Distortionary Income Taxes Research Articles

Balanced-budget fiscal rules and money growth pegging

This paper analyzes the interaction between monetary policy rule and distortionary balanced-budget tax policy rules on the stability properties of a one-sector Ramsey economy. The demand of money is motivated by a fractional cash-in-advance constraint on consumption expenditures. The monetary authority pegs the money growth factor while the fiscal authority uses a distortionary income tax or a distortionary consumption tax to balances its budget. Without or with distortionary taxes, we find a unique steady state and characterize its stability. The local stability of the unique steady state, when without distortionary taxes, depends on the interplay between the share of the liquidity constraint and the intertemporal elasticity of substitution of consumption. Regardless of the distortionary tax’s implementation, we demonstrate that the introduction of a balanced-budget rule, could promote or reduce self-fulfilling expectations, which depends on the amplitude of the liquidity constraint and the slope of the tax schedule. Monetary variables tend to reduce the likelihood of local indeterminacy while fiscal instruments tend to increase it when the slope of the tax schedule is positive. Finally, based on plausible empirical values, we present a simple numerical example considering countercyclical tax rates and show that, for both income and consumption tax rates, the introduction of balanced-budget fiscal rules could be stabilizing.

Public debt, positional concerns, and wealth inequality

We consider an AK growth model with positional concerns and public debt financed by distortionary income taxes. We show that if positional concerns are not too strong, there is a threshold level of the debt-to-GDP ratio. For the debt-to-GDP ratio below this level, the economy converges to a unique egalitarian balanced-growth equilibrium, whereas if this ratio is above the threshold level, the economy eventually settles on a two-class balanced-growth equilibrium. The rate of growth in the egalitarian equilibrium is higher than that in any possible two-class equilibrium. Thus, a reduction in public debt may cause the economy to switch from the two-class regime to the egalitarian regime and accelerate growth. Our results also suggest that policies aimed at reducing initial inequality using public debt may, in fact, increase wealth inequality in the long run.

Public policy, dynamic status preferences, and wealth inequality

AbstractThis paper studies the effect of productive government spending (taxation) on aggregate savings behavior and its consequences for the dynamics of wealth inequality, taking into consideration key behavioral changes that occur during the process of economic development. Substantial empirical evidence suggests that during this process agents' preferences toward status (positional consumption) evolves according to the average wealth of the society. The sources of wealth include private capital and productive public capital, the latter financed by a distortionary income tax. This dynamic status effect impacts peoples' responses to tax policy in ways which contrast with those of the standard neoclassical model. Specifically, we find that in response to an increase in the income tax, in economies with a strong (weak) enough dynamic status effect, savings and inequality increase (decrease). Incorporating the behavioral changes to fiscal policy expands the set of mechanisms available to explain the observed variations of savings and wealth distribution dynamics that cannot be attributed to technological or other structural factors.

Labour Supply and Commuting: Implications for Optimal Road Taxes

A new paradigm for transport economists has been established: revenues of a welfare-maximising road tax should be employed to reduce the level of a distortionary income tax. An essential assumption to reach this conclusion is that the number of workdays is optimally chosen, whereas daily workhours are fixed, implying that given a road tax, workers may only reduce their commuting costs by reducing total labour supply. However, a labour supply model which also allows for optimally chosen daily hours implies that commuting costs increase daily hours, whereas the effect on total labour supply is ambiguous. This paper addresses this issue empirically by analysing the relationship between labour supply patterns and commuting distance using the socio-economic panel data for Germany between 1997 and 2007. Endogeneity of commuting distance is accounted for by using employer-induced changes in commuting distance. In line with the theoretical model developed, we find that commuting distance has a positive effect on daily hours. Our analysis does not find a negative effect of commuting distance on total labour supply, suggesting that a reduction in the income tax, as advocated in the literature, may not be necessary.

The political economy of mitigation and adaptation

Climate policies have very uneven effects in terms of their fiscal impact. While mitigation of climate change typically raises revenues, adaptation is costly to the taxpayer, and the more so, the more distortionary the tax system. Moreover, the benefits and costs of mitigation and adaptation vary across generations. In an OLG model with majority voting, we show that even in the absence of international pollution spillovers and strategic considerations, neither mitigation nor adaptation can be expected to be set efficiently. The reason is that voters have incentives to use climate policy as an instrument for redistribution. We find that these incentives depend on the underlying tax system. Furthermore, the chosen mitigation or adaptation level may be inefficiently high in a political equilibrium with a distortionary income tax system, although not simultaneously. This finding suggests that a distortionary income tax system favors one policy (mitigation or adaptation) at the expense of the other. The calibration of our model to the German economy reveals that both mitigation and adaptation are lower than their socially optimal levels.

