Ramsey monetary and fiscal policy: the role of consumption taxation

We study Ramsey monetary and fiscal policy in a small scale New Keynesian model where government spending has intrinsic value, public debt is state-noncontingent and the fiscal authority is constrained by using distortive taxation. We show that Ramsey policy is remarkably altered when consumption taxation is considered as a source of government revenues alongside or as an alternative to labour income taxes. First, we show that the optimal steady-state size of the public spending is, ceteris paribus, greater under consumption taxation than under labour income tax. We further show that adopting consumption taxation has enormous long run welfare gains and that these gains are increasing in the level of outstanding public debt. These welfare gains are not limited to the steady-state, but they are also present in the dynamic stochastic equilibrium. The reason is that the dynamic nature of consumption taxation enables the policy-maker to affect the stochastic discount factor via modifications of the marginal utility of consumption. This extra wedge impacts on the pricing decisions of firms, and hence on inflation stabilization, and greatly improves welfare in the stochastic equilibrium.