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Welfare costs of inflation with distortionary taxation
André C. Silva
We show that the welfare cost of inflation decreases when distortionary taxation is taken into account. The estimates of the welfare cost of inflation usually consider that governments are able to use lump sum taxation to finance their budget. However, governments can only use distortionary taxation, such as labor income taxes. When only distortionary taxation is available, the government can decrease the size of distortionary taxes by compensating the decrease in revenues with the revenues generated by inflation. We compare the case in which the government has access to lump sum taxes with the case in which only distortionary taxes are available. We keep the level of government expenditures as a percentage of output constant. We find that the welfare cost of an increase in inflation from 0 to 10% per year decreases from 1.3% in terms of income to 0.8%.