Optimal Delayed Taxation in the Presence of Financial Frictions

Abstract

In the presence of financial frictions, the timing of cash flows matters. We apply this insight to optimal income taxation by studying a new policy: delayed taxation. Introducing a delay between the accrual and payment of income taxes provides two sources of welfare gains when some agents are borrowing constrained. First, it improves consumption smoothing for financially constrained agents. Second, it reduces the present value tax rate from the perspective of constrained agents, thereby reducing the distortionary effects of income taxation. We characterize the conditions under which marginally delayed taxation is welfare enhancing under different assumptions about the sophistication of the benchmark tax system, and we contrast the welfare gains with those achievable by offering low-interest loans or changing nominal tax rates. We then characterize optimal delayed taxation in a model calibrated to the Norwegian economy. This exercise reveals substantial welfare gains from delayed taxation. When limiting the amount the government may borrow to finance any given reform, delayed taxation materially outperforms age-dependent taxation and a policy in which the government offers subsidized loans. Finally, we empirically test the hypothesis that delayed taxation substantially reduces income tax distortions in the context of young workers in Norway, where a kinked income-contingent student debt conversion scheme replicates an income tax with delayed payments. Bunching analyses reveal elasticities that are an order of magnitude lower than those we find for a regular income tax threshold, and that increase with ex ante financial resources. Taken together, our results underscore the potential for delayed taxation to be a powerful new component of optimal tax policy. Joint paper with Marius A. K. Ring.