Institutions, tax evasion, and optimal policy

The mix of inflation and income taxation that governments adopt vary considerably across countries. We take a Ramsey optimal-policy approach to explain these differences, focusing on the institutions of the country, modeled as the difficulty of tax evasion, as the key variation across countries. In the model households optimally choose the extent of informal activity and a benevolent government optimally chooses policies, both taking as given the institutions of the economy. The model matches qualitatively the observed relationships between institutions and inflation, taxes and tax evasion. In a cross-country quantitative exercise with 38 countries that have floating exchange rates, the model delivers a good fit: the correlation of data and model-generated values for inflation and taxes are 0.42 and 0.79, respectively. The quantitative exercise further provides evidence for the success of this Ramsey approach in a falsification test, as the fit of the model deteriorates significantly for countries with fixed exchange rates, where the assumptions underlying the Ramsey approach may not hold.