Simulating Fundamental Tax Reform in the U.S

This paper uses a new, large-scale, dynamic life-cycle simulation model to compare the welfare and macroeconomic effects of five fundamental alternatives to the U.S. federal income tax: a proportional income tax, a proportional consumption tax, a flat tax, a flat tax with transition relief, and a progressive variant of the flat tax called the X tax. The model incorporates intragenerational heterogeneity and detailed specification of alternative tax systems. It predicts significant long-run increases in output from the wholesale replacement of the progressive federal income-tax with a low-rate proportional consumption tax. In the long run, middleand upper-income groups gain from this policy. But their gains come at the expense of the current and future poor, who suffer from the removal of the current tax structure’s progressivity, and the wealthiest members of initial, older generations, who are hurt by the policy’s implicit capital levy. The flat tax adds a standard deduction to the consumption tax. This feature improves outcomes for the current and future poor. But it does so at an additional cost; long-run output increases less than half as much as under the proportional consumption tax, and middle-income groups experience a welfare loss, even in the long run. Moreover, the flat tax continues to leave some of the initial elderly worse off. Although one can insulate these individuals through transition relief, doing so further reduces the long-run gains from tax reform. Switching to a proportional income tax without deductions or exemptions is an alternative way to reform the federal income tax. Although the policy raises long-run output to roughly the same extent as the flat tax, eliminating the federal income tax’s progressivity hurts the poor, whether they are initially alive or are born after the reform. The X tax, a flat tax with a progressive subsidy to wages, makes everyone better off in the long run and also raises long-run output by more than the standard flat tax. But its higher tax rate on existing capital hits initial older generations particularly hard. Nearly all of the reforms analyzed would be approved by a majority of the existing adult population, based on the impact on their individual well-being. However, the degree of approval bears little relationship to a policy’s long-run benefits.