Wednesday, January 2, 2013

A Public Finance Dilemma

I am doing much more research on the output-gap elasticity problem of the deficit. One of the interesting findings I have encountered along the way is a dilemma for public finance:

In an economy with high pre-tax income inequality, the policy maker faces a trade-off between after-tax income inequality and income tax revenue volatility. In an economy with low pre-tax income inequality, there is no such trade-off.

A short explanation: Given high pre-tax income inequality, the policy maker which chooses to use the tax system to redistribute and reduce after-tax income inequality will draw a large share of income tax revenues from the high end of the income distribution. This end also sees high volatility of income; therefore income tax revenues will be highly volatile.


  1. Fortunately for the Americans, the US doesn't have particularly high pretax income inequality....

    Quick look at precisely this:

  2. High after-tax income inequality doesn't matter that much; what matters is low inequality after taxes and benefits. With a very progressive, inefficient tax code, and a limited, not very progressive welfare state, America gets the worst of both worlds.

    However, I don't think tax revenue volatility is all that much of a problem. If the deficit is very responsive to the business cycle, then we can just call that automatic stabilisers - it's not as if government borrowing to smooth spending over the cycle is particularly expensive.

    That said, while high income tax revenue volatility isn't economically costly, it might have damaging effects on political economy. We saw this in 2000, when the mostly-cyclical Clinton surplus was spent on tax cuts only to find that it was never going to last anyway. We're seeing it again now, when the large deficit is being used as an excuse to cut spending. So tax revenue might lead to a) suboptimal long-term economic policy and b) spending volatility. And those ARE problems we should be worried about.

    Overall I think whether you want to have flatter taxes and a stronger, more progressive welfare state or very progressive taxes but a smaller welfare state depends very much on the relative economic damage caused by distortionary taxes vs distortionary welfare benefits. And that's an empirical question I can't really answer.

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  4. Evan, whilst I agree that there is a trade off between income tax volatility and wealth reallocation, it is very much secondary to considerations of total tax receipts and the broader economic effects of changing the nature of taxation (which I'd argue is necessary to preserve total tax receipts without crippling low/mid income earners). I'm just not sure whether in practice, you can reduce income tax volatility without reducing total tax receipts. However, I'd argue that by maintaining the current, volatile, tax system through growth years, and coupling it with a budget surplus, you can reduce the effects of income tax volatility on the deficit; not by reducing deficit volatility but by reducing the downside to that volatility.

    A fuller response is here :

  5. Evan,

    I don't think you go far enough in examining this issue. Tax volatility at the high-end stems largely from two sources, which could be labeled bonus volatility (in ordinary income largely) and capital gain volatility (reported mostly as capital gains, but also impacting option proceeds that are treated as ordinary income). My guess is that capital gain volatility is a more important source of overall volatility as its a function of capital market performance and is somewhat discretionary in its timing. Lastly, the discretionary timing of capital gains is also a function of changing taxes rates as investors anticipate changes (cap gains will surprise to the upside in 2012 for this reason).

    This characterization implies some obvious policy remedies such as lower reliance on capital gains taxes and more on income taxes and more stable tax policy. Lastly, steadier economic growth (NGDP targeting) would lead likely lead to less capital market volatility that would flow through as less tax revenue volatility.