Taxation without Commitment in a Heterogeneous-Agent Economy

Jang, Youngsoo (2022): Taxation without Commitment in a Heterogeneous-Agent Economy.

Abstract

How do differences in the government's political and commitment structure affect the aggregate economy, inequality, and welfare? I examine this question using a standard incomplete markets model with uninsurable idiosyncratic income risk, wherein a flat tax rate and transfers are endogenously determined according to its political and commitment structure. I compare three economies over the transitional path: an economy with the optimal tax with commitment, an economy with the optimal tax without commitment, and a political economy with sequential voting. Using the generalized Euler equation, I characterize the Markov perfect equilibria of the cases without commitment. Additionally, through quantitative exercises, I obtain two main findings. First, a lack of commitment hinders the government from managing the evolution of inequalities in the long run but instead makes it pursue more income with a lower tax rate in the short run. This incapability results in substantially lower welfare in the case without commitment. Second, given a lack of commitment, the economy with sequential voting yields significantly different macroeconomic and distributional implications from the economy with the optimal policy. In the political economy, the government considers only the interests of the median voter, who is middle class and reluctant to bear larger distortions from a higher tax rate. Therefore, the political economy becomes more efficient but less equal, leading to a worse welfare outcome with the utilitarian criterion.

• Item Type: MPRA Paper
• Language: English
• Keywords: Commitment, Time-Consistent Policy, Political Economy, Voting
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination; H - Public Economics > H1 - Structure and Scope of Government > H11 - Structure, Scope, and Performance of Government; P - Economic Systems > P1 - Capitalist Systems > P16 - Political Economy

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