Dynamic Mirrlees Taxation Under Political Economy Constraints

Abstract

We study the structure of nonlinear incentive-compatible taxes, in a dynamic economy subject to political economy and commitment problems. In contrast to existing analyses of dynamic and/or nonlinear taxation problems, we relax the assumptions that taxes are set by a benevolent government and that there is commitment to policies. Instead, in our model economy taxes are set by a self-interested politician, without any commitment power. This politician is partly controlled by the citizens via elections. The resulting environment is one of a dynamic mechanism design without commitment. We focus on the best sustainable mechanism, which is the mechanism that maximizes the ex ante utility of the citizens. Towards a full characterization of the allocations implied by the best sustainable mechanism, we first prove that a version of the revelation principle applies in our environment and that attention can be restricted to direct truth-telling mechanisms. Using this result, we prove that the provision of incentives to politicians can be separated from the provision of incentives to, and from redistribution, across individuals. This also enables us to develop a method of characterizing the best sustainable mechanism as a solution to a standard dynamic mechanism design problem subject to additional political economy and commitment constraints formulated only as functions of aggregate variables. Using this formulation, we provide conditions under which distortions created by political economy and commitment problems persist or disappear in the long run. In particular, if politicians are as patient as (or more patient than) the citizens, these distortions disappear asymptotically, and they remain positive otherwise. Finally, we extend our analysis to the case where the government cares both about its own consumption and the future utility of the citizens. This extension generalizes our results to environments where the key constraint is the time-inconsistency of a (partially) benevolent government.

Keywords: dynamic incentive problems, mechanism design, optimal taxation, political economy,revelation principle

JEL Classification: H11, H21, E61, P16