Tax Structure and Government Behavior: Implications for Tax Policy
NBER Working Paper No. 7244
Changes in tax policy can affect all aspects of the economy. Not only do firms and individuals change behavior, creating efficiency costs, but government expenditure choices can also change. Unless these expenditure choices had been optimal' previously, changes in response to a tax reform affect welfare and should be taken into account when designing tax policy. This paper develops a specific model of government behavior and then explores the implications of government, as well as private, behavioral responses for tax policy. In particular, we assume that government officials favor expenditure (or regulatory) choices that increase the government's budget. As a result, higher tax rates on a particular activity encourage government behavior that aids the growth of this activity. This response enables tax policy to redirect government activity in desirable directions, but it also makes Pigovian taxes on negative externalities less effective.