1

Determination of optimal government policy

Timing: The government chooses y Y first and then the household (HH) chooses x X(y). We
assume that the government is rational and has no commitment problem.
Let the HHs preferences be given by U (x).
When the government sets its policy, it has to take into account how the HH responds to it, in particular
it needs to know how the HHs equilibrium choice x varies with the governments choice y.
Knowing how x varies with y, the government chooses the y that maximizes the HHs utility. In some
special cases, there might be only one feasible y value. Then, the government would simply pick that y
to be the equilibrium government policy.
Thus, Step 1 in finding the equilibrium government policy is to obtain the HHs choice x as a function
of governments choice y. In particular, let x (y) be the equilibrium choice of the HH for an arbitrary
y. x (y) solves
x (y) = arg max U (x).
xX(y)

Step 2: Given x (y), the governments problem is

max U (x (y)).
yY

1.1

Example

Consider a two-period economy.

The HHs preferences is given by u(c1 ) + u(c2 ) (where u(c) = log(c)).
Assume that the government uses consumption tax (c1 , c2 ) to raises revenue to finance (G1 , G2 ).
The HHs budget constraint is
c1 (1 + c1 ) +

e2
c2
(1 + c2 ) = e1 +
.
1+r
1+r

Step 1: Find the HHs consumption allocation for some arbitrary (c1 , c2 )
max u(c1 ) + u(c2 )
c1 ,c2

s.t.
c1 (1 + c1 ) +

c2
e2
(1 + c2 ) = e1 +
.
1+r
1+r

The HHs optimal choice should satisfy

u0 (c1 ) = (1 + r)

1 + c1 0
u (c2 )
1 + c2

and the lifetime budget constraint.

One can see that the optimal (c1 , c2 ) will be functions of (c1 , c2 ). Denote the consumers optimal choice
(c1 (c1 , c2 ), c2 (c1 , c2 )). These functions describe the equilibrium consumption choice of the HH as a
function of (c1 , c2 ).
1

 With log utility, we obtain c1 (c1 , c2 ) =

1
(1+)(1+c1 )

e1 +

e2
1+r

and c2 (c1 , c2 ) =

(1+r)
(1+)(1+c2 )

e1 +

e2
1+r

Step 2: The government will choose the tax rates (c1 , c2 ) to maximize the households utility subject
to satisfying the PV government budget constraint. In doing so, it will take into account the HHs
consumption response (c1 (c1 , c2 ), c2 (c1 , c2 )) as it contemplates over tax rates to select.
The problem of the government is then
max u(c1 (c1 , c2 )) + u(c2 (c1 , c2 ))

c1 ,c2

subject to
c1 (c1 , c2 )c1 +
Log: First define P V e = e1 +

e2
1+r

G2
c2 (c1 , c2 ) 2
c = G1 +
.
1+r
1+r

and P V G = G1 +

G2
1+r .

1. Some special (restrictive) cases in which there is only one feasible tax choice:
(a) c1 = c2 = : In this case, the budget constraint for the government becomes




1
e2

e2
G2
,
e1 +
+
e1 +
= G1 +
(1 + )(1 + )
1+r
(1 + )(1 + )
1+r
1+r
which gives
=

PV G
.
PV e PV G

(b) c1 = 0 and c2 > 0: In this case, the budget constraint for the government becomes



e2
G2
e
+
2 = G1 +
,
1
(1 + )(1 + c2 )
1+r c
1+r
which gives
c2 =

(1 + )P V G
.
P V e (1 + )P V G

2. If we want to find the optimal combination of tax rates (c1 , c2 ), we need to solve the problem
max u(c1 (c1 , c2 )) + u(c2 (c1 , c2 ))

c1 ,c2

subject to
c2 (c1 , c2 ) 2
G2
c = G1 +
.
1+r
1+r
Inserting the consumers consumption choices into the problem above, we obtain
c1 (c1 , c2 )c1 +


max log

c1 ,c2

1
(1 + )(1 + c1 )

e2
e1 +
1+r




+ log

(1 + r)
(1 + )(1 + c2 )

e2
e1 +
1+r



subject to
1
(1 + )(1 + c1 )


e1 +

e2
1+r

c1 +

(1 + r)
(1 + )(1 + c2 )


e1 +

e2
1+r

1
G2
2 = G1 +
.
1+r c
1+r

The consumers problem becomes


log
max
1 2

c ,c

1
1 + c1


+ log

1
1 + c2

+ a constant that does not depend on 0 s

subject to
c1
c2
PV G
+
= (1 + )
.
1
1 + c
1 + c2
PV e
Subtract both sides of the budget constraint from 1 + to obtain



