Political Sustainability and the Design of Environmental Taxes

This paper studies the issue of political support for environmental taxes. The environmental tax is determined by majority voting, given a refund rule that specifies the allocation of tax proceeds. The refund rule is chosen by a welfare-maximizing constitutional planner. We show that: (i) The equilibrium tax rate is increasing in the proportion of tax reductions based on wage incomes. (ii) If labor and capital income taxes are reduced in the same proportion, to keep the government's budget balanced, majority voting yields a rate of environmental taxation that is lower than the optimal (Pigouvian) level. (iii) To mitigate this negative bias, the government reduces wage taxes by a higher proportion than capital income taxes. (iv) The final outcome will either be the Pigouvian tax or else all reductions will be given in wage taxes. This depends on individuals' preferences for the polluting good as well as wage and capital income distributions.     

Fiscal equalisation schemes under competition

This paper considers optimal fiscal equalisation in a federation that competes with other federations for business tax base. It formalises the argument that, under certain circumstances, federations have an incentive to foster tax competition among their subunits in order to attract tax base from other federations. We show that optimal fiscal equalisation serves the purpose of redistributing income from rich to poor subunits and of choosing an optimal level of tax competition. The latter is chosen as a trade-off between three goals. First, decentralised tax rate setting has positive fiscal externalities within the federation and, thus, tax rates are inefficiently low. Second, in the presence of hold-up problems in investment, tax rates may be inefficiently high. Then, tax competition serves as a commitment device for low future tax rates and is, thus, welfare enhancing. Third, generous fiscal equalisation within the federation is a commitment to not aggressively compete with subunits outside the federation for tax base; as a consequence, with optimal equalisation, equilibrium tax rates are higher within and outside the federation—and even higher than in the case of centralised (i.e. federal level) tax rate setting.     

The assignment and division of the tax base in a system of hierarchical governments

Vertical externalities, changes in one level of government’s policies that affect the budget of another level of government, may lead to non-optimal government policies. These externalities are associated with tax bases that are shared or “co-occupied” by two levels of government. Here I consider whether co-occupancy of tax bases is desirable. I examine the optimal extent of the tax bases of a lower level of government (local) and a higher level (state). I find that it is optimal to have co-occupancy in the absence of other corrective policies if commodities in the tax bases are substitutes. Further, if the state government can differentially tax the co-occupied segment of the tax base and the segment it alone taxes it will obtain the (second-best) outcome obtained with other policy instruments such as intergovernmental grants.     

The effects of population aging on optimal redistributive taxes in an overlapping generations model

The impact of population aging on the steady-state solution to an Ordover and Phelps (J. Public Econ. 12:1?C26, 1979) overlapping generations optimal nonlinear income tax problem with two types of worker and quasilinear-in-leisure preferences is investigated. A decrease in the rate of population growth, which leads to an aging population, increases the relative price of consumption per person in retirement, which tends to decrease optimal consumption for retirees of both skill types. Nevertheless, it is also shown that the optimal marginal income tax rates are independent of the rate of population growth. In addition, the steady-state interest rate unambiguously declines when the rate of population growth declines. Resulting adjustments in production plans have an ambiguous effect on the aggregate wage rate. This article identifies factors contributing to an increase in the aggregate wage when the population ages, namely normality of consumption in retirement, complementarity between capital and labor in production, and a large capital deepening effect relative to the increase in dependency owing to demographic change. Depending on the sign of this wage effect, ambiguities may arise in the direction of change in the optimal steady-state consumption and production plans. However, when the dependency effect is sufficiently strong, it is possible to sign the direction of change in all production and consumption plans. Moreover, regardless of the direction of change in optimal consumption plans, the absolute value of the changes in consumption plans are smaller for low-skilled workers than for high-skilled when utility is time-separable and preferences exhibit decreasing absolute risk aversion. Adopting, instead, a quasilinear-in-consumption specification of preferences sharpens the comparative statics of consumption allocations, but introduces ambiguity into the effect of the rate of population growth on the optimal marginal income tax rate.     

