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I am inclined to think that in a country like the USA where tax compliance is a more than respectable 83%, there is less sense in reducing tax rates in an effort to increase tax revenue through hoping for a higher tax compliance, and simultaneously to stimulate the economy by leaving more money in the hands of people hoping that they will spend some of it and stimulate the economy. So, apart from the occasional stimulus checks, expansionary monetary policy remains the only significant tool for stimulating the economy when required. Am I right in thinking in this way?

If I am right, does it imply that in an economy where tax compliance is low, fiscal measures such as reducing tax rates and improving tax compliance should be tried out before lowering interest rates? I ask this because lowering tax rates in low tax compliance countries (<20%) could increase tax compliance thus leading to increased tax revenues. This paper seems to substantiate this view through the Laffer curve mechanism. The Laffer curve is an inverted U-shaped curve of tax revenue against tax rates that indicates that there is an optimal tax rate at which tax revenue is maximized and this optimum can be achieved at times through lowering tax rates that encourage tax compliance. Lowering tax rates when tax compliance is low would leave more money in the hands of people who already were paying taxes, and a less than previous but still a reasonable amount of money in the hands of people who were earlier tax non-compliant. This should stimulate the economy through increased spending, as well as leave more money in the hands of the government for government spending.

If what I have written above makes sense, does it then make more sense to exhaust all fiscal tools and ensure as high a tax compliance as possible even at the expense of reducing tax rates before turning to monetary policy to stimulate the economy? Why induce people to assume leverage when they can be taxed less, can be made more tax-compliant, and can be induced to spend more through letting them have more disposable income (at least for the ones who already were tax-compliant)?

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  • $\begingroup$ 1) This question is too broad, and almost any answer is going to be disputed. 2) The title is only slightly related to the bulk of the question. Realistically, you need to narrow this to a single question, and not assert things that could be disputed (the relationship between tax rates and compliance). $\endgroup$ – Brian Romanchuk Jul 5 at 17:16
  • $\begingroup$ I found a paper that supports this view, and I have included a link to it in my edit. $\endgroup$ – Ajax Jul 5 at 18:33
  • $\begingroup$ There is strong evidence that low tax rates encourage tax compliance. A case in point is Russia where replacement of the 12%, 20%, and 30% tax brackets by a single 13% flat tax rate led to an immediate increase in tax revenue through increased tax compliance. $\endgroup$ – Ajax Jul 6 at 7:13
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Your question is very broad, but as far as I understand, it relates to two things: 1. tax compliance and 2. fiscal vs. monetary policy.

First, it is well known from a large literature that lower tax rates can increase compliance.

However, you are mistaken about the centrality of compliance when it comes to optimal tax and fiscal policy. The Laffer curve is not only driven by compliance, but also disincentives to work due to taxes. Suppose the income tax is 100% and the government can perfectly ensure compliance. The tax revenue is still zero because no one would want to work. Similarly, at an extremely low positive tax rate (almost zero), we can assume there is some work and therefore some positive tax revenue. These two facts together mean that somewhere in the middle (above 0 and below 100) there is an optimal tax rate, which gives rise to the Laffer curve.

Further, you are wrong to think that monetary policy is "the only significant tool for stimulating the economy when required" when compliance is high/perfect. That's again because compliance is not everything, as already briefly discussed. Along these lines, you also ask:

"Does it then make more sense to exhaust all fiscal tools and ensure as high a tax compliance as possible even at the expense of reducing tax rates before turning to monetary policy to stimulate the economy?"

Again this is not necessarily true and is part of an extensive debate. The perfect balance between fiscal and monetary policy is an incredibly broad question that is beyond the scope of a single question on this site. So I cannot fully answer that. However, suffice to say that both fiscal and monetary policy can have a role to play.

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  • $\begingroup$ Thank you. What are you referring to when you write "mistaken about the centrality of compliance when it comes to optimal tax and fiscal policy."? $\endgroup$ – Ajax Jul 7 at 4:28
  • $\begingroup$ In the USA, although tax rates are nowhere close to 0, compliance is 83%. These together bring in significant tax revenue. In low compliance regimes, if the sweet spot is found by moderately reducing tax rates, wouldn't that boost both compliance and tax revenue? $\endgroup$ – Ajax Jul 7 at 4:45
  • $\begingroup$ I mean that the “sweet spot” is not entirely driven by compliance. There is more to optimal tax and fiscal policy than just tax compliance. Even if tax compliance was at 100% always or just always constant no matter what (at any level), then the Laffer curve would still exist and choosing between fiscal and monetary policy would still not be straightforward. $\endgroup$ – BB King Jul 7 at 4:49
  • $\begingroup$ But does compliance not govern to a significant extent (although not entirely) movement along the Laffer curve? For example, if the compliance were 15% or so, would lowering tax rates not tend to improve it? $\endgroup$ – Ajax Jul 7 at 6:11
  • $\begingroup$ In a low tax compliance regime, shouldn't bringing up compliance by any means possible (including lowering taxes) not be the first goal of fiscal policy? If being tax compliant is expensive, the demand for being tax compliant will naturally fall. $\endgroup$ – Ajax Jul 7 at 6:14

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