Optimal tax design attempts to resolve a well-known trade-off: namely, that high taxes are bad insofar as they discourage people from working, but good to the degree that, by redistributing wealth, they help insure people against productivity shocks. Until recently, however, economic research on this question either ignored people's uncertainty about their future productivities or imposed strong and unrealistic functional form restrictions on taxes. In response to these problems, the new dynamic public finance was developed to study the design of optimal taxes given only minimal restrictions on the set of possible tax instruments, and on the nature of shocks affecting people in the economy. In this book, Narayana Kocherlakota surveys and discusses this exciting new approach to public finance. An important book for advanced PhD courses in public finance and macroeconomics, The New Dynamic Public Finance provides a formal connection between the problem of dynamic optimal taxation and dynamic principal-agent contracting theory. This connection means that the properties of solutions to principal-agent problems can be used to determine the properties of optimal tax systems. The book shows that such optimal tax systems necessarily involve asset income taxes, which may depend in sophisticated ways on current and past labor incomes. It also addresses the implications of this new approach for qualitative properties of optimal monetary policy, optimal government debt policy, and optimal bequest taxes. In addition, the book describes computational methods for approximate calculation of optimal taxes, and discusses possible paths for future research.

Preface ixChapter 1: Introduction 1
1.1 Scope 4
1.2 Lessons 5
1.3 Structure 9
References 11


Chapter 2: The Ramsey Approach and Its Problems 13
2.1 A Simple Model of Government Finance 14
2.2 The Dynamic Ramsey Taxation Problem: Setup 16
2.3 The Dynamic Ramsey Taxation Problem: Solution 19
2.4 Problems with the Ramsey Approach 24
2.5 Summary 28
2.6 Technical Notes 28
References 33


Chapter 3: Basics of Dynamic Social Contracting 34
3.1 Class of Environments 35
3.2 Incentive-Compatibility 39
3.3 Remarks on Incentive-Compatibility 42
3.4 Pareto Optimal Allocations 45
3.5 The Reciprocal Euler Equation 47
3.6 Dynamics of Pareto Optimal Consumption 58
3.7 Long-Run Properties of Pareto Optima 61
3.8 Summary 69
3.9 Technical Notes 71
References 79


Chapter 4: Dynamic Optimal Taxation: Lessons for Macroeconomists 81
4.1 A Nonlinear Tax Problem 82
4.2 Any Tax Equilibrium Is Incentive-Compatible 87
4.3 Building an Optimal Tax System 89
4.4 Properties of the Optimal Tax System 112
4.5 Remarks about the Optimal System 125
4.6 Summary 130
4.7 Technical Notes 131
References 137


Chapter 5: Optimal Intergenerational Taxation 140
5.1 An Intergenerational Tax Problem 141
5.2 Another Reciprocal Euler Equation 150
5.3 Properties of Socially Optimal Allocations 154
5.4 Optimal Bequest Taxation 159
5.5 Summary 164
5.6 Technical Notes 165
References 167


Chapter 6: Quantitative Analysis: Methods and Results 168
6.1 Immortal Agents in an Open Economy 169
6.2 A Closed Overlapping Generations Economy 184
6.3 Summary 198
References 199


Chapter 7: The Way Forward 201
7.1 More Widely Applicable Tax Systems 201
7.2 New Solution Methods 204
7.3 Inputs from the Data 208
7.4 Summary 210
7.5 Technical Notes 211


References 213
Index 215