The Complexity of Economic Policy: I. Restricted Local Optima in Tax Policy Design
AbstractEconomists traditionally tackle normative problems by computing optimal policy, i.e. the one that maximizes a social welfare function. In practice, however, a succession of marginal changes to a limited number of policy instruments are implemented, until no further improvement is feasible. I call such an outcome a ”restricted local optimum”. I consider the outcome of such a tatonnement process for a government which wants to optimally set taxes given a tax code with a fixed number of brackets. I show that there is history dependence, in that several local optima may be reached, and which one is reached depends on initial conditions. History dependence is stronger (i.e. there are more local optima), the more complex the design of economic policy, i.e. the greater the number of tax brackets. It is also typically stronger, the greater the interaction of policy instruments with one another – which in my model is equivalent to agents having a more elastic labor supply behavior. Finally, for a given economy and a given tax code, I define the latter’s average performance as the average value of the social welfare function across all the local optima. One finds that it eventually sharply falls with the number of brackets, so that the best performing tax code typically involves no more than three brackets.
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Bibliographic InfoPaper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 480.
Length: 24 pages
Date of creation: Apr 2002
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Other versions of this item:
- Saint-Paul, Gilles, 2002. "The Complexity of Economic Policy: I. Restricted Local Optima in Tax Policy Design," IDEI Working Papers 142, Institut d'Économie Industrielle (IDEI), Toulouse.
- Saint-Paul, Gilles, 2002. "The Complexity of Economic Policy: I. Restricted Local Optima in Tax Policy Design," CEPR Discussion Papers 3339, C.E.P.R. Discussion Papers.
- Saint-Paul, Gilles, 2007. "The complexity of economic policy: restricted local optima in tax policy design," Economics Discussion Papers 2007-4, Kiel Institute for the World Economy.
- H2 - Public Economics - - Taxation, Subsidies, and Revenue
- H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
- J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
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- NEP-ALL-2002-05-03 (All new papers)
- NEP-PBE-2002-05-03 (Public Economics)
- NEP-PUB-2002-05-03 (Public Finance)
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