Distortionary Taxes Research Articles

Optimal Taxation with Endogenous Default under Incomplete Markets

How are the optimal tax and debt policies affected if the government can default on its debt? We address this question from a normative perspective in an economy with noncontingent government debt, domestic default, and labor taxes. On one hand, default prevents the government from incurring future tax distortions associated with servicing the debt. On the other hand, default risk gives rise to endogenous credit limits that hinder the government's ability to smooth taxes. We characterize the fiscal policy and show how the option to default alters the near–unit root component of taxes in the economy with risk-free borrowing. (JEL D52, E62, H21, H24, H63)

Sharing the dividend tax credit pie: The influence of individual investors on ex-dividend day returns

Taxes create distortions in financial markets. A tax credit attached to dividend payments in Australia creates a wedge in valuations as it can be utilized only by certain investors. Individual investors, who benefit most from the credit, buy aggressively cum-dividend and sell aggressively ex-dividend, demanding liquidity from institutional investors. Stocks with higher net purchases by individual investors operating through discount brokers in the cum-dividend period have ex-day returns that are 25 bps lower. The tax distortion allows individual investors to capture the tax credit and institutional investors to increase trading profits. Individual investor trading influences ex-dividend pricing.

The determination of public debt under both aggregate and idiosyncratic uncertainty

We use an analytically tractable, heterogeneous-agent incomplete-markets model to show that the Ramsey planner's decision to finance stochastic public expenditures implies a departure from tax smoothing and an endogenous mean-reverting force to support positive debt growth despite the government's precautionary saving motives. Specifically, the government's attempt to balance the competing incentives between its own precautionary saving (tax smoothing) and households' precautionary saving (individual consumption smoothing)—even at the cost of extra tax distortion—implies an endogenous, soft lower bound on the stochastic unit-root dynamics of optimal taxes and public debt.

DOUBLE DIVIDEND REVISITED: NON-REVENUE NEUTRAL TAX REFORMS

The rebound effect requires a rethink of revenue recycling. It is this that this paper offers an alternative to mitigate this effect. Specifically, we adapt and extend the consumption-neutral tax reform of Haibara (Journal of Globalization and Development, 8, 1–11, 2017) to include pollution externalities. Unlike a revenue-neutral tax reform, this reform increases welfare irrespectively of the level of intercommodity tax distortions. With consumption-neutral schemes, exogenous energy efficiency improvements induce higher taxes on the dirty good consumption. Such tax hikes improve welfare more than would be the case in their absence. Consumption-neutral reforms can translate economic costs into a negative rebound effect and increase the first dividend. The double dividend is welcome but need not be a policy priority.

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.

A Comparative Mathematical Study of the Relationship Between Marginal Social Cost and Pigouvian Tax in the Presence of Commodity and Wage Taxes: Putting Ramsey theorem into Practice

The aim of this paper is to examine the relationship between Pigouvian tax and marginal social cost in the presence of distortionary taxes such as commodity and wage taxes in a Ramsey setting. The Ramsey theory highlights the amount of tax required to raise a given revenue for the government which also maximizes household utility. Previous research in this regard has been carried out either under homogeneous household preferences or constant marginal social cost. In this paper we go further by analyzing the relationship between Pigouvian tax and marginal social cost in the presence of commodity taxes when households have heterogeneous preferences as opposed to being assumed homogeneous. In addition, we also consider the relationship between Pigouvian tax and marginal social cost in the presence of wage tax when the marginal social cost is considered as a variable depending on Pigouvian tax as opposed to being considered a constant in previous literature. The results indicate that the Pigouvian tax in the presence of wage tax is higher when the marginal social cost was considered a variable as opposed to a constant. Under certain conditions, in the presence of commodity taxes it was observed that the value of the Pigouvian tax is higher when households have heterogeneous preferences as opposed to homogeneous preferences. The mathematical models used in this study enable to see the factors, such as homogeneity/heterogeneity of household preferences and marginal social cost assumed as a variable as opposed to a constant, that impact the dynamics in determining the optimal Pigouvian tax.
 Keywords: Ramsey Theory, Pigou Tax, Marginal Social Cost, Lagrange Multiplier

FDI and firm productivity in host countries: The role of financial constraints

This paper studies the effect of FDI firms’ financial advantages on firm productivity in host countries and examines the related policy implications. If FDI firms face lower financing costs but have higher fixed production costs than local firms, a simple Melitz-type model predicts that FDI firms could have even lower cutoff productivity than local firms, especially in financially vulnerable sectors. The same mechanism will also lower the average productivity of FDI firms especially in financially vulnerable sectors, although FDI firms on average are still more productive than local firms. These predictions are supported by the Chinese firm-level data. Then, we study policy implications in a two-country model that resembles these empirical patterns. The counterfactual policy analysis shows that offering tax benefits to FDI firms could be counterproductive because it attracts FDI firms that are even less productive than local firms. The policy in the host country to improve its financial market efficiency could also hurt the country’s welfare because of the interaction between financial market reforms and the distortionary taxes imposed on local firms to finance FDI subsidies.

