Optimal Taxation under Imperfect Trust

Abstract: This short note studies optimal taxation when the use of tax revenue for public consumption is uncertain. We consider a one-period general-equilibrium economy with a representative household and a competitive firm. The government may be honest, in which case revenue is converted one-for-one into public consumption, or opportunistic, in which case nothing is delivered. We treat trust as the prior probability that the government is honest and ask how it shapes both the overall scale of taxation and the choice between a labor tax and a broad commodity (output) tax. Three results emerge. First, there is a trust threshold below which any positive tax lowers welfare. Second, above that threshold there is an equivalence frontier: a continuum of tax mixes that implement the same allocation and welfare. Third, small instrument-specific administrative or salience costs uniquely select the revenue instrument, typically favoring the cheaper broad base. An isoelastic specialization yields closed-form expressions that make the threshold, optimal rates, delivered public consumption, and welfare transparent. The framework offers a compact policy map: build credibility before raising rates, keep the base broad, and let measured trust determine the scale.