Taxation without Commitment in a Heterogeneous-Agent Economy

Abstract

How do differences in the government's commitment and political structure affect the aggregate economy, inequality, and welfare? I examine this question by using a standard incomplete markets model with uninsurable idiosyncratic income risk, wherein a flat tax rate and transfers are endogenously determined according to a government's commitment and political structure. I compare the following three economies over the transitional path: an economy with the optimal tax with commitment; an economy with the optimal tax without commitment; and a political economy with sequential voting. I characterize the Markov perfect equilibria of the cases without commitment, using the generalized Euler equation that reveals the underlying economic forces behind the government's policy decision. Additionally, through quantitative exercises, I obtain two main findings. First, a lack of commitment hinders the government from managing the evolution of inequalities in the long run but instead makes it pursue more income with a lower tax rate in the short run. This incapability results in substantially lower welfare when compared to the case with commitment. Second, given a lack of commitment, the economy with sequential voting yields significantly different macroeconomic and distributional implications from the economy with the optimal policy. In the political economy, 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. Therefore, the political economy becomes more efficient but less equal, leading to a worse welfare outcome with the utilitarian criterion.

Keywords: Commitment, Time-Consistent Policy, Political Economy, Voting

JEL Classification: E61, H11, P16