Reducing Distortions

Reducing Distortions from Taxes Suppose a government faces a large expense today and can tax labor income to pay for it. One option is to increase income taxes today by a lot to finance this expense. This would cause a reduction in labor supply and thus in employment and real gross domestic product (GDP). This distortion in labor supply is an economic cost of the tax. Alternatively, the government could increase taxes a little bit today and a little bit in future years. This spreads out the tax over many years and leads to less distortion. The government budget constraint tells us that the government can spread out taxes by borrowing new and levying taxes later to pay off the debt. If the government had access to a nondistortionary tax instead of income taxes, it would be better to use that tax instead. For a tax not to be distortionary, it must be the case that economic decisions (how much to buy and sell, how much labor to supply, etc.) do not change when the tax changes. At first glance, it seems that the inflation tax might fit the bill. Remember the inflation tax makes people’s existing stocks of money worth less in real terms. People have already decided how much money to hold. So if the government levies an inflation tax, it is not distortionary; people have already made their decisions on how much money they want to own. But there is a danger here. Our argument rests on the idea that the decisions about which assets to hold have already been made by households. The inflation tax might be nondistortionary the first time that the government tried it. But people would rapidly come to anticipate that the government would be likely to use it again. At that point they would start changing their decisions about how much money to hold, and the tax would be distortionary after all.