PV G
1
+
= (1 + ) 1
.
1 + c1
1 + c2
PV e
Letting x =

1
1+c1

and y =

1
1+c2 ,

we can rewrite the problem as

max log(x) + log(y) + a constant

x,y

subject to


PV G
.
x + y = (1 + ) 1
PV e
Setting up the Lagrangian, we obtain 1/x = and /y = , which implies that x = y, thus c1 = c2 =
. Inserting this to the governments budget constraint, we obtain
=

PV G
.
PV e PV G

We found that it is optimal to have the same consumption tax rate in both periods. Why is this
optimal? By imposing the same tax rate, the government avoids creating distortions in consumptionsavings decision of the consumer. If the taxes were distortionary, i.e. if the consumer could avoid taxes
by changing her consumption allocation, she would strategically change her allocation to avoid taxes,
which would result in a less efficient allocation. Since the consumer cannot avoid taxes by changing her
consumption choices when the consumption tax in both periods are the same, she chooses the efficient
allocation.
Note that any feasible tax choice of the government has to satisfy PV govnt budget constraint
c1 (c1 , c2 )c1 +

c2 (c1 , c2 ) 2
G2
c = G1 +
.
1+r
1+r

Note also that any feasible choice (c1 , c2 ) (not necessarily the optimal choice) of the consumer has to
satisfy
c2
e2
c1 (1 + c1 ) +
(1 + c2 ) = e1 +
.
1+r
1+r
When consumer makes her choice, she faces this budget line. The optimal choice of the consumer on
the other hand has to satisfy both this budget constraint and the governments budget constraint above
(since the govnt bases its policies on the consumers optimal choice). That is
c1 (c1 , c2 )(1 + c1 ) +
and
c1 (c1 , c2 )c1 +

c2 (c1 , c2 )
e2
(1 + c2 ) = e1 +
1+r
1+r
c2 (c1 , c2 ) 2
G2
c = G1 +
.
1+r
1+r
3

Substracting the second from the first constraint, we obtain

c1 (c1 , c2 ) +

c2 (c1 , c2 )
e2
G2
= e1 +
G1
.
1+r
1+r
1+r

The last expression is called the resource constraint for the economy, which states that the present
value of consumers consumption and government spending has to be equal to present value of income.
Important point to notice is that the resource constraint holds at the optimal consumption choice of
the consumer, not necessarily in any other point of the consumers budget constraint (unless in special
cases in which the resource constraint and consumers budget constraint are identical, which happens
with lump-sum taxes for example).
The analysis above show how to obtain equilibrium allocation. In particular, the equilibrium allocations
(c1 (c1 , c2 ), c2 (c1 , c2 )) and tax policy (c1 , c2 ) have to satisfy
1. The consumers budget constraint:
c1 (1 + c1 ) +

e2
c2
(1 + c2 ) = e1 +
.
1+r
1+r

2. The economys resource constraint:

c1 +

c2
e2
G2
= e1 +
G1
.
1+r
1+r
1+r

3. The consumers optimality (tangency) condition:

u0 (c1 ) = (1 + r)

1 + c1 0
u (c2 ).
1 + c2

First best allocation: We know that the equilibrium consumption allocation under any feasible
government policy has to satisfy the economys resource constraint. Thus, if we maximize the consumers
utility subject to economys resource constraint, we obtain the first best allocation, which gives the
maximum possible utility that can be achieved by the best government policy. Note that not all
government policies can achieve this first best. With lump-sum taxes, we know that the consumers
budget constraint becomes exactly the same as the economys resource constraint. Thus, the first best
allocation is achieved when the government uses lump-sum taxes. Figure 1 illustrates the first best
allocation.
Examples:
1. c1 = c2 = : In this case, the consumers budget constraint is
c1 (1 + ) +

c2
(1 + ) = P V e
1+r

Rewriting, we obtain
PV e
.
1+
Note that this budget constraint has the same slope as the economys resource constraint. Since
the consumers optimal consumption choice has to be on both the consumers budget constraint
and the economys resource constraint, the only possible case is that the two constraints overlap as
in Figure 2. Thus, when the consumption tax is the same in both periods, the first best allocation
is achieved.
c2 = (1 + r)c1 + (1 + r)

2. c1 = 0 and c2 > 0: The consumers budget constraint is given by

c2 =

1+r
1+r
c1 +
P V e.
2
1 + c
1 + c2

Note that this constraint has a flatter slope than the economys resource constraint. The equilibrium consumption allocation is given by point E in figure 3. Figure 3 also illustrates the first best
allocation (denoted by F B). It can be seen that the consumption allocation with this particular
tax system generates a lower utility than the first best allocation.

