Optimal policy with credibility concerns

This paper considers a reputation model of optimal taxation in which the public is unsure about the government type. A long-lived government can be trustworthy (meaning that it commits to its announced tax rate) or opportunistic (meaning that it retains the ability to change its tax rate after announcing it). Unlike in most prior studies, the committed strategy in this model is optimally chosen by the trustworthy type. We show that this change has signi…cant consequences for the equilibrium dynamics. The optimal committed strategy is found to vary with the time preferences of the two government types, the initial reputation of the government, and the elasticity of household production. This formulation explains di¤erences in policy responses across governments in the face of similar credibility problems. Keywords: imperfect credibility, reputation game, optimal taxation, time inconsistency JEL codes: E61, E62, D82 I would like to thank the editor and the three anonymous referees for their helpful comments. I owe a great debt of gratitude to Robert G. King for his constant guidance and support. The paper also bene…ted from discussions with Russell Cooper, Martin Cripps, Steve Davis, Piero Gottardi, Veronica Guerrieri, Peter Ireland, Yuanchuan Lien, Bart Lipman, Lars Stole, and seminar participants at Boston University, Green Line Macro Meeting, UC Santa Cruz, UChicago-Booth, FRB Richmond, FRB Kansas City, FRB Philadelphia, Hong Kong University, Hong Kong University of Science and Technology, Chinese University of Hong Kong, City University of Hong Kong, European University Institute, Toulouse School of Economics and LUISS. All errors are my own.