Democracy or Optimal Policy: Income Tax Decisions without Commitment

Youngsoo Jang

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Commitment; Time-Consistent Policy; Political Economy; Voting (search for similar items in EconPapers)
JEL-codes: E61 H11 P16 (search for similar items in EconPapers)
Date: 2021-10
New Economics Papers: this item is included in nep-mac and nep-pbe
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https://mpra.ub.uni-muenchen.de/112503/8/MPRA_paper_112503.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/112556/1/MPRA_paper_112556.pdf revised version (application/pdf)
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https://mpra.ub.uni-muenchen.de/117190/1/Time_Consistency_UBI_v6.pdf revised version (application/pdf)

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