Increasing Taxes After a Financial Crisis: Not a Bad Idea After All...

43 Pages Posted: 16 Dec 2018

See all articles by Christos Koulovatianos

Christos Koulovatianos

Department of Finance, University of Luxembourg

Dimitris Mavridis

Paris School of Economics (PSE); The World Bank

Date Written: November 24, 2018

Abstract

Based on OECD evidence, equity/housing-price busts and credit crunches are followed by substantial increases in public consumption. These increases in unproductive public spending lead to increases in distortionary marginal taxes, a policy in sharp contrast with presumably optimal Keynesian fiscal stimulus after a crisis. Here we claim that this seemingly adverse policy selection is optimal under rational learning about the frequency of rare capital-value busts. Bayesian updating after a bust implies massive belief jumps toward pessimism, with investors and policymakers believing that busts will be arriving more frequently in the future. Lowering taxes would be as if trying to kick a sick horse in order to stand up and run, since pessimistic markets would be unwilling to invest enough under any temporarily generous tax regime.

Keywords: Bayesian learning, controlled diffusions and jump processes, learning about jumps, Gamma distribution, rational learning

JEL Classification: H30, D83, C11, D90, E21, D81, C61

Suggested Citation

Koulovatianos, Christos and Mavridis, Dimitris, Increasing Taxes After a Financial Crisis: Not a Bad Idea After All... (November 24, 2018). Center for Financial Studies Working Paper No. 614, Available at SSRN: https://ssrn.com/abstract=3289947 or http://dx.doi.org/10.2139/ssrn.3289947

Christos Koulovatianos (Contact Author)

Department of Finance, University of Luxembourg ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

Dimitris Mavridis

Paris School of Economics (PSE) ( email )

48 Boulevard Jourdan
Paris, 75014 75014
France

The World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States
2024734750 (Phone)

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