Redistributive tax policy example

Question: Consider a static (one-period) economy with two types of households, who differ in their wage
rates. i represents the household type (i {1, 2}). There are equal number of each type. Household i
earns wage rate wi . Assume that w2 > w1 . The preference of each household is given by Ui = log(ci n2i ),
where ci is the consumption and ni is the labor supply of household i. The government wants to implement
a redistribution policy. For this purpose it taxes labor income of both households at rate l and gives
back a lump-sum transfer T to both households. Thus, the consumption of household i is given by ci =
(1 l )wi ni + T . There is no government expenditure and the government budget balances, i.e. the total
labor income tax collected is equal to the total lump-sum transfer distributed. The government cares both
types of households equally, that is, it aims to maximize the sum of the utility of both types of households.
a. Show that the optimal l (and thus T ) is positive.
b. Show that the optimal policy in part (a) redistributes income from the high earner (i = 2) to the low
earner (i = 1).
c. Find the first best allocation that the government can possibly achieve.
d. Is the first best allocation redistributive relative to the laissez-faire (the equilibrium allocation without
government interntion, i.e. with l = 0 and T = 0)?
e. Can the policy in part (a) achieve the first best allocation? Explaing why.
TRY TO SOLVE THIS QUESTION WITHOUT LOOKING AT THE ANSWER. UNDERSTANDING THE SOLUTION IS NEVER ENOUGH.

Answer:
a. Step 1: Solve the problem of each household for a given policy (l , T ). Household is problem is given by
Ui (l , T )

max log(ci n2i )

(1 l )wi ni + T.

ci ,ni

s.t.
ci

We will denote the optimal consumption and leisure choices of household i by ci (l , T ) and ni (l , T )
respectively. The solution to the problem above gives
ni (l , T ) =

(1 l )wi
2

and

(1 l )2 wi2
+ T.
2
Step 2: Given ci (l , T ) and ni (l , T ), the govenment maximizes the sum of the utilities of both households subject to the government budget constraint. Note that the government bases its decisions taking
into account how the households responds to its tax policy. Thus, the governments budget is given by
ci (l , T ) =

2T = w1 n1 (l , T )l + w2 n2 (l , T )l .
The left hand side of the expression above is the total transfers distributed and the right hand side is
the total labor income tax collected.
Given ci (l , T ) and ni (l , T ), the govenments problem then is




2
2
max log c1 (l , T ) (n1 (l , T )) + log c2 (l , T ) (n2 (l , T ))
l ,T

s.t.
2T = w1 n1 (l , T )l + w2 n2 (l , T )l .
Plugging the expressions for ci (l , T ) and ni (l , T ), household is utility function becomes




(1 l )2 wi2
2
+T ,
Ui (l , T ) = log ci (l , T ) (ni (l , T )) = log
4
and the government budget constraint becomes
T =

l (1 l ) 2
w1 + w22 .
4

10

Then, the problem of the government becomes





(1 l )2 w12
(1 l )2 w22
max log
+ T + log
+T
l ,T
4
4
s.t.


l (1 l ) 2
w1 + w22 .
4
Note that we can substitute T from the budget constraint into the objective function of the government.
Then, the governments objective function becomes




(1 l )2 w12
(1 l )2 w22
log
+ T + log
+T
4
4
T =


= log








(1 l )2 w12
l (1 l ) 2
(1 l )2 w22
l (1 l ) 2
+
w1 + w22 + log
+
w1 + w22 .
4
4
4
4

Denote this objective function by W (l ). Using properties of log utility, W (l ) can be simplified to
W (l ) = 2 log(1 l ) + log(w12 + l w22 ) + log(w22 + l w12 ) 2 log(4).
Typically, we take derivative of objective function with respect to l and set it to zero in order to find the
optimal l . If you try to do this, you will see that the expression turns out to be complex. Instead, what we
could do is to look at how the derivative of the objective function behaves. We will use the following three
properties of the derivative:
1. The derivative of the objective function at l = 0 is positive, i.e
2.

d
dl W (0)

> 0 whenever w1 6= w2 .

d
dl W (l )

is decreasing in l , i.e. the second derivative of the objective function with respect to l is
negative for all values of l .

