Discussion Paper 37

The Macroeconomic Effects of Distortionary Taxation

Ellen R. McGrattan | Consultant

Published January 1, 1991

This paper develops a model of competitive economy which is used to study the effect that distortionary taxes have on the business cycle and on agents’ welfare. In the presence of distortions, the equilibria are not Pareto optimal and standard computational techniques cannot be used. Instead, methods that take into account the presence of distorting taxes are applied. Maximum likelihood estimates of taste, technology and policy parameters from U.S. post-war time series are used to obtain several results. I find that a significant portion of the variance of the aggregate consumption, output, hours worked, capital stock, and investment can be attributed to the factor tax and government spending processes. Also, I compute the deadweight loss due to alternative tax changes and compare these estimates to others in the literature. Specification of taxes as constant versus state-contingent can have a significant effect on the results.

Published In: Journal of Monetary Economics (Vol. 33, No. 3, 1994, pp. 573-601)

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