On the Optimality of the Friedman Rule with Heterogeneous Agents and Nonlinear Income Taxation

Abstract

We study the optimal inflation tax in an economy with heterogeneous agents subject to nonlinear taxation of labor income. We find that the Friedman rule is Pareto efficient when combined with a nondecreasing labor income tax. In addition, the optimum for a utilitarian social welfare function lies on this region of the Pareto frontier. The welfare costs from inflation are bounded below by the area under the demand curve. (c) 2008 by The University of Chicago. All rights reserved..

The Friedman rule in an overlapping-generations model with nonlinear taxation and income misreporting

“…Interestingly, they show that the Friedman rule is optimal in their setting (for any social welfare function that redistributes from the rich to the poor). As with Chari et al's (1991Chari et al's ( , 1996 earlier result, da Costa and Werning's (2008) …nding is also related to the uniform taxation result in public …nance, albeit a di¤erent one. Whereas Chari et al (1991Chari et al ( , 1996 draw on Sandmo's tax uniformity (1974) result derived within a Ramsey setting, da Costa and Werning's (2008) has its roots in Atkinson and Stiglitz (1976).…”

“…As with Chari et al's (1991Chari et al's ( , 1996 earlier result, da Costa and Werning's (2008) …nding is also related to the uniform taxation result in public …nance, albeit a di¤erent one. Whereas Chari et al (1991Chari et al ( , 1996 draw on Sandmo's tax uniformity (1974) result derived within a Ramsey setting, da Costa and Werning's (2008) has its roots in Atkinson and Stiglitz (1976). This classic paper on the design of tax structures was particularly concerned with the usefulness of commodity taxes in the presence of a general income tax in economies with heterogeneous agents.…”

“…da Costa and Werning's (2008) results as well as the earlier Chari et al's (1991Chari et al's ( , 1996 results are all derived in settings that disregard tax evasion. Yet many empirical studies over the past few decades con…rm that tax evasion is a widespread phenomenon all over the world; see Shaw et al (2011) for a recent survey.…”

“…In da Costa and Werning (2008) the uniformity result, which implies a zero nominal interest rate, holds with preference separability. With non-separable preferences, da Costa and Werning assume that real cash balances and labor supply are complements so that cash balances should be subsidized.…”

“…5 A second related drawback of these studies is their reliance on the Ramsey tax framework, which assumes that all tax instruments, including the income tax, are set linearly. 6 In a recent contribution, da Costa and Werning (2008) break with this tradition and consider the optimality of the Friedman rule in a model with heterogeneous agents and allow the government to levy nonlinear income taxes. Interestingly, they show that the Friedman rule is optimal in their setting (for any social welfare function that redistributes from the rich to the poor).…”