Optimal taxation in the presence of bailouts
The termination of a representative financial firm due to excessive leverage may lead to substantial bankruptcy costs. A government in the tradition of Ramsey (1927) may be inclined to provide transfers to the firm so as to prevent its liquidation and the associated deadweight costs. It is shown that the optimal taxation policy to finance such transfers exhibits countercyclicality and history dependence, even in a complete market. These results are in contrast with pre-existing literature on optimal fiscal policy, and are driven by the endogeneity of the transfer payments that are required to salvage the financial firm.
This paper was prepared for the April 2009 Carnegie Rochester Conference on Public Policy "Credit Market Turmoil: Implications for Policy". I would like to thank Andy Abel, Rui Albuquerque, John Heaton, and participants at the Carnegie Rochester conference for useful comments and discussion. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.