The Complexity of Economic Policy: I. Restricted Local Optima in Tax Policy Design

23 Pages Posted: 27 May 2002

See all articles by Gilles Saint-Paul

Gilles Saint-Paul

University of Toulouse I - GREMAQ-IDEI; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute); IZA Institute of Labor Economics

Multiple version iconThere are 2 versions of this paper

Date Written: April 2002

Abstract

Economists traditionally tackle normative problems by computing optimal policy, i.e. the one that maximizes a social welfare function. In practice, however, a succession of marginal changes to a limited number of policy instruments are implemented, until no further improvement is feasible. I call such an outcome a "restricted local optimum". I consider the outcome of such a tatonnement process for a government which wants to optimally set taxes given a tax code with a fixed number of brackets. I show that there is history dependence, in that several local optima may be reached, and which one is reached depends on initial conditions. History dependence is stronger (i.e. there are more local optima), the more complex the design of economic policy, i.e. the greater the number of tax brackets. It is also typically stronger, the greater the interaction of policy instruments with one another; which in my model is equivalent to agents having a more elastic labor supply behavior. Finally, for a given economy and a given tax code, I define the latter's average performance as the average value of the social welfare function across all the local optima. One finds that it eventually sharply falls with the number of brackets, so that the best performing tax code typically involves no more than three brackets.

Keywords: Complexity, Optimal Taxation, Bounded Rationality, Learning, Multiple Equilibria, Path Dependence

JEL Classification: H2, H21, J22

Suggested Citation

Saint-Paul, Gilles, The Complexity of Economic Policy: I. Restricted Local Optima in Tax Policy Design (April 2002). IZA Discussion Paper No. 480. Available at SSRN: https://ssrn.com/abstract=310365

Gilles Saint-Paul (Contact Author)

University of Toulouse I - GREMAQ-IDEI ( email )

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IZA Institute of Labor Economics

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