Information Frictions and Tax Inertia

Tax rates tend to be adjusted rarely. This paper proposes information frictions on the side of policymakers as a possible explanation for tax inertia. Information frictions therefore result in sub-optimal tax rates. The implications for two classes of models, namely noisy information and rational inattention, are explored. The paper examines independent as well as interrelated policymakers, who either face independent or common shocks. I find that information frictions can cause tax inertia, which is increasing in the noise of the information content. Furthermore, the degree of strategic complementarity among policymakers can also increase inertia and bunching of tax rates. I also find that investments in information processing technology as well as increased performance incentives on the side of policymakers can decrease inertia.