ROW: Distributional Effects of Distortionary Taxation

This project plans to study the distributional effects of distortionary tax policy. In most analyses of tax reform, the question of how tax policy affects agents with different preferences, endowments or investment opportunities is not addressed. In the case of dynamic economies, the main reason for this omission is that the task is computationally formidable. However, preliminary indications show that numerical methods used in fluid dynamics and structural mechanics for solving partial differential equations may be applicable. This research investigates their application to a model with heterogeneous agents and distortionary taxation. The project requires several planning activities. The first is to test the methods on cases for which there is a known solution. Such problems usually involve a distortion-free economy inhabited by identical agents. The second is to test the methods on models with identical agents and distortionary taxes. For some models of a distorted economy, there exists a transformation of parameters or variables which makes it resemble a distortion-free economy. For both sets of test cases, alternative numerical methods will be used to validate the results. Preliminary results show that finite difference techniques perform well and may be sufficiently efficient for maximum likelihood estimation. Finally, the alternative finite-element and variational methods will also be explored.