Distortionary Taxation, Debt, and the Price Level

This paper compares the determinacy of equilibria under exogenous interest rates in an economy with a cash constraint, in which taxation is lump-sum or distortionary. Under passive fiscal policies lump-sum taxes generate nominal indeterminacy, while with distortionary taxes indeterminacy can be real, but not purely nominal. In general, under distortionary taxation uniqueness of the equilibrium allocation depends on monetary and fiscal policy interactions through taxes, debt, and interest rates. To illustrate this principle, we consider balanced-budget policies under distortionary income taxation and show that a unique equilibrium allocation prevails if interest rates are set consistent with long-run deflation. A separate section extends the analysis to endogenous interest rates.     

Taxes and stabilization in contemporary macroeconomic models

The role of proportional and procyclic labor income taxes for automatic stabilization with stochastic productivity is analyzed in a contemporary macroeconomic model based on imperfect competition. The importance of short-run nominal wage rigidity for the effectiveness of progressive taxes on labor income for stabilizing output and raising household welfare is examined in a model that yields complete analytical solutions with stochastic output shocks. Increasing the procyclicity of labor income tax rates raises welfare with and without rigid nominal wages in the model economy. With fully flexible prices and wages, a positive covariance between the distortionary tax rate and productivity reduces the volatility of production and employment. This effect disappears under nominal wage rigidity, although progressive taxation can still raise welfare by reducing the distortion caused by a proportional labor tax. With rigid nominal wages and flexible consumer goods prices, payroll taxes levied at rates that rise with output can serve as automatic stabilizers. JEL Code E62 · H20     

Financing Public Goods with Income Taxation: Provision Rules vs. Provision Level

Due to the use of distortionary taxation, many believe that real-world economies should attain a lower level of public expenditures than in a situation where lump-sum taxes are available. The present paper examines this hypothesis by means of the two-type self-selection model of income taxation. Based on the findings of Boadway and Keen (1993), I provide sufficient conditions for both a lower and a higher level of public expenditures in second best than in first best. In particular, it is shown that the separability assumption of Christiansen (1981) leads to under-provision of the public good in the income tax optimum.     

The marginal cost of public funds is one at the optimal tax system

This paper develops a Mirrlees framework with skill and preference heterogeneity to analyze optimal linear and nonlinear redistributive taxes, optimal provision of public goods, and the marginal cost of public funds (MCF). It is shown that the MCF equals one at the optimal tax system, for both lump-sum and distortionary taxes, for linear and nonlinear taxes, and for both income and consumption taxes. By allowing for redistributional concerns, the marginal excess burden of distortionary taxes is shown to be equal to the marginal distributional gain at the optimal tax system. Consequently, the modified Samuelson rule should not be corrected for the marginal cost of public funds. Outside the optimum, the marginal cost of public funds for distortionary taxes can be either smaller or larger than one. The findings of this paper have potentially important implications for applied tax policy and social cost–benefit analysis.     

The Marginal Cost of Public Funds in Closed and Small Open Economies

The efficiency cost of taxation has become an increasingly important consideration in the evaluation of alternative tax policy options. This paper provides a review of estimates of the efficiency costs of taxation and presents some new estimates for small open economies. The available studies suggest that, in closed economies, the distortions from taxation are highest for corporate taxes and lowest for wage taxes. This efficiency ranking of different taxes does not hold in small open economies. It is shown that, in a small open economy, this ranking is reversed. Personal income taxes are less distortionary than wage taxes primarily because the link between domestic saving and investment is severed. Corporate taxes are also less distortionary for a variety of factors, such as changes in depreciation levels, payments to foreigners and terms of trade.     

BAD taxation: Disintermediation and illiquidity in a bank account debits tax model

This paper uses a dynamic general equilibrium model to study the economic effects of bank account debits (BAD) taxation. Australia and various Latin American countries have levied or levy BAD taxes. Aspects such as financial disintermediation, market illiquidity, and impacts on dividend and interest rates are considered. Part of the BAD tax revenue may be fictitious, due to increased interest payments on government debt. The Brazilian BAD tax (CPMF) experience is evaluated. The empirical analysis confirms some theoretical predictions. Incidence base over GDP appears to be sensitive to the tax rate, possibly engendering a Laffer curve. The tax may also cause real interest rates to increase. Furthermore, the deadweight losses are relatively large, even if revenues are small. The theoretical and empirical results suggest that the BAD tax is not adequate for revenue collection. JEL Code E62 · H20     

Environmental taxation and the double dividend: A reader's guide

There has been considerable debate as to whether the revenue-neutral substitution of environmental taxes for ordinary income taxes might offer a double dividend: not only (1) improve the environment but also (2) reduce certain costs of the tax system. This paper articulates different notions of double dividend and examines the theoretical and empirical evidence for each. It also connects the double-dividend issue with principles of optimal environmental taxation in a second-best setting.A weak double-dividend claim-that returning tax revenues through cuts in distortionary taxes leads to cost savings relative to the case where revenues are returned lump sum-is easily defended on theoretical grounds and (thankfully) receives wide support from numerical simulations. The stronger versions contend that revenueneutral swaps of environmental taxes for ordinary distortionary taxes involve zero or negative gross costs. Theoretical analyses and numerical results tend to cast doubt on the strong double-dividend claim, although the theoretical case is not air-tight and the numerical evidence is mixed.     

