Are Consumption Taxes Better Than Labor Income Taxes? Theoretical And Quantitative Implications Of The Choice Of Tax Base

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Doctor of Philosophy (PhD)
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consumption taxation
optimal taxation
progressive taxation
Public Policy
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Shaw, Kristin

In many standard models, taxes on labor income and taxes on consumption are outcome-equivalent. However, this is not the case when taxes are non-linear and households differ with respect to wages and earnings. In this dissertation, I evaluate how consumption-based and earnings-based tax systems differ in the presence of wage heterogeneity and progressive rate schedules. To understand the macroeconomic implications of the choice of tax base, I study two versions of a dynamic consumption-savings model, one analytically and the other numerically. I begin with a tractable two-period framework and show that the theoretical advantages of consumption taxation are twofold. First, it eliminates an intertemporal distortion on labor supply. Second, consumption is more strongly correlated with lifetime resources, which matters for the distributional impact of the tax system. To assess the quantitative implications, I construct a standard overlapping generations model with incomplete markets and elastic labor supply. After calibrating the model to the U.S. economy, I replace a progressive labor income tax with an equally progressive consumption tax, taking into account post-reform transition dynamics. This reform produces moderate gains in physical capital (1.9%), output (1.3%), consumption (1.5%) and welfare (0.9%). Most of the benefits stem from improvements in labor efficiency that follow from the mitigation of distortions on work decisions. Because baseline progressivity is suboptimal for both tax bases, I also perform a best-on-best comparison by numerically characterizing the welfare-maximizing tax code under both regimes. The quantitative conclusions from this exercise are broadly unchanged from the simple reform. A progressive consumption tax is most easily implemented by adopting a cash-flow consumption tax, as described by Kaldor (1955) among others. Since the administration of a cash-flow tax is more complicated than that of a pure labor income tax, my quantitative results provide novel guidance for policy-makers discerning between the two tax bases.

Petra Todd
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