Dynamic Model of Fiscal Solvency: Comparative Dynamic Analysis

Abstract

Tax revenues and the issuance of debt are interdependent because governments are afraid of becoming insolvent. Therefore the long-term tax policy involving: adjustment of capital taxation, taxation of explicit consumption and the issuance of bonds ensures solvency and hampers capital tax competition. Applying long-term dynamic model of capital and consumption taxation, the revenue maximizing government can obtain the equilibrium with reasonable tax rates. The equilibrium solution fulfills simple solvency constraint imposed on bonds issuance and takes into account the possibility of capital income shifting and the limited taxation of consumption. The two tax rates, the levels of capital and consumption are driven by: capital income shifting parameter, explicit consumption and the intertemporal preferences. The interdependences in equilibrium between variables and selected parameters are provided with numerical simulation, as well as the behavior of variables in time after the changes of equilibrium parameters. The solution predicts positive level of bonds in long-term equilibrium and taxation rates positively dependent on the abundance of tax bases. The latter are strongly affected by the value of income shifting parameter and explicit consumption parameter.