Marco Bassetto

Political economy of taxation in an overlapping-generations economy

This paper analyzes the effects of intergenerational conflict on capital and labor income tax rates, transfers, and government spending in a model of multidimensional policy choice. The different nature of tax liabilities for the young and the old can explain why the old receive large gross lump-sum transfers through social security, while the young receive little or none. A natural link also emerges between the size of the government as a provider of public goods and the magnitude of transfers that the same government will implement. (Copyright: Elsevier)

Credit Crunches and Credit Allocation in a Model of Entrepreneurship

We study the effects of credit shocks in a model with heterogeneous entrepreneurs, financing constraints, and a realistic firm size distribution. As entrepreneurial firms can grow only slowly and rely heavily on retained earnings to expand the size of their business in this set-up, we show that, by reducing entrepreneurial firm size and earnings, negative shocks have a very persistent effect on real activity. In determining the speed of recovery from an adverse economic shock, the most important factor is the extent to which the shock erodes entrepreneurial wealth.

Optimal fiscal policy with heterogeneous agents

The aim of this paper is to study the relationship between the intertemporal behavior of taxes and wealth distribution. The optimal‐taxation literature has often concentrated on representative‐agent models, in which it is optimal to smooth distortionary taxes. When tax liabilities are unevenly spread in the population, deviations from tax smoothing lead to interest rate changes that redistribute wealth. When a “bad shock” hits the economy, the optimal policy will then call for smaller or larger deficits, depending on the political power of different groups. This effect is particularly relevant in the case of large shocks to government finances, such as wars.

Is Inflation Default? The Role of Information in Debt Crises

In the aftermath of the financial crisis, countries which had control over their monetary policy, such as the United States, the United Kingdom, and Japan, were able to borrow at extremely low rates, even though they experienced very high deficit/GDP ratios (the UK) or debt/GDP ratios (Japan). In contrast, peripheral Eurozone countries with a high deficit/GDP ratio (Spain) or a high debt/GDP ratio (Italy) faced volatile interest rates. In a frictionless benchmark, default and inflation have the same economic effect. Creditors care about the real rate of return on their investment: whether they anticipate losing money to default or inflation, they will require an identical interest rate spread over risk-free bonds. We break this equivalence by introducing two classes of heterogeneously informed agents: bondholders, who decide whether to roll over their credit, and workers, who decide whether to accept currency in payment for their services. Domestic and foreign-currency borrowing are now distinguished by the identity of the marginal agent who triggers a crisis. We show conditions under which domestic-currency debt makes the economy more resilient to fiscal shocks.

Public Investment and Budget Rules for State vs. Local Governments

Across different layers of the U.S. government there are surprisingly large differences in institutional provisions that impose fiscal discipline, such as constitutionally mandated deficit or debt limits, or specific tax bases. In this paper we develop a framework that can be used to quantitatively assess their costs and benefits. The model features both endogenous and exogenous mobility across jurisdictions, so we can evaluate whether the different degree of mobility at the local vs. national level can justify different institutional restrictions. In preliminary results, we show that pure land taxes have very beneficial incentive effects, but can only raise limited amounts of revenues. In contrast, under exogenous mobility, income taxes lead unambiguously to insufficient incentives to invest in public capital, unless the fiscal constraints explicitly favor such investment. This conclusion seems to hold even with the introduction of endogenous mobility, since adverse congestion effects from inefficient migration offset the beneficial impact of (partial) capitalization of future taxes into land prices.

The Interplay between Financial Conditions and Monetary Policy Shocks

We study the interplay between monetary policy and financial conditions shocks. Such shocks have a significant and similar impact on the real economy, though with different degrees of persistence. The systematic fed funds rate response to a financial shock contributes to bringing the economy back towards trend, but a zero lower bound on policy rates can prevent this from happening, with a significant cost in terms of output and investment. In a retrospective analysis of the U.S. economy over the past 20 years, we decompose the realization of economic variables into the contributions of financial, monetary policy, and other shocks.

Speculative Runs on Interest Rate Pegs - The Frictionless Case

In this paper we show that interest rate rules lead to multiple equilibria when the central bank faces a limit to its ability to print money, or when private agents are limited in the amount of bonds that can be pledged to the central bank in exchange for money. Some of the equilibria are familiar and common to the environments where limits to money growth are not considered. However, new equilibria emerge, where money growth and inflation are higher. These equilibria involve a run on the central banks interest target: households borrow as much as possible from the central bank, and the shadow interest rate in the private market is different from the policy target.