3. Finally,

d
dl W (l )

is minus infinity at l = 1.

These properties of the derivative suggest that dd l W (l ) and W (l ) are as in the following figure. That is,
there is a unique 0 < l < 1, such that dd l W (l ) = 0 and that the objective function is increasing until l
and then it is decreasing. Thus, the maximum is achieved at l = l . Thus, the optimal policy is to have a
positive l .
To prove the three properties above, take the derivative of the objective function to obtain
d
2
w2
w2
W (l ) =
+ 2 2 2 + 2 1 2.
dl
1 l
w1 + l w2
w2 + l w1
It is easy to show that properties 2 and 3 above hold. To prove property 1, evaluate
w12 w22
d
w2
w2
w4 2w12 w22 + w24
W (0) = 2 + 22 + 12 = 1
=
dl
w1
w2
w12 w22
w12 w22

d
dl W (l )

at l = 0,

2
.

Note that dd l W (0) > 0 whenever w1 6= w2 . Thus, the three properties above imply that it is optimal for the
government to impose a labor income tax and give a lump-sum transfer back to both agents.

11

12

b. To illustrate why l > 0 is a redistributive policy, first note that w2 > w1 , which implies that n2 (l , T ) >
n1 (l , T ) and thus w2 n2 (l , T ) > w1 n1 (l , T ). We will show that the low earner receives a transfer more
than the tax she pays, while the high earner receives a transfer less than the tax she pays. Thus, this
system redistributes income from the high earner to the low earner. To see this, note that the govenment
budget constraint is
2T = w1 n1 (l , T )l + w2 n2 (l , T )l .
Together with the fact that w2 n2 (l , T ) > w1 n1 (l , T ), the government budget constraint implies
that l w2 n2 (l , T ) > T > l w1 n1 (l , T ), which in turn implies that T l w1 n1 (l , T ) > 0 and T
w2 n2 (l , T ) < 0.
c. The first best allocation is obtained by maximizing the sum of utilities of both housholds subject to the
economy-wide resource constraint. Although, the economy-wide resource constraint is independent of
which tax policy the government uses, it would be convenient to derive it from the budget constraint
of the consumers and the government in part (a). For the consumers, we have c1 = (1 l )w1 n1 + T
and c2 = (1 l )w2 n2 + T , and for the government we have 2T = w1 n1 l + w2 n2 l . Adding these we
obtain the economys resouce constraint, which is
c1 + c2 = w1 n1 + w2 n2 .
(Small digression: Note that the resource constraint for the economy basically states that total expenditures on goods should be equal to total income. Here, we do not have government expenditures and
investment expenditures. Thus, government expenditures and investment expenditures do not appear
on the expenditure side.)
The first best solution is given by the solution to the following problem
max

c1 ,c2 ,n1 ,n2

log(c1 n21 ) + log(c2 n22 )

s.t.
c1 + c2 = w1 n1 + w2 n2 .
Setting up a Lagrangian, we obtain the following FOCs:
1
= ,
c1 n21
1
= ,
c2 n22
2n1
= w1 ,
c1 n21
2n2
= w2 .
c2 n22
These FOCs imply that c1 n21 = c2 n22 , n1 =

w1
2 ,

and n2 =

w2
2 .

Using these expressions and the

resource constraint for the economy, we obtain optimal consumptions are c1 =

3w12 +w22
8

d. Note that the equilibrium consumption allocations in part (a) in laissez-faire are c1 =
3w2 +w2

w2

3w2 +w2

w2

and c2 =
w12
2

3w22 +w12
.
8

and c2 =

w22
2 .

1
2
2
1
Since
> 21 and
< 22 , the first best allocation gives more consumption to the poor
8
8
household relative to what she would consume in laissez-faire and less consumption to the rich household

13

relative to what she would consumer in laissez-faire. Thus, the first best allocation is redistributive
relative to laissez-faire. This suggests that the government wants to redistribute income from rich to
poor. However, whether it can achieve the first best allocation or not depends on the type of the
policy that it uses to do redistribution. In general, since all policies in real life are distortionary, the
government cannot implement the first best allocation. See part (e) below as an example.
e. The policy in part (a) cannot achieve the first best allocation because ni = w2i under the first best
allocation, but ni = (1 l ) w2i (with l > 0) under the optimal policy in part (a). This is because of
the fact the labor income tax distorts labor supply decision of households and it leads to a lower labor
supply than what can be achieved under the first best.

14