On the Optimality of the Friedman Rule with Heterogeneous Agents and Nonlinear Income Taxation

We study the optimal inflation tax in an economy with heterogeneous agents subject to nonlinear taxation of labor income. We find that the Friedman rule is Pareto efficient when combined with a nondecreasing labor income tax. In addition, the optimum for a utilitarian social welfare function lies on this region of the Pareto frontier. The welfare costs from inflation are bounded below by the area under the demand curve.