Limits of Tax Policy

Abstract: The size of government has increased dramatically over the last century. Given the magnitude of government involvement in the economy and the potential influence it has on individuals as well as the economy, studies documenting the effects of government size may offer particularly timely insights. This thesis addresses some of these issues. Chapter two and three deal with welfare reform. Welfare systems are currently under criticism worldwide. Many of these reforms aim to provide incentives for welfare recipients to join the work force, something often currently lacking. The second chapter estimates effective marginal tax rates for earned and unearned income over the entire income distribution in the U.S., defined as the change in net payments to government from all taxes and means-tested welfare programs resulting from a unit rise in income. Estimated marginal tax rates are very high for low-income households, which suggests that concerns about the disincentive effects of current welfare system are well founded. Chapter three subsequently develops a model that derives bounds on the optimal benefit-reduction rate, that is the rate at which welfare recipients lose welfare when their income increases by a unit. Specifically, the optimal income taxation model is augmented with the benefit-reduction rate. In some countries, Sweden for example, I find estimated optimal rates that are clearly below actual prevailing rates. Chapter four examines the effect of government size on the economy. The relationship between government size and growth is estimated using panel-data from 21 OECD countries over the period 1973-1992. I use a fixed effects estimation model that controls for country- and time-specific fixed factors that may confound simpler estimators. The result is a negative and statistically significant relationship between the size of government and the growth rate. When I omit these fixed factors, however, this relationship disappears suggesting that many earlier studies may have important statistical problems. Finally, I ask in the last chapter whether the large government sizes that have evolved are sustainable or whether government sizes have peaked in industrialized countries and are now decreasing due to limits to taxation. Theoretical limits to the government size are computed in a Laffer-style model, and then compared to actual measures of fiscal sizes of government in 22 OECD countries. To make comparisons between numbers derived in the model and actual data meaningful, I introduce a measure of fiscal size that is more consistent with our theoretical tax model. I find support for the hypothesis that declines in government sizes may be a result of limits to taxation.