26/02/2012: What happens when debt is too high and taxes are distortionary?

An interesting paper: Public Debt, Distortionary Taxation, and Monetary Policy by Alessandro Piergallini and Giorgio Rodano from February 7, 2012 (CEIS WorkingPaper No. 220 ).

In traditional literature, starting with Leeper’s (1991):

• if fiscal policy is passive (so that it simply focuses on a guaranteed / constitutionally or legislatively mandated public debt stabilization irrespectively of the inflation path), 
• then monetary policy can independently be set to focus solely on inflation targeting (ECB) ignoring real economy objectives, such as, for example, unemployment and growth targeting. 

The twin separate objectives of fiscal and monetary policy can be delivered by following the Taylor principle. This means if the monetary authorities observe an upward rise in inflation, they can hike nominal interest rates by greater proportion than the rise in inflation. This is feasible, because in the traditional setting, fiscal policy objective of sustaining public debt at stable levels can be achieved - in theory - by raising non-distortionary taxes that are not linked to inflation (for example, distortionary VAT and sales taxes yield revenues that are linked to inflation, so monetary policy to reduce inflation will lead to reduced economic activity and reduced revenues for the Government at the same time; in contrast, non-distortionary lump sum taxes yield fixed revenue no matter what income or price level applies, so that anti-inflationary increase in the interest rates is not going to have any impact on tax revenue).

Of course, if fiscal policy is active (does not focus on debt stabilization), monetary policy under Taylor rule should be passive (so interest rates hikes should of smaller percentage than inflationary spike). Such passive monetary policy will allow Governments to inflate their tax revenues without raising rates of distortionary taxation and

In many real world environments Governments, however, can only finance public expenditures by levying distortionary taxes (progressive taxation). So in this environment, the question is - what happens to the 'passive fiscal - active monetary' policies mix? According to Piergallini and Rodano, "It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate."

Ok, what does this mean? It means that if you want passive rules (public debt targeting - e.g. fiscal compact EU is trying to legislate) you need inflation (to transfer funds to the Government from the private individuals and companies).

Per authors: "The analytical results derived in this paper give theoretical support to the argument recently advanced by Cochrane (2011) and Davig, Leeper and Walker (2011) that the large fiscal deficits decided by governments to offset the crisis can lead to the “Laffer limit” beyond which inflation must endogenously jump up according to the fiscal theory of the price level."

Now, we often hear the arguments that in the near term there will be no inflation as slow growth will prevent prices from rising. Sure, folks. Good luck with that.