Tax Holidays and the International Capital Market

The paper shows how a tax holiday may signal to a skepticalcapital market that the future level of taxation will be moderate.After the signal has informed investors that the host countrygovernment is a low-spender, the tax profile flattens out, correspondingto a tax reform stage. Contrary to the recent literature on taxholidays, this model assumes that: the capital market is perfectlycompetitive; sunk costs are captured by a convex cost function,instead of fixed costs; taxation is distortionary, not lump-sum;and the government maximizes a welfare function rather than taxrevenue.     

Gender-based and couple-based taxation

In this paper, I explore the optimal taxation of singles and couples in an economy with bargaining couples. The government is concerned with the redistribution of income from individuals with high utility to individuals with low utility, recognizing that some individuals live in couple households where resources are unevenly distributed. I analyze how redistributive linear income taxes, which depend on either gender or household composition (or both) impact the distribution of utility within and across households. An interesting implication arising from the interaction between the model elements is that even though between-group lump-sum transfers always favor women, when the bargaining power of men is high, women are subject to a higher tax rate; this in contrast to previous analyses of gender-based taxation. My quantitative analysis demonstrates that the welfare effects of gender-based taxation are sizable and even larger when taxes depend on the composition of the household.     

Comparing the top and the bottom income earners: Distribution of income and taxes in the United States

Tax reform is again at the center stage as Congress grapples with ideas to reduce the US budget deficit and the country readies itself for another election year. Given this unusually charged tax reform season, populist and party rhetoric appears to the general population to have largely replaced reasoned debate as politicians, economists and pundits “cherry pick” facts to justify their claims. Our contribution to the current debate on tax equity is that this is one of the very few studies that jointly consider the impact of payroll and income taxes. Most tax equity studies focus only on the federal income tax and as such issue misleading implications. It is important to jointly consider payroll and income taxes because (a) for taxpayers in lower income ranges, the payroll tax burden outweighs the income tax burden, while (b) for higher income taxpayers income from wages above $106,800 ($110,000 in 2012) are payroll-tax free, and (c) other sources of income, namely dividends and capital gains, are not subject to payroll taxes at all. Thus, we provide a more comprehensive picture of the overall progressivity (or lack thereof) exhibited by the current tax laws. In addition, we also consider how some often-raised tax proposals would prospectively affect income inequality and tax progressivity.     

Optimal commodity taxation with duty-free shopping

International travellers are frequently offered the opportunity to purchase a certain quantity of goods duty-free. Individuals differ in their opportunities to benefit from duty-free shopping, and we focus on the implications of these differences for optimal commodity taxation within a version of the optimal tax model of Mirrlees (Review of Economic Studies, 38, 175–208, 1971). We show how duty-free alters the constraints on the use of commodity taxes to reduce the distortionary costs of income taxation or to reflect externalities. Beyond characterising optimal taxes in the duty-free regime, we discuss conditions under which allowing duty-free would increase or reduce social welfare.      

Effective labor taxation and the international location of headquarters

Profit taxes are widely acknowledged to influence the location of firms’ headquarters. This paper sheds light on the role of aspects of labor taxation for the international location of headquarters. While profit taxes can be avoided in various ways, it is much harder for firms to manipulate the firm-specific labor tax base so that labor taxes may be relatively important for firm location. We construct a unique data set of effective labor taxes in 120 countries and use data on the location of 35,206 firms to analyze the impact of labor income tax rates, the progressivity of the income tax schedule, and social security contributions on firms’ decisions where to locate their headquarters. The findings suggest that both a higher progressivity of the tax system and higher (employee- and employer-borne) social security contributions negatively influence a country’s attractiveness for headquarters location. Hence, a one percentage point increase in these payroll taxes, reduces the probability of a country to attract headquarters by 6.1 %. The results prove robust in various empirical model specifications and subsets of the data.     

Voting on Pensions with Endogenous Retirement Age

It is often argued that the observed trend towards early retirement is due mainly to the implicit tax imposed on continued activity of elderly workers. We study the relevance of such a distortion in a political economy model with endogenous age of retirement. The setting is a two-period overlapping generations model. Individuals differ in their productivity. In the first period they work a fixed amount of time; in the second, they choose when to retire and then receive a flat rate pension benefit. Pensions are financed by a payroll tax on earnings in the first and in the second period of life. Such a tax is non distortionary in the first period; it is distortionary in the second period. We allow for some rebating of the second period tax. Individuals vote on the level of the payroll tax given the rebate which can range from 0 (biased system) to 100% (neutral system). We provide sufficient conditions for the existence of a voting equilibrium and study its properties. Under these conditions, high tax rates are supported by all the old and by low productivity young individuals. We show that the pivotal voter is a young individual. The number of young individuals who have higher wage than the pivotal voter equals half the total population. We also show that the introduction of a bias increases the political support for the pension system. Finally, we study the simultaneous determination of the bias and the tax rate through a voting procedure and show that the equilibrium (if any) implies a bias which is always positive and may or not be larger than one.     

