Tax Structure, Welfare, and the Stability of Equilibrium in a Model of Dynamic Optimal Fiscal Policy (original) (raw)

This paper shows that the assumed structure of taxation can have dramatic effects on economic welfare and the stability of the steady state in a dynamic general-equilibrium model of optimal fiscal policy. Specifically, tax structure refers to the use of separate versus uniform tax rates on labor and capital income, the level of taxation of firm dividends (single versus double taxation), and the tax treatment of depreciation. Under each tax structure, the government selects a balanced-budget fiscal policy (consisting of tax rates and the level of public expenditures) which maximizes the welfare of the representative household. We find that household welfare is highest under a tax structure that includes separate tax rates on labor and capital income, double taxation of dividends, and tax deductible depreciation. Moreover, single taxation of dividends yields an unstable steady state under a structure with separate tax rates on labor and capital income and tax deductible depreciation. This instability, which is robust to changes in parameter values, can be removed by implementing various changes to the tax structure, such as (1) imposing double taxation of dividends, (2) taxing labor and capital income at the same rate, or (3) eliminating the depreciation allowance. Of these three options, imposing double taxation of dividends yields the highest welfare. clevelandfed.org/research/workpaper/index.cfm 'see Guo and Lansing (1994) for a more detailed analysis of this aspect of tax structure in a related model.