Inflation and Taxes - A Dynamic General Equilibrium Analysis of Fiscal Drag in Germany
Abstract: This thesis analyses fiscal drag and its implications on efficiency, welfare, inequality and tax revenue in Germany. For this analysis, I construct a dynamic general equilibrium model and calibrate it to resemble central features of the German economy and tax code. I find that steady state output after three years of 1.6% inflation decreases output by 0.4% and reduces utility for all income groups considered. Net income is distributed more equally and tax revenue increases by 2.4%. Additionally, I compare fiscal drag to a proportional increase in wage taxes and an increase in consumption taxes regarding the costs of each tax reform to increase tax revenue by the same amount. Fiscal drag has less negative implications on the economy than the proportional increase in wage taxes, but more than the increase in consumption taxes. If the government does not want to relinquish higher tax revenue, then a switch from fiscal drag to higher consumption taxes is still a strict Pareto improvement for all income groups considered, despite increasing inequality in net earnings. The same amount of tax revenue is raised as under fiscal drag with output increasing by 0.3%.
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