Fiscal Policy and the Terms of Trade in an Analytical Two-Country Dynamic Model

This paper presents a two-country dynamic perfect foresight Ricardian model with wealth effects to study the relationship between government spending financed by alternative taxation, the terms of trade and welfare. An increase in domestic government spending financed by a distortionary capital income tax leads the real exchange rate initially to appreciate (a pure demand effect). But along the transitional path an intertemporal terms of trade effect (a supply side effect) operates and the real exchange rate depreciates to a steady state value ultimately higher relative to the initial equilibrium. The welfare of the domestic resident increases due to a reversed immiserizing growth effect.     

Prospects for Agricultural Land Taxation in Developing Countries

Countries that collect tax revenue from the agricultural sectorthrough export taxes, marketing boards, and overvalued domesticcurrencies are often loath to abandon these distorting policiesbecause of the consequent revenue loss. One potential alternativeis to replace these distortionary taxes with a land tax, whichwould not depress output prices or discourage foreign exchangeearnings and which could be, in theory, a highly progressivetax. The advantages and disadvantages of a land tax are examinedtheoretically and using the specific experiences of Bangladesh,Argentina, and Uruguay. It is concluded that the land tax isnot necessarily more efficient than other types of taxes; theAchilles Heel of land taxation is administration; progressivetax rates based on land holdings are nearly impossible to administer;land taxes have been ineffective at promoting nonrevenue goals;political support by farmers is necessary to implement the tax;and the most promising prospects for a moderate land tax systemare in financing local, rather than central, government expenditures.     

Environmental Tax Reform in a Small Open Economy With Structural Unemployment

The paper examines the effects of an environmental tax reform in a small open economy with decentralised wage bargaining, monopolistically competitive firms and equilibrium unemployment. There is a tradable and a non-tradable sector and all firms use labour as well as an imported polluting factor of production (energy). A key result is that a tax on energy, recycled to reduce the payroll tax, reduces unemployment if there is a tradable sector wage premium. However, even if energy taxes may boost employment, welfare will not necessarily improve. Numerical simulations suggest that energy taxes in general provide an environmental dividend but also reduce real GDP.     

Monetary-fiscal policy interactions and the price level:Background and beyond

The paper presents the fiscal theory of the price level in a variety of models, including endowment economies with lump-sum taxes and production economies with proportional income taxes. We offer a microeconomic perspective on the fiscal theory by computing a Slutsky-Hicks decomposition of the effects of tax changes into substitution, wealth, and revaluation effects. Revaluation effects arise whenever tax changes alter the value of outstanding nominal government liabilities by changing the price level. Under certain assumptions on monetary and fiscal behavior, the revaluation effect reflects the fiscal theory mechanism. When taxes distort, two Laffer curves arise, implying that a tax increase can lower or raise the price level and the revaluation effect can be positive or negative, depending on which side of a particular Laffer curve the economy resides. Jel Code: E31 · E52 · E62     

Fiscal Externalities and Efficient Transfers in a Federation

This paper investigates properties of the second best allocation in a fiscal federal system in which both federal tax and intergovernmental grants are involved and the taxation is distortionary. Also, optimal federal grants and tax policies in a decentralized fiscal system are examined. Our major findings are: (i) the second best does not require the equalization of marginal cost of public funds across regions in a conventional form; (ii) matching grants based on either the local tax rates or tax revenues should be introduced to internalize the tax externality; and (iii) once lump-sum and matching grants are optimized, federal tax policy becomes redundant so the optimal fiscal gap is indeterminate.     

The optimal mix of taxes on money,consumption and income

We determine the optimal combination of taxes on money, consumption and income in transactions technology models where exogenous government expenditures must be financed with distortionary taxes. We show that the optimal policy does not tax money, regardless of whether the government can use as alternative fiscal instruments an income tax, a consumption tax, or the two taxes jointly. These results are at odds with recent literature. We argue that the reason for this divergence is an inappropriate specification of the transactions technology adopted in the literature.     

Labor tax reform, unemployment, and search

A key obstacle to reducing payroll taxes in many industrialized and transition countries is the direct revenue loss to the government that it implies. This paper studies a simple and practical labor tax reform of reducing a payroll tax and increasing a progressive wage tax that keeps the marginal tax wedge unchanged. Such a strategy increases employment, reduces the equilibrium unemployment rate, and increases public revenue as long as workers do not have all the bargaining power in wage negotiations. Moreover, welfare rises if workers’ bargaining power is sufficiently large to exceed a critical value determined by the second-best Hosios condition.