Changes in the Composition of Tax Revenues: Implications for Monetary and Fiscal Policy

Abstract

This paper examines how changes in the composition of tax revenues affect monetary and fiscal policy interactions. We do so in an environment where households’ wages and interest income as well as firms’ profits are taxed. As in other non Ricardian economies, government debt becomes relevant for long run and local inflation dynamics. In addition, when interest income is taxed, there is a direct channel through which fiscal policy affects inflation. The extent of such effect cannot be assessed without explicit reference to all fiscal considerations. In this paper we quantitatively evaluate how compositional changes in tax revenues between households and firms and also within households affect the nature of long run equilibria as well as inflation and debt dynamics. When calibrated to the U.S. economy, we find that the composition of households’ tax revenue matters. When households face no taxes on interest income, there always exists a unique steady state and standard monetary and fiscal policy prescriptions hold. This is not the case when interest income is taxed. Moreover, we find that a lower share of corporate to total tax revenues expands the parameter space consistent with unique and locally determinate equilibria and better stabilizes the economy when a fiscal shock is experienced. Furthermore, a Fiscal-led regime is more likely to generate desirable equilibria. Finally, our findings suggest that when the government follows a Fiscal-led regime, ignoring the increasing debt levels and lower shares of corporate and interest income taxes that the U.S. is about to face due to Covid-19 is likely to overestimate the impact of monetary and fiscal policy shocks. This is not the case when the government follows a Monetary-led regime.

Keywords: Taxes, Interest Income, Monetary and Fiscal Policy Interactions.