The Jointly Optimal Inflation Tax, Income Tax Structure, and Transfers

The welfare-maximizing income tax structure, rate of money creation, and amounts of intergenerational transfers are jointly determined for given rates of government consumption. When government consumption is zero, it is found for the parameter values examined that the income tax structure is progressive, the rate of money change is negative, and positive transfers are made to the old. As government consumption increases, the tax structure’s progressivity declines and turns increasingly regressive, the rate of money change rises, and transfers decrease. It is found that the bulk of the increase in government consumption is optimally financed by a cut in transfers. *The author thanks Dan Chin for his capable research assistance. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Suppose government consumption permanently increases. Should greater or diminished use be made of the inflation tax? Should the income tax be made more or less progressive? Should intergenerational transfers be increased or decreased? In this paper the answers to all three of these questions are jointly determined. The model used for analysis is the third in a progression. The first in the progression, Miller (1984), assumed a real economy with serially independent shocks to technology. The second, Miller (1993a), extended the original model by incorporating endogenously valued fiat money in fixed supply. The model in the current paper extends the model in Miller (1993a) in three ways by allowing 1. positive rates of government consumption, 2. nonzero rates of money growth, and 3. serial correlation in the technology shocks. With the exception of these noted differences, the economic environment of all three models is the same. The general modeling approach taken here shares many attributes of other modern approaches to public finance. The model is general equilibrium with explicit description of endowments, production processes, information availability, market structure, government policies, and individual optimization problems. The general equilibrium approach offers at least three advantages over a macroeconomic approach. First, it assures internal consistency of behavioral functions, since they are all derived within a common economic environment. Second, behavioral relations are invariant to changes in policy rules, that is, the model is not subject to the Lucas critique, because individual decision rules explicitly depend on the policy rules. Third, the policy objectives can be stated in terms of individual welfare. This follows because the utilities of all individuals can be determined as functions of their consumption and leisure.