Tax Collection Costs, Tax Evasion and Optimal Interest Rates

Abstract

I investigate to what extent the cross-country variation in nominal interest rates can be explained as being due to governments' optimal response to economic conditions such as tax collection costs, tax evasion and government consumption needs. In particular, I study the effects of costly income taxes in the presence of an informal sector on the solution to a Ramsey problem in a general equilibrium framework. Unlike most of the previous analyses of optimal inflationary finance, the model postulates that conventional taxes carry collection costs whereas fiat money can be printed costlessly. Using estimates of tax collection costs and tax evasion reported in the literature, I calculate the optimal interest rate based on the model. Comparison of the actual and optimal interest rates demonstrates that the model can in fact partly explain the observed deviations from the Friedman Rule. Furthermore, allowing cross-country differences in the elasticity of substitution between formal and informal sectors can increase the model's explanatory power.