On the optimal and best sustainable taxes in an open economy

We study a representative agent, open economy in which government-provided services that enter the domestic production function must be financed with distortionary taxes, and focus on the optimal size of government and the associated optimal tax rate. If the government can precommit its actions, it maximizes individual welfare by announcing and implementing a constant tax rate, which we refer to as the 'first-best' tax rate. This tax rate is time inconsistent, and under discretion the government implements a tax that maximizes each period's output - which may be higher or lower than the first-best rate, depending on whether the elasticity of substitution in production between private and public inputs is below or above one. In this paper we characterize the best sequence of tax rates that can be sustained through trigger strategies. This best sustainable sequence of tax rates is constant, and lies between the first-best and discretionary extremes.