4  Distortionary taxation

Economic objective

The economic objective of tax smoothing is to minimise the economic value of the deadweight losses of taxation.

The motivation for this objective is that taxes, due to their involuntary nature, create incentives for taxpayers to substitute away from taxed activities toward activities that are not taxed, or are taxed at lower marginal rates. If the taxed activities would otherwise be worthwhile, the substitution reduces welfare and creates a deadweight loss. An appropriate policy objective is to minimise the deadweight losses of taxation subject to satisfying the Crown’s inter-temporal budget constraint (IBC).[8]

Key insights for policy

The literature shows that detailed conclusions about alternative policies depend on the assumptions made regarding departures from the other Ricardian conditions, e.g. whether capital markets are imperfect and/or incomplete and whether citizens alter their other wealth portfolios response to changes in the Crown balance sheet. These are discussed below.

Though not analysed specifically in the literature, the shape of the deadweight loss function also has important implications for Crown financial policy. The standard case assumed in the literature is that the deadweight loss function is convex in the tax rate, with the result that minimising the variability of the tax rate would maximise economic welfare. However, it is an open empirical question as to whether the losses due to variability in the tax rate are economically significant to the extent that a policy response would be warranted. It is therefore of interest to consider implications for policy in the case where the deadweight loss function is linear in the tax rate. The discussion below analyses the cases for both linear and convex deadweight loss functions.

The results reported in this section (and throughout the paper) were derived from models where distortionary taxation affects the level of economic activity but not the growth rate. The omission of policy conclusions relating specifically to economic growth reflects the absence of suitable models in the literature, which thus far has focused on how taxes impact on long-run equilibrium growth but not the impacts of alternative time profiles of the tax rate or uncertainty about the tax rate.[9] This is an area where further development could produce important insights for policy.

The cases discussed in following subsections are:

• linear loss function;
• convex loss function;
• incomplete capital markets;
• misperceptions of default risk; and
• non-responsive citizens.

4.1  Linear loss function

Assume all other non-tax related conditions for Ricardian equivalence hold. If the economic loss or “excess burden” were linear in the tax rate, economic welfare may be affected by the long-run average tax rate but not by the time profile or variability of the tax rate. Tax smoothing is irrelevant. Under linearity, the appropriate tax policy objective would be to minimise the long-run average tax rate so as to minimise deadweight losses on average over time.

Government spending policy is a key determinant of the long run tax rate. Another determinant is the composition of the Crown balance sheet, since net returns on the Crown portfolio flow into the government’s Operating Balance. An immediate implication, in contrast to Section 3, is that all diversifiable risks should be hedged so that the Crown portfolio lies on the CML. This would ensure maximum expected portfolio returns for any given level of portfolio risk, as illustrated in Figure 2 below.

Less obvious is that Crown financial policy should be indifferent to positions along the CML.[10] Intuition suggests that the tax policy objective of minimising the average tax rate, combined with the irrelevance of tax smoothing under linearity, would imply the Crown should leverage to the maximum extent possible to generate expected portfolio returns at the highest possible level, i.e. move up and rightward along the CML. The higher expected returns would reduce the expected tax rate, thereby reducing deadweight losses.

Figure 2 – Portfolio target under linear loss function

However, this is a fallacy where citizens are risk averse. The problem is that moving the portfolio up and rightward along the CML incurs systematic risk.[11] In equilibrium, the assets offering high expected returns are precisely those assets which offer high payoffs in states where marginal utility is low, and low payoffs in states where marginal utility is high. The high expected return is compensation for this unfortunate distribution of payoffs (relative to the distribution of marginal utility). As a result, Crown investments in high return assets tends to achieve low taxes (and low deadweight losses) in periods where citizens are doing well, and high taxes (and high deadweight losses) in periods where citizens are doing badly. Overall, after taking into account that citizens can achieve their desired risk/return position on their total wealth portfolio, a Crown strategy of investing in high return assets would be neutral for economic welfare.[12]

Summary for linear loss function

Economic objective

Minimise the expected economic value of deadweight losses of taxation

CFP objectives

Tax policy

Minimise the long-run average tax rate subject to IBC

Portfolio policy

Ensure Crown portfolio lies on CML

Target

Zero diversifiable risk

Instruments

Portfolio weights as appropriate