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A Ramsey Theory of Financial Distortions
The return on government debt is lower than that of asset with similar payoffs. We study optimal debt management and taxation when the government cannot directly redistribute towards the agents in need of liquidity but otherwise has access to a complete set of linear tax instruments. Optimal government debt provision calls for gradually closing the wedge between the returns as much as possible, but tax policy may work as a countervailing force: as long as financial frictions bind, it can be optimal to tax capital even if this magnifies the discrepancy in returns.