Optimal Taxes under Private Information: The Role of Inflation

Once explicit information available to the taxing authority and incentives associated with private information problems are explicitly taken into account, only a limited set of policy instruments are consistent with agents not engaging in side trades. Within this spirit, we study the role of taxes and inflation in minimizing the dead‐weight loss associated with the provision of good incentives and other market imperfections when fiat money is essential. When the government has a rich information set and can observe savings, effort, and consumption in frictionless markets, the constrained efficient allocation can be achieved with affine history‐dependent consumption taxes. Thus, monetary policy is redundant. In contrast, when the government observes sales, rather than actual consumption, a tax arbitrage exists. Uniform affine consumption taxes prevent side trades. We also find that a deviation from the Friedman rule is optimal as it helps induce truth‐telling and alleviate a pecuniary externality. However, optimal monetary and fiscal policies in this setting cannot implement the constrained efficient allocation.