The Political Economy of Mitigation and Adaptation

In this paper, we acknowledge that the mitigation of and adaptation to climate change have differential fiscal impacts. Whereas mitigation typically raises fiscal revenues, adaptation is costly to the taxpayer and to a greater extent the more distortionary the tax system is. In an OLG model with majority voting, we analyze how the choices of mitigation and adaptation are distorted under a lump-sum and a distortionary income tax regime. We find that whenever emissions and adaptation exhibit stock characteristics, the levels of mitigation and adaptation are chosen inefficiently low in the political equilibrium under lump-sum taxation. By contrast, the political equilibrium may entail inefficiently high mitigation or inefficiently high adaptation (but not both simultaneously) if the tax system is distortionary. A calibration of our model to the German economy shows that both mitigation and adaptation can be expected to be inefficiently low in the political equilibrium. Furthermore, the standard assumption of a lump-sum tax system when analyzing mitigation and adaptation is found to underestimate the loss in utilitarian welfare relative to a distortionary tax system, although mitigation levels are generally higher under the latter regime.

Is It Time to Raise the Gas Tax? Optimal Gasoline Taxes for Ontario and Toronto

This article uses a representative agent model and Canadian data to calculate the optimal gasoline taxes for Ontario and the Greater Toronto-Hamilton Area (GTHA) in a second-best setting with pre-existing distortionary income taxes. The results suggest a second-best optimal gasoline tax of 40.57 cents per litre in 2006 Canadian dollars for the GTHA that is much higher than the current tax rate of 24.7 cents per litre, and also higher than recently proposed increases. The resulting value is insensitive to whether the additional revenue is used to reduce taxes on income or to incrementally fund increased public transit infrastructure (the Big Move plan). However, in the absence of a regional tax, the second-best optimal gasoline tax for Ontario as a whole of 28.51 cents per litre in 2006 Canadian dollars is slightly higher than the current tax rate and in line with proposed increases.

The Second-Best Optimal Gasoline Tax for the Greater Toronto-Hamilton Area

This paper uses a representative agent model and Canadian data to calculate the optimal gasoline taxes for Ontario and the Greater Toronto-Hamilton Area (GTHA) in a second-best setting with pre-existing distortionary income taxes. The results suggest a second-best optimal gasoline tax (40.57 cents per litre in 2006 Canadian dollars) for the GTHA that is much higher than the current tax rate (24.7 cents per litre), and also higher than recently proposed increases. The resulting value is insensitive to whether the additional revenue is used to reduce taxes on income or to incrementally fund increased public transit infrastructure (The Big Move plan). However, in the absence of a regional tax, the second-best optimal gasoline tax for Ontario as a whole (28.51 cents per litre in 2006 Canadian dollars) is slightly higher than the current tax rate and in-line with proposed increases.

Public debt in a basic endogenous growth model

We work out the mechanism that makes public debt affect the allocation of resources in the long-run. To do so we analyze an AK growth model with elastic labor supply and a government sector. The government levies a distortionary income tax and issues bonds to finance lump-sum transfers and non-distortionary public spending. We show that the long-run growth rate is the smaller the higher the debt ratio if the government adjusts public spending to fulfill its inter-temporal budget constraint. If the government adjusts lump-sum transfers the public debt ratio does not affect the balanced growth rate.

Public Debt in a Basic Endogenous Growth Model

In this note we work out the mechanism that makes public debt affect the allocation of resources in the long-run. To do so we analyze an AK growth model with elastic labour supply and a government sector. The government levies a distortionary income tax and issues bonds to finance both lump-sum transfers and non-distortionary public spending. We show that the long-run growth rate is the smaller the higher the debt ratio if the government adjusts public spending to meet its intertemporal budget constraint. If the government adjusts lump-sum transfers to fulfill its intertemporal budget constraint the public debt ratio does not affect the balanced growth rate.

Moving U.S. Climate Policy Forward: Are Carbon Taxes the Only Good Alternative?

This paper estimates the welfare costs of the main medium-term options for significantly reducing U.S. energy-related carbon dioxide (CO2) emissions, including carbon taxes and cap-and-trade systems applied economy-wide and to the power sector only, and an emissions rate standard for power generation. The key theme is that welfare costs depend importantly on how policies interact with distortions in the economy created by the broader fiscal system. If allowance rent is not used to increase economic efficiency, economy-wide cap-and-trade systems perform the worst on cost-effectiveness grounds. In contrast, if revenues are used to substitute for distortionary income taxes (either directly, or indirectly through deficit reduction), economy-wide carbon taxes (or auctioned allowance systems) may have (slightly) negative costs. The bottom line is that revenues or rents created under economy-wide, market-based carbon policies must be used to increase economic efficiency to ensure that these instruments are more cost-effective than regulatory or sectoral approaches.

Labour Supply and Commuting

A new paradigm for transport economists has been established: revenues of a welfare-maximising road tax should be employed to reduce the level of a distortionary income tax. An essential modelling assumption to reach this conclusion is that the number of workdays is optimally chosen, whereas daily workhours are fixed, implying that given a road tax, workers may only reduce their commuting costs by reducing total labour supply. However, a labour supply model which also allows for optimally chosen daily hours implies that commuting costs increase daily hours, whereas the effect on total labour supply is ambiguous. This paper addresses this issue empirically by analysing the relationship between labour supply patterns and commuting distance using the socio-economic panel data for Germany between 1997 and 2007. Endogeneity of commuting distance is accounted for by using employer-induced changes in commuting distance. In line with the theoretical model developed, we find that commuting distance has a positive effect on daily hours. Our analysis does not find a negative effect of commuting distance on total labour supply, suggesting that a reduction in the income tax, as advocated in the literature, may not be necessary.

