06 July 2015

The Lesser of Two Evils: Choosing Optimal Methods of 'Distortionary' Taxation

The ideal method of taxation comes up frequently in political debate. Governments often tweak the levels of financing they receive from a wide gamut of taxes. Of course, most of the debate over government policy remains uninformed by the members of academia so the various recommendations for ideal methods of taxation have little basis in economic theory.

Here, I won't pretend to be any kind of expert on fiscal policy, or even computing (Ramsey) optimal policy in general, but I will compare welfare under a "High Income Tax - Low Consumption Tax" regime and a "Low Income Tax - High Consumption Tax" regime in an attempt to add some model-based input.

I ran two different simulations. The first one determines which regime is better for consumer welfare when there is a 1% shock to the government spending to GDP ratio and the second one looks at which regimes provides more welfare and/or more tax revenue in the long run (steady state). As it turns out, the results to each test are slightly different.

In test #1, the high income tax regime (with a 10% flat consumption tax and a 50% flat income tax) edges out the high consumption tax regime (50% consumption, 10% income). When the government increases spending, the household's objective function (welfare) is higher throughout due mainly to less of an increase in output and subsequently less of an increase in labor as well as a smaller reduction in consumption.

 (click here for the rest of the comparisons)

In the long run, however, the consumption-tax-dominant regime is superior for welfare in the long run and output in the short run. Steady state welfare is much higher in this regime, pointing to the long run advantages of having higher consumption taxes and lower income taxes.

The disadvantage of consumption-tax-dominance is that tax revenues are lower in the steady state. Lower revenues either mean a lower level of government spending in the long run (which also means less output which is socially optimal, but maybe not optimal from a policy perspective) or higher deficits.

Consumption taxes turn out to be optimal in most economic situations as they are less 'distortionary' than income taxes and they increase consumer welfare in the long run (basically consumption per unit of labor). The only case for keeping an income-tax-dominant regime (assuming both taxes are flat), is if government spending is extremely volatile. In all other cases, cutting income taxes and raising consumption taxes is more optimal. Of course, if government spending had the ability to increase welfare in my model, then the results could be very different indeed.

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