Macroeconomics seminar - Youngsoo Jang (SUFE)
Title: Democracy or Optimal Policy: Decision on Income Tax without Commitment
Abstract: How do differences in political and commitment structure of government affect the aggregate economy, inequality, and welfare? I analyze this question, using a calibrated Ayagari economy with wealth effects of labor supply wherein a flat tax rate and transfers are endogenously determined according to its political and commitment structure. Specifically, I compare four economies: baseline economy, an economy with the optimal tax in all steady states with commitment, an economy with the optimal tax without commitment, and a political economy with sequential voting. My finding is that, without commitment, the political economy with voting brings about a better welfare outcome than the case with the optimal policy. A lack of commitment hinders the government from implementing a more frugal policy that is desirable in the long run; instead, it cares more for low-income and -wealth households, resulting in a substantial efficient loss. However, in the political economy with voting, the government considers only an interest of the median voter in the middle class, who is reluctant to take more enormous distortions from a higher tax rate and larger transfers. This mechanism alleviates efficiency loss, leading to a better welfare outcome than the optimal policy without commitment.