Optimal Taxes under Private Information: The Role of Inflation

• Published date: 01 October 2022
• Author: PEDRO GOMIS‐PORQUERAS,CHRISTOPHER WALLER
• Date: 01 October 2022
• DOI: http://doi.org/10.1111/jmcb.12965

DOI: 10.1111/jmcb.12965

PEDRO GOMIS-PORQUERAS

CHRISTOPHER WALLER

Optimal Taxes under Private Information: The Role

of Ination

Once explicit information available to the taxing authority and incentives

associated with private information problems are explicitly taken into ac-

count, only a limited set of policy instruments are consistent with agents not

engaging in side trades. Within this spirit, we study the role of taxes and in-

ation in minimizing the dead-weight loss associated with the provision of

good incentivesand other market imperfections when at money is essential.

When the government has a rich information set and can observe savings,

effort, and consumption in frictionless markets, the constrained efcient al-

location can be achieved with afne history-dependent consumption taxes.

Thus, monetary policy is redundant. In contrast, when the government ob-

serves sales, rather than actual consumption, a tax arbitrage exists. Uniform

afne consumption taxes prevent side trades. We also nd that a deviation

from the Friedman rule is optimal as it helps induce truth-telling and allevi-

ate a pecuniary externality. However, optimal monetary and scal policies

in this setting cannot implement the constrained efcient allocation.

JEL codes: E40, H21

Keywords: at money, taxation, privateinformation

T     taxation posits that a

tax system should be chosen to maximize a social welfare function, while taking into

account private agents’ behavior. Within this spirit, Mirrlees (1971) emphasized the

importance of explicitly taking into account the informational asymmetries between

different tax payers and the scal authority. This is the case as optimal tax schemes

The views expressed are those of the authors and do not reect the ofcial position of the Federal

Reserve System or the Board of Governors. Weare grateful to Guillaume Rocheteau, Francesco Carli, and

Lukas Altermatt for very helpful comments. We also would liketo thank the Editor and referees for their

valuable feedback.

chris.waller@frb.gov

P G-P is School of Economics and Finance, Queensland Universityof Technology,

Brisbane, Australia (E-mail: peregomis@gmail.com) C W is at the Federal Reserve

Board (E-mail: chris.waller@frb.gov).

Received October 16, 2020; and accepted in revised form December 1, 2021.

Journal of Money, Credit and Banking, Vol. 54, No. 7 (October 2022)

© 2022 The Ohio State University.

1942 :MONEY,CREDIT AND BANKING

generically involveredistribution, which relies on individuals’ information. However,

private agents have an incentive to conceal information in order to reduce their tax

liabilities. Once these incentive problems are recognized, it is clear that only a limited

set of scal instruments are coalition proof.1Thus, given a levelof enforcement, what

can be observed by the taxing authority is key in restricting the policyinstruments that

prevent side trades. The goal of this paper is to design monetary and scal policies that

minimize the dead-weight loss associated with the provision of good incentives in an

environment where at money is essential.2In particular, we provide answers to the

following questions. When the taxing authority faces private information problems,

what sort of tax schemes can reproduce the constrained efcient social planner’s al-

location? Is ination part of the optimal tax plan? When the government has a more

restricted information set, are positive nominal interest rates part of the optimal tax

plan? In this scenario, does the ination tax lead to constrained efciency?

The study of optimal ination in environments with private information has been

previously studied in the literature. Prominent examples are those of da Costa and

Werning (2008) and Gahvaria and Micheletto (2014). In these papers, money is val-

ued because it is an argument in the utility function. As a result, they do not explicitly

take into account the informational frictions that render at money essential. These

additional frictions, together with the standard private information studied by the new

public nance literature, are likely to deliver differentrationales for optimal tax plans.

In this paper we explore how frictions that make money essential, together with pri-

vate agents’ information problems, shape optimal policies.

To answer the aforementioned questions, we enrich the overlapping generation

(OLG) monetary search framework of Zhu (2008) by considering private informa-

tion and by endowing the government with different information sets. Considering

an OLG framework is both substantive and technical. This is the case as an OLG

framework allows for intra- and intergenerational trade. It also allows for the possi-

bility that agents, when old, cannot self-insure by working. These are realistic fea-

tures that are typically not considered by the new public nance literature. Con-

sidering an OLG framework is technical in that it allows for wealth effects to be

analyzed, yet the wealth distribution is not a state variable. This greatly simplies

the analysis and allows us to draw concrete results without resorting to numerical

methods. Thus, in our environment, agents live for three periods (young, middle-

aged, and old) and can work when young and middle-aged, and retire when old.

Over their lifetime, agents trade sequentially in two different competitive markets.

Young and old agents trade a perishable good in a frictionless market, which we re-

fer to as CM. The other perishable good is only traded by middle-aged agents in a

frictional market, which we refer to as DM. Middle-aged agents experience shocks,

which are private information, making them either producers or consumers with dif-

1. We refer to Hammond (1971, 1981) for more on this important observation.

2. Essentially of money refers to a situation where its existence increases the consumption possibilities

of agents.