Fiscal Progressivity and the Time Consistency of Monetary Policy

This paper studies how progressive fiscal policy influences the conduct of monetary policy in a tractable heterogeneous agent economies. A priori, progressive labor taxation is undesirable because it generates costly distortions. Nonetheless, it is an effective instrument to mitigate the inflation bias of monetary policy because it achieves a redistributive purpose. I analyze this commitment channel of progressive labor taxes through the lens of political conflicts. When agents vote on monetary and fiscal instruments, progressivity is decisive in curbing the inflation bias because it generates distributional conflicts, lower-productivity agents support higher labor taxes to preserve the consumption value of money holding and shift the burden of policy distortions to higher-productivity agents. Anticipating the reduction in inflation, agents unanimously desire to adopt a progressive fiscal system.