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Tax Collection Costs, Tax Evasion and Optimal Interest Rates

  • Pinar Yesin


    (Studienzentrum Gerzensee and Swiss National Bank)

In this paper, I investigate to what extent the cross-country variation in nominal interest rates can be explained as being due to governments' optimal response to economic conditions such as tax collection costs, tax evasion and government consumption needs. In particular, I study the effects of costly income taxes in the presence of an informal sector on the solution to a Ramsey problem in a general equilibrium framework. Unlike most of the previous analyses of optimal inflationary finance, the model postulates that conventional taxes carry collection costs whereas fiat money can be printed costlessly. For some countries, I measure tax collection costs, use the tax evasion estimates reported in the literature, and then calculate the optimal interest rate based on the model. Comparison of the actual and optimal interest rates demonstrates that the model can in fact partly explain the observed deviations from the Friedman Rule. I also show that allowing cross-country differences in the elasticity of substitution between formal and informal sectors can increase the model's explanatory power.

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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 04.02.

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Length: 31
Date of creation: May 2004
Date of revision:
Handle: RePEc:szg:worpap:0402
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  1. Nicolini, Juan Pablo, 1998. "Tax evasion and the optimal inflation tax," Journal of Development Economics, Elsevier, vol. 55(1), pages 215-232, February.
  2. Fethi Ogunc & Gokhan Yilmaz, 2000. "Estimating The Underground Economy In Turkey," Discussion Papers 0004, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
  3. Dominik H. Enste & Friedrich Schneider, 2000. "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 77-114, March.
  4. Johnson, Simon & Kaufmann, Daniel & Zoido-Lobaton, Pablo, 1998. "Regulatory Discretion and the Unofficial Economy," American Economic Review, American Economic Association, vol. 88(2), pages 387-92, May.
  5. repec:cup:macdyn:v:7:y:2003:i:3:p:333-62 is not listed on IDEAS
  6. Isabel Correia & Pedro Teles, 1999. "The Optimal Inflation Tax," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(2), pages 325-346, April.
  7. Carlos A. Végh, 1989. "Government Spending and Inflationary Finance: A Public Finance Approach," IMF Staff Papers, Palgrave Macmillan, vol. 36(3), pages 657-677, September.
  8. de V. Cavalcanti, Tiago V. & Villamil, Anne P., 2003. "Optimal Inflation Tax And Structural Reform," Macroeconomic Dynamics, Cambridge University Press, vol. 7(03), pages 333-362, June.
  9. V. V. Chari & Patrick J. Kehoe, 1998. "Optimal fiscal and monetary policy," Staff Report 251, Federal Reserve Bank of Minneapolis.
  10. Click, Reid W, 1998. "Seigniorage in a Cross-Section of Countries," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(2), pages 154-71, May.
  11. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  12. Cukierman, Alex & Edwards, Sebastian & Tabellini, Guido, 1992. "Seigniorage and Political Instability," American Economic Review, American Economic Association, vol. 82(3), pages 537-55, June.
  13. De Fiore, Fiorella, 2000. "The optimal inflation tax when taxes are costly to collect," Working Paper Series 0038, European Central Bank.
  14. Schneider, Friedrich, 2002. "The Size and Development of the Shadow Economies of 22 Transition and 21 OECD Countries," IZA Discussion Papers 514, Institute for the Study of Labor (IZA).
  15. Lemieux, Thomas & Fortin, Bernard & Frechette, Pierre, 1994. "The Effect of Taxes on Labor Supply in the Underground Economy," American Economic Review, American Economic Association, vol. 84(1), pages 231-54, March.
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