Optimal taxation: full-commitment versus time-consistent equilibrium

Abstract

This paper examines the properties of the optimal tax mix under different types of policy equilibria and tries to narrow the gap between what the theory suggests and what the actual data show. To do so, we use a two-period deterministic version of the standard neoclassical growth model with heterogeneous agents. In particular, we search for the socially optimal mix of taxes on capital and labour income when the government is able to commit to future policies. Then, we compare this solution to the case in which the government cannot commit to future policies. We show that the optimal tax mix is closer to the actual data in the former case. Furthermore, we show that the lack of commitment creates the incentive for a degree of capitalist bias on the part of the government.