The Timing of Income Tax Changes in the Face of Projected Debt Increases

Abstract

This article examines the time path of the income tax rate chosen by a hypothetical policy-maker, in a model where an increasing ratio of government debt to GDP is projected in the absence of policy changes. The policymaker is assumed to maximise an objective function expressed in terms of a number of aggregate variables, including the excess burden of taxation and a desired debt ratio. Tax policy changes have feedback effects, as a result of incentives and other endogenous influences that impose constraints on the efficacy of those policies. Emphasis is given to the importance of uncertainty in devising an optimal policy and the consequent value of waiting instead of imposing a sharp initial increase in anticipation of otherwise higher future debt.