On the Role of Commitment forTax Dynamics

Joint with: Per Krusell

We argue that in very natural settings, optimal tax dynamics involve fluctuations. We illustrate our point in a simple model of human capital accumulation where the payoffs from current effort involves a stream of future productivity improvements, as opposed to when labor

effort only gives static payoffs. Thus, the general principle of smoothing distortions, as opposed

to smoothing taxes, can actually give rise to tax fluctuations. Not being convinced that tax fluctuations characterize taxes implemented in real-world economies, we go on to argue that if the government maximizes consumer welfare but cannot commit to future tax rates, a natural

dampening, or elimination, of tax fluctuation occurs. The conclusion from this argument is that, if institutions allowing commitment could be set up, the resulting policy changes should move toward higher fluctuations in tax rates (and lower fluctuations in distortions).

For more information, contact Antonio Merlo.