Social Insurance and Redistribution with Moral Hazard and Adverse Selection*

Abstract Rochet (1991) showed that with distortionary income taxes, social insurance is a desirable redistributive device when risk and ability are negatively correlated. This finding is re‐examined when ex post moral hazard and adverse selection are included, and under different informational assumptions. Individuals can take actions influencing the size of the loss in the event of accident (or ill health). Social insurance can be supplemented by private insurance, but private insurance markets are affected by both adverse selection and moral hazard. We study how equity and efficiency considerations should be traded off in choosing the optimal coverage of social insurance when those features are introduced. The case for social insurance is strongest when the government is well informed about household productivity.

The Jamaican Parliament and Public Spending

This paper presents a Jamaican dynamic political economy theory of public spending, taxation and debt. Policy choices are made by a Jamaican legislature consisting of representatives elected by geographically-defined areas. The legislature can raise revenues via a distortionary income tax and by borrowing. These revenues can be used to finance a Jamaican national public good and area-specific transfers (interpreted as Jamaican pork-barrel spending-scarce benefits and spoils). The value of the Jamaican public good is stochastic (non-deterministic), reflecting shocks such as civil disturbances or natural disasters such as hurricanes or earthquakes or floods. In equilibrium, Jamaican policy-making cycles between two distinct regimes: 1. BAU business-as-usual in which legislators bargain over the allocation of scarce benefits and spoils and 2. RPM responsible-policy-making in which policies maximize the collective good of the Nation. Transitions between the two regimes in Jamaica are brought about by shocks in the value of the public good. In the long run, equilibrium tax rates are too high and too volatile, public good provision is too low and debt levels are too high. In Jamaica, a balanced budget requirement could improve citizen welfare.

Empirical Estimates for Environmental Policy Making in a Second-Best Setting

This study estimates parameters necessary to calculate the optimal second-best gasoline tax, most notably the cross-price elasticity between gasoline and leisure. Prior work indicates that in a second-best setting with distortionary income taxes, both the cost of environmental regulation and the optimal environmental tax rate depend crucially on the cross-price elasticity between a polluting good and leisure. However, no prior study on second-best environmental regulation has estimated this elasticity. Using household data, we find that gasoline is a relative complement to leisure, and thus that the optimal gasoline tax is significantly higher than marginal damages the opposite of the result suggested by the prior literature. Following this approach to estimate cross-price elasticities with leisure for other major polluting goods could strongly influence estimates of optimal environmental taxes.

Social Insurance and Redistribution with Moral Hazard and Adverse Selection

Rochet (1989) showed that with distortionary income taxes, social insurance is a desirable redistributive device when risk and ability are negatively correlated. This finding is reexamined when ex post moral hazard and adverse selection are included, and under different informational assumptions. Individuals can take actions influencing the size of the loss in the event of accident (or ill health). Social insurance can be supplemented by private insurance, but private insurance markets are affected by both adverse selection and moral hazard. We study how equity and efficiency considerations should be traded off in choosing the optimal coverage of social insurance when those features are introduced. The case for social insurance is strongest when the government is well informed about household productivity.

The Humean Critique of Lump Sum Taxation (or the Implausibility of Pure Lump Sum Taxes in Autocracy)

This paper revives Hume's idea that it is unlikely forsovereign governments to implement pure lump-sum taxationbecause lump-sum taxes are arbitrary. We phrase the problem asone of time-inconsistency of tax collection for a tax revenuemaximizing Leviathan government. We demonstrate that whilelump-sum taxation is more efficient than distortionary incometax in terms of the ex ante amount of tax revenueraised, honoring a lump-sum tax is less likely to be crediblethan honoring a distortionary income tax. We also extend theframework to understanding the relationship betweenexpropriation risk and the lack of foreign direct investment.

Optimal fiscal and monetary policy under sticky prices

This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing nominal non-state-contingent bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates) the optimal volatility of inflation is near zero. Second, small deviations from full price flexibility induce near random walk behavior in government debt and tax rates. Finally, price stickiness induces deviation from the Friedman rule.

Optimal Fiscal And Monetary Policy Under Sticky Prices

This paper studies optimal .scal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy without capital. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk-free bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates)the optimal volatility of in.ation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce near random walk behavior in government debt and tax rates, as in economies with real non-state-contingent debt only. Finally, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule.

Optimal fiscal policy in open economies with labour market distortions

We set up a general equilibrium model with unemployment owing to distortions in the labour market. It is shown that a public expansion, financed by a distortionary income tax, may give rise to a decrease in unemployment. Even if public goods are pure waste, such an expansion may give rise to an increase in welfare if it is associated with a decrease in unemployment. Since part of the gain from a fiscal expansion is achieved at the expense of welfare in other countries, non-cooperative policies tend to be too expansionary.