revenue and welfare gains relative to the policy experiments examined by the previous literature are dramatic.