Democracy or Optimal Policy: Income Tax Decisions without Commitment

Jang, Youngsoo (2021): Democracy or Optimal Policy: Income Tax Decisions without Commitment.

Abstract

How do differences in the government’s political and commitment structure affect the aggregate economy, inequality, and welfare? I analyze this question, using a calibrated Aiyagari’s (1994) economy with wealth effects of labor supply wherein a flat tax rate and transfers are endogenously determined according to its political and commitment structure. I compare four economies: a baseline economy, an economy with the optimal tax with commitment in all steady states, an economy with the optimal tax without commitment, and a political economy with sequential voting. I obtain two main findings. First, the commitment structure shifts the government’s weighting between redistribution and efficiency. A lack of commitment leads the government to pursue a more redistributive policy at the expense of efficiency. Second, given a lack of commitment, the political economy with voting yields greater welfare than the economy with the time-consistent optimal policy. In the latter case, a lack of commitment hinders the government from implementing a more frugal policy desirable in the long run; instead, it cares more for low-income and wealth households, resulting in a substantial efficient loss. However, in the political economy with voting, 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 and larger transfers. These findings imply that in terms of welfare, policies targeting the middle class would possibly be better than those exquisitely designed for the general public.

• 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

References

Aiyagari, S Rao, “Uninsured idiosyncratic risk and aggregate saving,” The Quarterly Journal of Economics, 1994, 109 (3), 659–684.

and Dan Peled, “Social insurance and taxation under sequential majority voting and utilitarian regimes,” Journal of Economic Dynamics and Control, 1995, 19 (8), 1511–1528.

Barro, Robert J and David B Gordon, “Rules, discretion and reputation in a model of monetary policy,” Journal of monetary economics, 1983, 12 (1), 101–121.

Calvo, Guillermo A, “On the Time Consistency of Optimal Policy in a Monetary Economy,” Econometrica, 1978, 46 (6), 1411–1428.

Carroll, Christopher D, “The method of endogenous gridpoints for solving dynamic stochastic optimization problems,” Economics letters, 2006, 91 (3), 312–320.

Conesa, Juan Carlos, Sagiri Kitao, and Dirk Krueger, “Taxing capital? Not a bad idea after all!,” American Economic Review, 2009, 99 (1), 25–48.

Corbae, Dean, Pablo D’Erasmo, and Burhanettin Kuruscu, “Politico-economic consequences of rising wage inequality,” Journal of Monetary Economics, 2009, 56 (1), 43–61.

Farhi, Emmanuel, Christopher Sleet, Ivan Werning, and Sevin Yeltekin, “Non-linear capital taxation without commitment,” Review of Economic Studies, 2012, 79 (4), 1469–1493.

Greenwood, Jeremy, Zvi Hercowitz, and Gregory W Huffman, “Investment, capacity utilization, and the real business cycle,” The American Economic Review, 1988, pp. 402–417.

Haan, Wouter J Den, “Assessing the accuracy of the aggregate law of motion in models with heterogeneous agents,” Journal of Economic Dynamics and Control, 2010, 34 (1), 79–99.

Heathcote, Jonathan, Kjetil Storesletten, and Giovanni L Violante, “Presidential Address 2019: How Should Tax Progressivity Respond to Rising Income Inequality?,” Journal of the European Economic Association, 2020, 18 (6), 2715–2754.

Holter, Hans A, Dirk Krueger, and Serhiy Stepanchuk, “How do tax progressivity and household heterogeneity affect Laffer curves?,” Quantitative Economics, 2019, 10 (4), 1317–1356.

Jang, Youngsoo, “Credit, Default, and Optimal Health Insurance,” Available at SSRN 3429441, 2020.

Kim, Heejeong, “Inequality, disaster risk, and the great recession,” Review of Economic Dynamics, 2021.

Klein, Paul and Jos´e-V´ıctor R´ıos-Rull, “Time-consistent optimal fiscal policy,” International Economic Review, 2003, 44 (4), 1217–1245.

, Per Krusell, and Jose-Victor Rios-Rull, “Time-consistent public policy,” The Review of Economic Studies, 2008, 75 (3), 789–808.

Krusell, Per and Anthony A Smith Jr, “Income and wealth heterogeneity in the macroeconomy,” Journal of political Economy, 1998, 106 (5), 867–896.

and Jose-Victor Rios-Rull, “On the size of US government: political economy in the neoclassical growth model,” American Economic Review, 1999, 89 (5), 1156–1181.

,Vincenzo Quadrini, and Jose-Victor Rios-Rull, “Are consumption taxes really better than income taxes?,” Journal of monetary Economics, 1996, 37 (3), 475–503.

Kydland, Finn E and Edward C Prescott, “Rules rather than discretion: The inconsistency of optimal plans,” Journal of political economy, 1977, 85 (3), 473–491.

Reiter, Michael, “Recursive computation of heterogeneous agent models,” manuscript, Universitat Pompeu Fabra, 2002, pp. 28–35.

, “Solving the incomplete markets model with aggregate uncertainty by backward induction,” Journal of Economic Dynamics and Control, 2010, 34 (1), 28–35.

Rouwenhorst, K Geert, “Asset Pricing Implications of Equilibrium Business Cycle Models. In: Cooley, T.F. (Ed.),” in “Frontiers of business cycle research,” Princeton University Press, 1995, pp. 294–330.

Song, Zheng, Kjetil Storesletten, and Fabrizio Zilibotti, “Rotten parents and disciplined children: A politico-economic theory of public expenditure and debt,” Econometrica, 2012, 80 (6), 2785–2803.

Wu, Chunzan and Dirk Krueger, “Consumption insurance against wage risk: Family labor supply and optimal progressive income taxation,” American Economic Journal: Macroeconomics, 2021, 13 (1), 79–113.