The Distortion and Income Effects of Taxation

The distortion effect of distortion taxation lies in affecting the consumption leisure choice of people. We show that the government can manipulating the consumption taxation and labor taxation in the same way to affect people's consumption and investment decision, so as to smooth the consumption across time and states, better stabilizing the economy. Thus the taxation of consumption is equivalent to that of labor, in the optimally designed fiscal policy. We propose a simple fiscal rule as the minimum requirement for the design of optimal taxation. The income effect of distortion taxes lies in raising revenues for the government. In a calibration to the Chinese economy, we find that the income effect of distortion taxes is more remarkable than the distortion effect, in the steady states. The calibrated parameters that are consistent with the rate of labor tax in China are also listed.