On the economics of fiscal populism in an open economy

We study a representative agent, open economy in which government-provided services that enter the domestic production function must be financed with distortionary taxes, and focus on the optimal size of government and the associated optimal tax rate. If the government can precommit its actions, it maximizes individual welfare by announcing and implementing a constant tax rate, which we label the “orthodox” tax rate. This tax rate is time inconsistent, and under discretion the government implements a tax that maximizes each period’s output. We label this the “populist” tax rate. It may be higher or lower than the “orthodox” rate, depending on whether the elasticity of substitution in production between private and public inputs is below or above one. We also characterize the second-best tax rate that can be sustained through trigger strategies. This best sustainable tax rate is constant and lies between the “orthodox” and “populist” extremes.