Fiscal Progressivity and the Time Consistency of Monetary Policy

The conventional division of labour holds that central banks should not target distribution and that fiscal policy, with its targeted instruments, should handle the redistributive consequences of monetary decisions. This paper argues the opposite direction of influence also matters: in a stylized overlapping-generations economy with agents who differ in labour productivity, progressive labour taxation — which is purely costly on efficiency grounds, since it only raises marginal rates and labour-supply distortions — nonetheless serves as an effective instrument for mitigating the inflation bias of discretionary monetary policy, but only when policymakers or voters are concerned about the distribution of consumption. The mechanism runs through distributional conflict: with a flat tax, agents unanimously support financing entirely through the inflation tax, because money holdings of the old are a predetermined and hence non-distortionary tax base; with progressive taxation, lower-productivity agents instead support positive labour taxes to preserve the consumption value of their money holdings and shift the burden of distortionary taxation onto higher-productivity agents, so the median-productivity agent — shown to be the decisive voter — chooses positive labour taxes and thereby curbs the inflation tax. Anticipating that reduction in inflation, agents choosing progressivity behind a veil of ignorance one period in advance (tax inertia) unanimously prefer a strictly positive level of progressivity, even though their individual preferred levels differ and are non-monotonic in productivity. A numerical extension with incomplete markets and idiosyncratic productivity risk, calibrated to US moments (a market-income Gini of 0.48, after-tax Gini of 0.36, public consumption of 15% and transfers of 7% of output), shows that under discretion without progressivity the reliance on inflationary finance generates a collapse of money demand, with lifetime welfare falling to about 0.73 of the commitment benchmark, welfare dispersion rising to about 2.27 times, and output falling from 0.741 to 0.562; adding the calibrated level of progressivity brings both discretionary and majority-voting outcomes back to roughly the commitment benchmark. The analysis is deliberately stylized, and the author reports that the more persistent and volatile idiosyncratic shocks are — and the lower are lump-sum transfers or the higher policymakers’ inequality aversion — the more effective progressive labour taxes are at limiting the inflation bias.

Antoine Camous | Macro Paper Warehouse

Fiscal Progressivity and the Time Consistency of Monetary Policy