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.