Optimal Fiscal and Monetary Policy with Distorting Taxes

When government debt pays a lower return than private assets, the reasoning in Friedman’s (1969) essay on the optimal quantity of money suggests that it would be optimal to expand the debt until its return matched that on private assets. When the only other source of revenue is a distorting tax, however, this is not generally true. In a perfect foresight model, a benevolent government that can make credible commitments chooses a large gap in returns initially and high distorting taxation in the distant future. The optimal path of taxation is time inconsistent, with ever-increasing temptation to abandon the path. (JEL E23, E43, E52, E62, H20, H61, H63)