Changes in the Composition of Tax Revenues: Implications for Monetary and Fiscal Policy
32 Pages Posted: 13 Jun 2022
Date Written: June 6, 2022
This paper examines how the composition of tax revenues affects monetary and fiscal policy interactions. To do so, we consider an environment where households' wages and interest income as well as firms' profits are taxed. To implement policy, the government follows a Taylor rule and a fiscal rule that links tax revenues to public debt. The fiscal authority also sets the long-run debt to GDP ratio as well as the tax revenue composition. In this setting, both monetary and fiscal policies directly impact the demand for government liabilities. Thus, there is a direct channel through which fiscal policy affects inflation. As a result, the evolution of inflation and real debt are not independent of each other anymore. Because taxes are distortionary, there exists a Laffer curve potentially delivering multiple stationary equilibria. We also show that the composition of tax revenues is key in determining the combinations of monetary and fiscal policies that deliver locally determinate equilibria. When calibrated to the U.S. economy, we find that a lower contribution of corporate taxes to total tax revenues expands the parameter space consistent with a unique steady state. This is especially relevant for a high debt economy. Moreover, we find that a passive monetary and active fiscal policy mix is more likely to generate unique and desirable equilibria. Furthermore, the composition of tax revenues matters for dynamics for this policy regime.
Keywords: Taxes, Interest Income, Monetary and Fiscal Policy Interactions
JEL Classification: C11, E32, E62
Suggested Citation: Suggested Citation