Time Inconsistency in Tax Policy: A Colombian Case Study
By David Henderson
This discussion is related to the time inconsistency of optimal policy, which occurs when the government cannot implement an optimal tax policy because the stated policy is inconsistent with the government’s incentives over time. Consider a proposal made by the government of Colombia in 2002. To put down a rebellion, a tax of 1.2 percent of the value of their capital would be levied on all individuals and businesses whose assets exceeded the equivalent of $60,000. Importantly, the tax was to be imposed only one time; it would not be repeated in the future. While capitalists presumably would not be pleased to pay the tax, it would appear to have no impact on their current incentives to save for the future. Such a tax is in effect a lump sum levy and therefore fully efficient.
There is a problem, however. The Colombian government has an incentive to renege on its promise that the tax would only be levied once and pull exactly the same trick next year, raising yet more revenue without an excess burden. Thus, the stated tax policy is inconsistent with the government’s incentives over time. Even worse, the capitalists realize the government has an incentive to renege. They will change their saving behavior to reflect the expectation that the more they save now, the more they will be taxed next year. Because the expected tax changes behavior, it introduces an inefficiency.
This is from Harvey S. Rosen and Ted Gayer, Public Finance, 8th ed., 2008.
When I teach my Cost/Benefit course, I sometimes use this text and when we get to taxes, I highlight this beautiful example of time inconsistency.
By the way, I just noticed, in typing this out, that the authors talk about “capitalists.” I would have thought that all savers with substantial assets would not be pleased and would, on the margin, change their saving behavior. I have no idea why they would single out capitalists.
Back to the point. When I teach this point, I always check to see if the Colombian government has reneged. It appeared that it hadn’t. Well, now it has.
But wait. Here’s a paragraph from the Financial Times article linked to above:
His recently appointed deputy, Andrés Escobar, said this week that the proposed changes would lower the wealth tax threshold to $380,000 from $500,000. Those with assets of $500,000 to $1.5m would pay a 0.4 per cent annual rate; thos with $1.5m to $2.5m would pay 1.1 per cent; those with $2.5m to $4m would pay 2 per cent, and those with fortunes greater than $4m would pay 2.25 per cent. (Those with capital of less than $380,000 will pay nothing.)
So that makes it appear that the government reneged some time ago, which is kind of what I would have expected.
HT to Tyler Cowen.