Time-Consistent Public Policy and Inequality

Abstract:

We study optimal public policy without commitment in a heterogeneous-agent incomplete-markets economy. We develop a tractable Aiyagari-style model in which a benevolent government chooses public spending and distortionary taxes in Markov-perfect equilibrium, and derive a transparent Generalized Euler Equation that separates tax-base, direct redistribution, and price-mediated redistribution effects. We then examine how fiscal policy responds to permanent changes in wealth inequality. Using panel evidence for OECD countries, we find that increases in wealth inequality are associated with lower government consumption, higher transfers, and higher labor taxation. The model reproduces these responses under time-consistent policy, whereas Ramsey and constrained-efficient policies do not. The results highlight how lack of commitment interacts with household heterogeneity to shape the size and composition of government.