The optimal commodity tax structure in a four-good model

This paper examines the structure of optimal commodity tax rates in a four-good model with nonvanishing cross-elasticities between commodities. The following optimal tax rules are obtained: (i) at the optimum, the tax rate on the commodity that is the least substitutable for leisure is higher than that on the commodity that is the most substitutable for leisure; (ii) the greater the cross-substitutability between two commodities, the closer to uniformity are the optimal commodity tax rates on those two commodities. In addition, the condition under which all commodity tax rates are ranked is identified. JEL Classification H21     

First-and second-best allocations under economic and environmental uncertainty

This paper uses a micro-founded DSGE model to compare second-best optimal environmental policy, and the resulting Ramsey allocation, to first-best allocation. The focus is on the source and size of uncertainty, and how this affects optimal choices and the comparison between second- and first-best. While higher economic volatility is bad for social welfare in all cases studied, the welfare effects of higher environmental volatility depend on its size and the effectiveness of public abatement policy. The Ramsey environmental tax is pro-cyclical when there is an economic shock, while it is counter-cyclical when there is an environmental shock.     

The optimal inheritance tax in the presence of investment in education

This paper provides an example aimed at calculating the optimal inheritance tax in a model in which inheritances are used to finance investment in education. Two results are obtained: (1) The optimal inheritance tax schedule includes a threshold, estimated between 2.5 and 5.5 times per-capita GDP. This result holds for a Rawlsian social planner that maximizes the welfare of the poorest individual, who does not leave bequests. (2) Contrary to the result of a 100 % tax on pure accidental bequests, the optimal simulated tax rates are between 28 %, for the case of educational bequests, and 57 %, for the case where educational and accidental bequests interact. This range is in line with existing schedules in developed economies.     

Non-Homothetic Preferences and the Non-Environmental Effects of Environmental Taxes

We show that, if the utility function is non-homothetic, environmental taxes can have positive non-environmental effects. These effects are illustrated with specific reference to taxes on gasoline and tobacco, in the context of a computational model. We also clarify the relationship between the double dividend (associated with a marginal change from a tax system with low reliance on environmentally motivated taxes) and the situation in which the optimal environmental tax rate is greater than the Pigouvian tax rate. These two situations are generated by rather similar combinations of parameters.JEL Code: H21, H23, D58     

The Effect of Taxes and Depreciation on Corporate Investment and Financial Leverage

This paper provides an analysis of the effect of corporate and personal taxes on the firm's optimal investment and financing decisions under uncertainty. It extends the DeAngelo and Masulis capital structure model by endogenizing the firm's investment decision. The authors' results indicate that, when investment is allowed to adjust optimally, the existing predictions about the relationship between investment-related and debt-related tax shields must be modified. In particular, the authors show that increases in investment-related tax shields due to changes in the corporate tax code are not necessarily associated with reductions in leverage at the individual firm level. In cross-sectional analysis, firms with higher investment-related tax shields (normalized by expected earnings) need not have lower debt-related tax shields (normalized by expected earnings) unless all firms utilize the same production technology. Differences in production technologies across firms may thus explain why the empirical results of recent cross-sectional studies have not conformed to the predictions of DeAngelo and Masulis.     

Optimal taxation with monopolistic competition

This paper studies optimal taxation in a Dixit–Stiglitz model of monopolistic competition. In this setting, taxes may be used as an instrument to offset distortions caused by producer markups. Since markups tend to be higher in industries where firms face less elastic demand, tax rates will be pushed lower in these industries. This tends to work against the familiar inverse elasticities intuition associated with the Ramsey tax rule. However, a key feature of the model is that the Ramsey rule responds to the industry demand curve (Chamberlin’s DD) while the monopolistic markup is a response to the demand curve faced by firms (Chamberlin’s dd). Hence, the elasticities of both these curves influence the optimal tax rate, but in opposite directions.     

Environmental policy,pollution, unemployment,and endogenous growth

The paper develops a model of endogenous economic growth with pollution externalities and a labor market distorted by union monopoly power and by taxes and transfers. We study the optimal second-best pollution tax and abatement policy and find that a shift toward greener preferences will tend to reduce unemployment, although it will hamper growth. We also find that greater labor-market distortions call for higher pollution tax rates. Finally, we show that a switch from quantity control of pollution combined with grandfathering of pollution rights to regulation via emission charges has the potential to raise employment, growth, and welfere without damaging the environment.     

Product market threats and tax avoidance

In this paper, we find that product market threats increase firms’ tax avoidance. This association is especially observed for firms that pursue tax avoidance more than their optimal target level (i.e., actively tax-avoiding firms). In addition, among these firms with active tax avoidance practices, firms with weaker corporate governance structure, lower financial flexibility, and greater predation risk are more likely to experience the positive relationship between product market threats and tax avoidance. Further evidence suggests that higher levels of tax avoidance driven by product market threats do not come with higher levels of tax uncertainty and rather positively affect firms’ profitability. This result highlights the decoupling relationship between tax avoidance and tax uncertainty.     

