Financial Markets as a Commitment Device for the Government

How does the presence of financial markets shape the government's ability to implement social redistribution? Individuals typically do not constrain consumption to equal their net-of-tax income every period, but instead use financial markets to allocate their resources over time. Optimal redistributive policy ought to take agents' involvement in financial markets into account. I study a two period endowment economy with heterogeneous income types that are private information where a government without commitment cannot provide any social redistribution. I show how agents' involvement in a financial market can improve the government's ability to commit at least to a partially separating allocation in the second period, enabling it to provide some redistribution across agents. In this world, agents borrow against their promised income and enter long-term consumption commitments. Changing these contracts is costly. This changes the government's ex-post incentives to renege on the promised tax schedule and fully redistribute, because some agents would have to default on their loans. I show that whenever this default cost is positive, the government is able to commit to a schedule that only pools some agents of similar type together. In other words, it serves as a commitment device in the sense that it enables the government to commit to not exploit a limited amount of information. As the default costs increase, the government is able to commit to a higher degree of separation, eventually reaching full commitment. Thus, the presence of well-functioning financial markets may in fact facilitate rather than hinder redistribution.