On the Optimality of the Friedman Rule with Costly Tax Enforcement

This paper studies the interaction between monetary policy and tax policy in a cash and credit economy when tax enforcement is costly and the set of tax instruments may be incomplete. A positive interest rate and inflation are optimal when enforcement costs are positive and tax enforcement is imperfect. If the government can tax informal workers only imperfectly, it is optimal to increase the inflation tax and deviate from the Friedman rule. Inflation becomes a second best tax due to an imperfect tax system. For a positive detection probability, the Friedman rule can be recovered if monitoring is costless or, equivalently, if evasion penalties are sufficiently high. The optimal interest rate is higher when the government is constrained to set the tax on informal income equal to zero. Our results suggest that the government should tax informal activities heavily to compensate for enforcement expenditures, in accordance with the uniform taxation result.