INFLATION TAX AND CAPITAL FLIGHT IN AN OVERLAPPING GENERATIONS MODEL

This essay analyzes smuggling as an intertemporal activity in a dynami c general equilibrium model where only distorting taxes are available to finance a given time-path of government spending. I use a small cou ntry overlapping generations framework and assume that the government can raise revenue by creating currency and/or by confiscating illegall y held foreign currency obtained through illegal trade. In this model, smuggling arises entirely by way of attempts by people to hold foreig n currency and, thereby, avoid the inflation tax on holdings of domest ic currency. The government manipulates the growth rate of money suppl y (thereby manipulating the inflation tax) and the degree to which it confiscates illegal holdings of foreign currency. With risk-neutral pr eferences, it does not matter, in terms of the Pareto criterion, from which of the two sources the government obtains its revenue. However, with risk-averse preferences, the welfare comparison of the two revenu e sources depends on how the size of total savings of a representative agent changes when holding foreign currency illegally is introduced a s a portfolio choice.