Optimal Taxation Without State-Contingent Debt

In Lucas and Stokey's (1983) economy, tax rates inherit the serial correlation structure of government expenditures, belying Barro's (1979) result that taxes should be a random walk for any stochastic process of government expenditures. To recover a version of Barro's 'random walk' tax-smoothing outcome, we modify Lucas and Stokey's (1983) economy to permit only risk-free debt. Having only risk-free debt confronts the Ramsey planner with additional constraints on equilibrium allocations beyond one imposed by Lucas and Stokey's assumption of complete markets. The Ramsey outcome blends features of Barro's model with Lucas and Stokey's. In our model, the contemporaneous effects of exogenous government expenditures on the government deficit and taxes resemble those in Lucas and Stokey's model, but incomplete markets put a near unit root component into government debt and taxes, an outcome like Barro's. However, we show that without ad hoc limits on the government's asset holdings, outcomes can diverge in important ways from Barro's. Our results use and extend recent advances in the consumption smoothing literature