Dynamic Optimal Taxation

Within the rational expectations framework, policy has effect if it alters relative prices and policy evaluations are exercises in modern public finance theory. The time inconsistency of an optimal taxation plan precludes the use of standard control theory for its determination. This article recursive methods are developed that overcome this difficulty. The technique is novel in that the constraint set as well as the value function are determined recursively. Even though there is little hope of the optimal plan being implemented - because of its time inconsistency - we think the exercise is of more than pedagogical interest. The optimal plan's return is a benchmark with which to compare the time consistent solution under alternative institutional constraints which society might choose to impose upon itself.