ON THE OPTIMAL AND BEST SUSTAINABLE TAXES IN AN OPEN-ECONOMY

We study a representative agent, open economy in which government-prov ided services that enter the domestic production function must be fina nced with distortionary taxes, and focus on the optimal size of govern ment and the associated optimal tax rate. If the government can precom mit its actions, it maximizes individual welfare by announcing and imp lementing a constant tax rate, which we refer to as the 'first-best' t ax rate. This tax rate is time inconsistent, and under discretion the government implements a tax that maximizes each period's output - whic h may be higher or lower than the first-best rate, depending on whethe r the elasticity of substitution in production between private and pub lic inputs is below or above one. In this paper we characterize the be st sequence of tax rates that can be sustained through trigger strateg ies. This best sustainable sequence of tax rates is constant, and lies between the first-best and discretionary extremes.