Welfare Effects of Consumption Taxes (Job Market Paper)

Driven by high government deficits and an unevenly distributed tax burden, recent debates on economic policy have revolved mostly around reforms in the American tax codes. Consumption tax reforms are considered to circumvent the efficiency-equity tradeoff that other reforms might encounter. This paper studies long run consequences of changing to a consumption tax regime, as well as short run welfare effects evaluated in transitional dynamics. Switching from labor income taxes to consumption taxes stimulates stronger precautionary motives, leading to a substantial increase in aggregate capital and labor supply under a balanced government budget. Furthermore, consumption tax reforms favor households with a low wealth-to-earnings ratio. Therefore, given that the wealth distribution is more concentrated than the distribution of earnings, consumption tax reforms effectively reduce the welfare inequality. Another novel aspect of this paper is to quantify the effects of progressive consumption tax reforms. The tax scheme I adopt is clean and easy to implement. It allows for tax exemptions in consumption, while imposing a constant marginal tax rate on the additional amounts. I find that households with low earnings benefit most from the reform.