Optimal taxation in the face of restrictions on the government budget deficit1

In the present paper we focus on how a benevolent government would react to a change in the budget deficit restriction. When financial markets are perfect, anonymous lump-sum taxes are sufficient to achieve irrelevance and the maximal attainable welfare is unaffected by the change in the restriction. With imperfect consumer credit markets welfare irrelevance may not hold. In a pure exchange economy we show that irrelevance still holds in the presence of endogenous credit constraints provided there exists a sufficiently large number of anonymous consumption taxes. In productive economies, the conditions for welfare irrelevance are much more difficult to obtain. If production is perfectly smooth, allocation and welfare irrelevance usually does not hold, and a reform in the GBDR is expected to have a real effect on the economy. On the other hand, exact welfare irrelevance may be achieved if some inputs are non-substitutable or some consumption goods are supplied as endowments. However, even when all inputs are substitutable the optimal reaction of the government is expected to include consumption taxes.