Fundamental Tax Reform: The Growth and Utility Effects of a Revenue-Neutral Flat Tax

Hlavac, Marek (2008): Fundamental Tax Reform: The Growth and Utility Effects of a Revenue-Neutral Flat Tax.

Abstract

We estimate the growth and utility effects of switching from a graduated-rate federal income tax to a flat tax along the lines of Hall-Rabushka (1995). We, furthermore, calculate the post-reform transition dynamics for a number of variables, including the economic growth rate, the representative household’s utility – using consumption equivalents as suggested by Lucas (2003) – , the allocation of time to education and market work, as well as the interest and wage rates. To achieve these goals, we rely on a dynamic equilibrium model proposed by Cassou and Lansing (2003), and calibrated to fit historical data about the U.S. economy and the Internal Revenue Service (IRS) tax return statistics for the 2005 tax year. In the process, we specify a step-by-step calibration procedure for the model – a non-trivial undertaking left largely unexplained in Cassou and Lansing (2003). We find that the flat tax reform increases long-term economic growth, and that the magnitude of this effect depends on the U.S. economy’s intertemporal elasticity of substitution in labor supply (IES). For values of IES that range from 0.25 to 1, the introduction of a Hall-Rabushka flat tax increases the long-term economic growth rate by 0.003 - 0.255 percentage points. Although the flat tax reform has clear benefits in the long run, we find that it decreases economic growth during the first post-reform year, and lowers utility for several years after its implementation. Politicians concerned about their re-election prospects may, as a result, be inclined to carefully consider the political consequences of the flat tax reform in the timing of its adoption.

• Item Type: MPRA Paper
• Language: English
• Keywords: tax; flat tax; public finance; economic growth; tax reform
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H20 - General; O - Economic Development, Innovation, Technological Change, and Growth > O4 - Economic Growth and Aggregate Productivity > O40 - General

References

Altig, David, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser. (2001). “Simulating Fundamental Tax Reform in the United States.” American Economic Review, Vol. 91(3), 574-595.

Altonji, Joseph G. (1986). “Intertemporal Substitution in Labor Supply: Evidence from Micro Data.” Journal of Political Economy, Vol. 94(3), S176-S215.

Ball, Laurence. (1990). “Intertemporal Substitution and Constraints on Labor Supply: Evidence from Panel Data.” Economic Inquiry, Vol. 28, 706-724.

Barro, Robert J. and Xavier Sala-i-Martin. (2004). Economic Growth, Second Edition. Cambridge, MA: MIT Press.

Beaudry, Paul and Eric van Wincoop. (1996). “The Intertemporal Elasticity of Substitution: An Exploration Using a US Panel of State Data.” Economica, Vol. 63(251), 495-512.

Becker, Gary S. (1965). “A Theory of the Allocation of Time.” Economic Journal, Vol. 75(299), 493-517.

Blanchard, Olivier. (2003). Macroeconomics, Third Edition. Upper Saddle River, New Jersey: Prentice Hall.

Boskin, Michael J. (1977). “Notes on the Tax Treatment of Human Capital.” Proceedings of the Treasury Conference on Tax Policy. Washington, DC: U.S. Department of Treasury.

Brender, Adi and Allan Drazen. (2005.) “How Do Budget Deficits and Economic Growth Affect Reelection Prospects?” Journal of Monetary Economics, Vol. 52(5), 1271-1295.

Bureau of Economic Analysis (BEA). (2007). “Current-dollar and Real GDP.” National Economic Accounts. Washington, DC: U.S. Department of Commerce. Data set available from: http://www.bea.gov/National/Index.htm

Bureau of Economic Analysis (BEA). (1999). “Fixed Reproducible Tangible Wealth in the United States, 1925-94.” Washington, D.C.: U.S. Department of Commerce.

Bureau of Labor Statistics (BLS). (2007). “American Time Use Survey – 2006 Results.” Washington, D.C.: U.S. Department of Labor.

Bütler, Monika. (2000). “The Political Feasibility of Pension Reform Options: The Case of Switzerland.” Journal of Public Economics, Vol. 75, 389-416.

Cassou, Steven P. and Kevin J. Lansing. (2003). “Growth Effects of Shifting from a Graduated-Rate Tax System to a Flat Tax.” Economic Inquiry, Vol. 42(2), 194-213.

Cobb, Charles W. and Paul H. Douglas. (1928). “A Theory of Production.” American Economic Review, Vol. 18(1), 139-165.

Conesa, Juan Carlos and Dirk Krueger. (1999). “Social Security Reform with Heterogenous Agents.” Review of Economic Dynamics, Vol. 2, 757-795.

Conesa, Juan Carlos and Dirk Krueger. (2006). “On the Optimal Progressivity of the Income Tax Code.” Journal of Monetary Economics, Vol. 53, 1425-1450.

Council of Economic Advisers (CEA). (2007). The Economic Report of the President. Washington, D.C.: U.S. Government Printing Office.

Current Population Survey (CPS). (2005). Fertility of American Women: June 2004. Washington, D.C.: U.S. Census Bureau and Bureau of Labor Statistics.

Davies, James and Whalley, John. (1989). “Taxes and Capital Formation: How Important Is Human Capital?” In Bernheim, Douglas B. and John B. Shoven, 1991, National Saving and Economic Performance. Chicago, IL: University of Chicago Press.

