Thursday, January 31, 2008

Four Goals of Tax Policy

I thought it might be useful to put the debate over fiscal stimulus in a broader perspective.

When designing a tax system and evaluating tax proposals, policy analysts have at least four goals in mind:
  1. Efficiency: The tax system should distort incentives as little as possible (and, in the case of externalities and Pigovian taxes, correct incentives when necessary).
  2. Intergenerational equity: The tax system should raise enough revenue so current generations do not unduly burden future generations.
  3. Egalitarianism: The tax system should try to achieve a more equal distribution of after-tax incomes.
  4. Stabilization: The tax system should help maintain the economy at full employment.

The current debate over fiscal stimulus involves trading off these goals. The stimulus package being discussed is mainly aimed at achieving goal 4, but it does so at the cost of sacrificing goals 1 and 2 to some degree. Efficiency is sacrificed because the phase out raises effective marginal tax rates and because the higher future taxes that result from the extra government debt will likely be distortionary. Of course, the phase out is there in order to achieve goal 3: This is the classic tradeoff between efficiency and equality.

Differences of opinion arise when policy analysts weight these goals differently. Advocates of fiscal stimulus put a large weight on goal 4. Critics of fiscal stimulus come in two varieties. One type of critic discounts goal 4 entirely because they are skeptical of Keynesian theories that underlie this goal. A second type of critic admits that goal 4 is legitimate in principle but believes that in the current environment macroeconomic stabilization is best left to monetary policy so fiscal policy can focus on goals 1 and 2. I am in this latter category.