Promoting education under distortionary taxation: equality of opportunity versus welfarism

A common claim in the policy discourse is that a government wishing to achieve equality of opportunity should use public provision of education for equalisation of opportunities rather than income taxation, which only equalizes incomes. We develop a framework in which the tax and education provision rules in the welfarist and non-welfarist/equality of opportunity cases can be transparently compared. We show that in addition to education policies, progressive taxation also plays a role in achieving equality of opportunity, and illustrate how its use may differ under the two objectives. We also show how the provision of public education depends on how private education choices respond, potentially differentially by higher- and lower-income families.

Tax smoothing and optimal inflation persistence in RBC monetary models revisited

This article re-examines the optimality of tax smoothing and optimal inflation persistence in the context of monetary models with cash constraints where the Friedman rule is not optimal. I consider distortionary taxes on either consumption or labor income. As a consequence of the non-optimality of the Friedman rule, the Ramsey-optimal policy features a tax rate volatility that is orders of magnitude larger than the cornerstone tax-smoothing result of the standard Ramsey literature. The Ramsey results also imply an optimal inflation rate that is much more persistent than the existing results. When all consumption goods are subject to a cash constraint, purposeful tax and interest rate volatilities are used to smooth wedges. Therefore, in contrast to the widely accepted view in the literature that in RBC models wedge smoothing implies tax smoothing, this paper shows that this is not necessarily true. I also discuss the Ramsey problem in the context of the cash-credit goods framework with non-homothetic preferences where neither tax-smoothing nor wedge smoothing result necessarily holds when the Friedman rule ceases to be optimal.

How Does the Deferral of a Distortive Tax Affect Overproduction and Asset Allocation?

Deferred income taxation is widely used to encourage investment or saving. However, most income tax bases are more or less distortive (non-neutral). Using lab experiments, we find that the deferral of a distortive income taxation can result in substantial overproduction and less willingness to take risks. Subjects underweight the deferred tax burden and neglect the tax distortion because they act myopically and tend to make choices in isolation rather than simultaneously (choice bracketing). Despite opportunities to learn, the overproduction remains substantial. Additional analyses confirm that the observed misperception of deferred taxes is not caused by low tax salience or low effort, as providing additional accounting information on deferred taxes and introducing accountability reports do not change overproduction behavior. Only if we change the timing of the taxation from deferred to an economically equivalent immediate distortive tax system do overproduction and the effect on asset allocation almost disappear.

Optimal Carbon Tax in DSGE Models with Distortionary Taxation

Optimal Carbon Tax in DSGE Models with Distortionary Taxation

Generalized Compensation Principle

Economic disruptions (techonological change, trade liberalization, immigration flows) generally create winners and losers, i.e., wage gains for some individuals and wage losses for others. The compensation problem consists of designing a reform of the existing income tax system that offsets the wefare losses by redistributing the gains of the winners. We derive a closed-form formula for the compensating tax reform and its impact on the government budget when only distortionary tax instruments are available and wages are determined endogenously in general equilibrium. We apply this result to the compensation of automation in the U.S. and Germany.

Inflation’s role in optimal monetary-fiscal policy

We address the optimal marginal source of financing shocks that raise fiscal needs in the presence of a maturity structure for nominal government debt, distortionary taxes, and sticky prices. We find: (1) the importance of innovations in current and expected inflation that revalue debt increases with both the average maturity and the level of debt; (2) an analytical trade off between inflation and output-gap stabilization as a function of debt maturity; (3) at current debt levels and maturity lengths in advanced economies, inflation would account for as much as 50 percent of marginal optimal financing; (4) maturity attenuates welfare losses from nominal rigidities.

Time-inconsistent optimal quantity of debt

A key property of the Aiyagari-type heterogeneous-agent models is that the equilibrium interest rate of public debt lies below the time discount rate. This fundamental property, however, implies that the Ramsey planner’s fiscal policy may be time-inconsistent because the forward-looking planner would have a dominant incentive to issue plenty of debt such that all households are fully self-insured against idiosyncratic risk. But such a full self-insurance allocation may be paradoxical because, to achieve it, the optimal labor tax rate may approach 100% and aggregate consumption may approach zero. This is puzzling from an intuitive perspective because near the point of full self-insurance the marginal gains of increasing debt should be less than the marginal costs of financing the debt under distortionary taxes. We show that this puzzling behavior originates from the assumption that the planner must commit to future plans at time zero. Under such a full commitment, the Ramsey planner opts to exploit the low interest cost of borrowing to front-load consumption by sacrificing future consumption in the long run because future utilities are heavily discounted compared to the inverse of the interest rate on government bonds. We demonstrate our points analytically using a tractable heterogeneous-agents model featuring non-linear preferences and a well-defined distribution of household wealth.

