Optimal Tax Policy

This chapter examines the optimal time path of the tax rate in a simple proportional tax structure, where an increasing ratio of government debt to GDP is projected in the absence of any policy changes. The projection model of Chapter 3, extended to allow for uncertainty in Chapter 5, is used. A constraint on policy choices is imposed by the need to ensure fiscal sustainability over the longer term, and the disincentive effects of high tax rates. The chapter analyses the optimal time path of the proportional income tax rate, although other adjustments are briefly considered. Decision making is complicated by the existence of considerable uncertainty, and the fact that costs imposed in one period, including excess burdens, cannot be reversed by subsequent tax rate adjustments. In this chapter, an independent judge maximises an evaluation function defined over a range of characteristics of the economy over a finite projection period. The implications of adopting various value judgements are considered.