Fiscal policy with banks and financial frictions

We assess the role of banks to the transmission of optimal and exogenous changes in fiscal policy to the economy. We built-up a dynamic stochastic general equilibrium model with patient and impatient agents, banks and a government to find that banks and their associated capital-adequacy constraint mitigate the negative spill-over effects to the economy from higher taxes. Specifically, we confirm that labour income tax is the most distortionary fiscal instrument. The optimal choice of a housing tax is the most favorable funding source to a temporary increase in public spending. The combination of housing and labour taxes is the most preferred tax bundle to be optimally chosen under negative output shocks. Moreover, a permanent increase in housing tax is beneficial if it is welfare enhancing and the existence of banks benefits mainly impatient households under permanently higher consumption taxes. Finally, these results remain robust to various robustness checks.     

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.     

Optimal income transfers

A substantial literature addresses the design of transfer programs and policies, including the negative income tax, other means-tested transfers, the earned income tax credit, categorical assistance, and work inducements. This work is largely independent of that on the optimal nonlinear income tax, yet formulations of such a tax necessarily address how low-income individuals should be treated. This paper draws on the optimal income taxation literature to illuminate the analysis of transfer programs, including the level and shape of marginal tax rates (including phase-outs), the structure of categorical assistance, and the role of work inducements in an optimal income transfer scheme. JEL Classification H21 · H53 · I38     

Optimal Financial Transaction Taxes

This paper characterizes the optimal transaction tax in an equilibrium model of financial markets. If investors hold heterogeneous beliefs unrelated to their fundamental trading motives and the planner calculates welfare using any single belief, a positive tax is optimal, regardless of the magnitude of fundamental trading. Under some conditions, the optimal tax is independent of the planner's belief. The optimal tax can be implemented by adjusting its value until total volume equals fundamental volume. Knowledge of (i) the share of nonfundamental trading volume and (ii) the semielasticity of trading volume to tax changes is sufficient to quantify the optimal tax.     

Reserve requirements and optimal seigniorage

This note presents a model of optimizing agents who chose to hold deposits at financial intermediaries, which are required to hold fractional reserves of fiat money. When the stock of fiat money is expanded, the reserve requirement functions as a tax on deposits. The combination of reserve requirements and inflation results in a lower steady-state utility than a direct tax on deposits. The optimal monetary policy when reserves are required is to minimize reserve requirements and inflate without limit the stock of fiat money.     

Optimal tax base with administrative fixed costs

This note characterizes the optimal base for commodity taxation in the presence of administrative fixed costs varying across goods. For low tax rates, the optimal base only comprises commodities whose discouragement index is greater than the ratio of their administrative costs to the tax they yield. An illustration with UK data shows that a category of goods should be taxed only if the revenue generated on this category is at least ten times greater than its administrative fixed cost. The cost imputable to the category of goods taxed at the standard rate would be at most 6 percent of total VAT revenue. The administration cost associated with categories of goods currently tax-free could justify exemption.     

On the design of an optimal non-linear tax/pension system with habit formation

We study the optimal tax/pension design in a two-period model where individuals differ in both productivity and discount rates or projection bias and where their utility of the retirement period consumption is not independent of the earlier standard of living. We consider both welfarist and paternalistic social objectives. The paternalistic government attempts to correct the projection bias by using a higher discount factor. We derive general mathematical expressions that characterize optimal tax/pension design (marginal tax/subsidy rates). They suggest that the pattern of marginal labor income taxes depends on habit formation. Negative marginal labor income tax rates are possible. To gain a better understanding, we examine numerically the properties of an optimal lifetime redistribution policy with habit formation. We find support for non-linear tax/pension program in which some types of individuals are taxed while some are subsidized. The effect of changes in the degree of habit formation is explored in the numerical simulations as well as the implications of different degrees of correlation between skill and projection bias.     

Pollution Externalities in a Model of Endogenous Fertility and Growth

An endogenous growth model with human capital formation, pollution caused by production of consumption goods, and endogenous fertility decisions made by altruistic agents with infinite horizons is presented. Consequences for optimal policy of modelling fertility as an explicit decision variable are examined. Because ordinary lump-sum transfers to individuals are no longer neutral, either revenue from a pollution tax must be redistributed to dynasties (working as an implicit tax on child births), or lump-sum transfers must be supplemented with an explicit fertility tax. Alternatively, the government can avoid distortions of the fertility decisions by maintaining an appropriate public debt. When abatement is highly productive, it can be optimal to subsidize fertility in order to increase total production.