Comparative Mathematical Study of the Relationship Between Marginal Social Cost and Pigouvian Tax in the Presence of Commodity and Wage Taxes: Putting Ramsey Theorem into Practice

The aim of this paper is to examine the relationship between the Pigouvian tax and marginal social cost in the presence of distortionary taxes such as commodity and wage taxes in a Ramsey setting. The Ramsey theory highlights the amount of tax required to raise a given revenue for the government which also maximizes household utility. Previous research in this regard has been carried out either under homogeneous household preferences or a constant marginal social cost. In this paper we go further by analyzing the relationship between Pigouvian tax and marginal social cost in the presence of commodity taxes when households have heterogeneous preferences as opposed to being assumed homogeneous. In addition, we also consider the relationship between Pigouvian tax and marginal social cost in the presence of wage tax when the marginal social cost is considered as a variable depending on Pigouvian tax as opposed to being considered a constant in previous literature. The results indicate that the Pigouvian tax in the presence of wage tax is higher when the marginal social cost was considered a variable as opposed to a constant. Under certain conditions, in the presence of commodity taxes it was observed that the value of the Pigouvian tax is higher when households have heterogeneous preferences as opposed to homogeneous preferences. The mathematical models used in this study enable to see the factors, such as homogeneity/heterogeneity of household preferences and marginal social cost assumed as a variable as opposed to a constant, that impact the dynamics in determining the optimal Pigouvian tax.
 Keywords: Distortionary tax, Ramsey theory, Pigou tax, Marginal social cost, Lagrange multiplier

Inequality and growth in the twenty‐first century

AbstractThis paper analyzes how economic growth can be caused by changes in the income distribution. Persson and Tabellini (1994, The American Economic Review, 84, 600‐621) argue that productivity‐induced income inequality leads to lower growth since distortionary taxes increase and harm capital accumulation. However, this prediction is often challenged empirically. This paper distinguishes between capital income inequality and inequality induced by differences in labor productivity. Greater capital income inequality leads to lower labor tax rates, leading to higher growth. Using data for OECD countries, subsequent growth is found to be positively related to capital income inequality, and negatively related to labor income inequality, as originally conjectured.

Fiscal Policy And the Nominal Term Premium

AbstractWe estimate a New Keynesian model on postwar U.S. data with the generalized method of moments using either constant or time‐varying debt and distortionary labor income taxes. We show that accounting for government debt and distortionary taxes help the New Keynesian model match the level of the nominal term premium with a lower relative risk‐aversion than typically found in the literature.

The macroeconomics of automation: Data, theory, and policy analysis

The decline in middle-wage occupations and rise in automation over the last decades are at the center of policy discussions. We develop an empirically relevant general equilibrium model that features endogenous labor force participation, occupational choice, and automation capital. We use the model to consider two types of policies: the retraining of workers who were adversely affected by automation, and redistribution policies that transfer resources to these workers. Our framework emphasizes general equilibrium effects such as displacement effects of retraining programs, complementarities between the factors of production, and the effects of distortionary taxation that is required to fund these programs.

A fiscal perspective on nominal GDP targeting

AbstractThis paper studies fiscal policy in a model with nominal gross domestic product (GDP) targeting. We find that, with wage rigidity, nominal GDP targeting generates lower welfare losses than inflation targeting and a Taylor rule. On the other hand, adopting this regime makes standard fiscal policy rules, whereby distortionary tax rates are designed to respond to economic activity, dependent on the behavior of inflation instead. We also find that the fiscal multipliers with nominal GDP targeting are smaller than the multipliers under inflation targeting and the Taylor rule. Therefore, nominal GDP targeting does not necessarily outperform other monetary policy rules.

The Government in SNA-Compliant DSGE Models

Abstract The government size in developed economies expanded remarkably after the Second World War. This growth shaped the role of the government as a key player in the economic activity and the aggregate dynamics of a country. However, the way in which the government is represented in DSGE models is often reductive, containing homogeneous public spending and a few distortionary taxes without clear counterparts in fiscal data. This paper shows how dynamic general equilibrium models can incorporate a detailed government sector as defined in the System of National Accounts (SNA). This government features six types of public expenditures (i.e. the government’s intermediate consumption, public wage bill, debt service, public investment, and transfers to households both in-kind and other-than-in-kind), and five distortionary taxes (i.e. consumption tax, capital and labor income taxes, corporate tax and social contributions).