OPTIMAL TAXATION AND INFLATION IN AN OPEN-ECONOMY

This paper examines the role of the inflation tax in the optimal revenue-raising tax package for a small open economy where money is held because it serves to reduce transacttions costs associated with purchasing goods. Consumers choose whether domestic money or foreign money will serve as the medium of exchange for various goods purchases so as to minimize such costs. Results are derived regarding the appropriate role of taxes on domestic and foreign money in the optimal tax structure. It is demonstrated that with a sufficiently rich tax structure Friedman's rule, which calls for a monetary policy that drives the nominal interest rate to zero, is a component of the optimal tax policy. © 1991.