Low public debt as a commitment device for fiscal policy

This paper studies the time-inconsistency issue in a setting where the present government pre-announces a tax rate on labor income, and output is a resource exploited by the government and privates' jointly. The present government is tempted to increase its consumption by implementing a tax rate higher than what it had announced and privates had agreed upon. When confronted with this temptation, it must take account of a threat of privates enacting trigger strate- gies that will eventually confine present and next governments to low consumption levels. The comparison between benefits and costs from defection also depends on the extent the present government discounts next governments welfare. In particular, the trade-off between contin- uation and defection is as follows: defection entails an immediate and temporary increase in the utility enjoyed by the present government. As a consequence of privates enacting trigger strategies, a utility loss is suffered directly by the present government until the next government starts, and indirectly as a consequence of every successive government being confined to low levels of consumption. By ensuring the value of continuation exceeds the value of defec- tion, a sufficiently low level of public debt acts as a commitment device for continuation of the pre-announced tax policy even when the util- ity loss suffered from the enactment of trigger strategies across the present government time horizon does not outweigh the benets that the present government directly enjoys from defection.