Executive Office of the President of the United States – Office of Management and Budget (OMB). (2006). Analytical Perspectives – Budget of the United States Government (Fiscal Year 2007). Washington, D.C.: U.S. Government Printing Office.

Fair, Ray C. (2006). “The Effect of Economic Events on Votes for President: 2004 Update.” Available from: http://fairmodel.econ.yale.edu/RAYFAIR/PDF/2006CHTM.HTM

Fair, Ray C. (1978), “The Effect of Economic Events on Votes for President.” Review of Economics and Statistics, Vol. 60(2), 159-173.

French, Eric. (2004). “The Labor Supply Response to (Mismeasured but) Predictable Wage Changes.” Review of Economics and Statistics, Vol. 86(2), 602-613.

Friedman, Milton. (1953). “The Methodology of Positive Economics.” In Essays in Positive Economics. Chicago, IL: University of Chicago Press.

Gallman, Robert E. (1960). “Commodity Output in the United States.” In Conference on Income and Wealth, Trends in the American Economy in the Nineteenth Century, 24, Studies in Income and Wealth. Princeton, NJ: Princeton University Press.

Geary, Roy C. (1958). “A Note on the Comparison of Exchange Rates and Purchasing Power Between Countries.” Journal of the Royal Statistical Society, Vol. 121(1), 97-99.

Grecu, Andrei. (2004). Flat Tax - The British Case. Adam Smith Institute: London, UK.

Greenwood, Jeremy, Richard Rogerson and Randall Wright. (1993). “Household Production in Real Business Cycle.” RCER Working Papers, No. 347, Rochester, NY: University of Rochester.

Gomme, Paul, Finn E. Kydland and Peter Rupert. (2001). “Home Production Meets Time to Build.” Journal of Political Economy, Vol. 109(5), 1115-1131.

Gruber, Jonathan. (2005). Public Finance and Public Policy. New York, NY: Worth Publishers.

Hall, Robert E. (1988). “Intertemporal Substitution in Consumption.” Journal of Political Economy, Vol. 96(2), 339-357.

Hall, Robert E. and Alvin Rabushka. “A Proposal to Simplify Our Tax System.” Wall Street Journal, 10 December 1981.

Hall, Robert E. and Alvin Rabushka. (1983). Low Tax, Simple Tax, Flat Tax. New York, NY: McGraw-Hill.

Hall, Robert E. and Alvin Rabushka. (1985). The Flat Tax. Palo Alto, CA: Hoover Institution, Stanford University.

Hall, Robert E. and Alvin Rabushka. (1995). The Flat Tax. Second Edition. Palo Alto, CA: Hoover Institution, Stanford University.

Ham, John C. and Kevin T. Reilly. (2006). “Using Micro Data to Estimate the Intertemporal Substitution Elasticity for Labor Supply in an Implicit Contract Model.” IEPR Working Paper, 06.54. Institute of Economic Policy Research, University of Southern California.

Hassett, Kevin A. (2005). “Marginal Tax Rates in 2004 vs. 1988.” American Enterprise Institute Short Publications. Washington, DC: American Enterprise Institute.

Hassett, Kevin A. and Anna Moore. (2005). “How Do Tax Policies Affect Low Income Workers?” National Poverty Center Working Papes Series. #05-16. Ann Arbor, MI: National Poverty Center, University of Michigan.

Heckman, James J. (1976). “A Life-Cycle Model of Earnings, Learning and Consumption.” Journal of Political Economy, Vol. 84(4), S11-S44.

Internal Revenue Service (IRS). Tax Statistics. Statistics of Income Division and Other Areas (SOI). Available from: http://www.irs.gov/taxstats/index.html

Internal Revenue Service (IRS). (2006). Publication 17: Your Federal Income Tax for Individuals. U.S. Department of the Tresury.

Internal Revenue Service (IRS). (2006). Publication 505: Tax Withholding and Estimated Tax. U.S. Department of the Tresury.

Internal Revenue Service (IRS). (2006). Publication 542. U.S. Department of the Tresury.

Internal Revenue Service (IRS). (2007). Publication 553: Highlights of 2006 Tax Changes. U.S. Department of the Treasury.

Internal Revenue Service (IRS). (2007). “Table 1.1: Individual Income Tax Returns: Selected Income and Tax Items, by Size and Accumulated Size of Adjusted Gross Income.” Table available from: http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html

Internal Revenue Service (IRS). Individual Complete Report - Publication 1304.(Tax Year 2005.) Washington, D.C.: U.S. Department of the Treasury.

Johnston, Louis D. and Samuel H. Williamson, (2007). "The Annual Real and Nominal GDP for the United States, 1790 - Present." Economic History Services. Miami, FL: University of Miami. Data set available from: http://eh.net/hmit/gdp/

Jones, Charles I. (2002). Introduction to Economic Growth, Second Edition. New York, NY: Norton & Company

Jones, Larry E., Rodolfo E. Manuelli and Peter E. Rossi. (1993). “Optimal Taxation in Models of Endogenous Growth.” Journal of Political Economy, Vol. 101(3), 485-517.

Jorgenson, Dale W. and Barbara M. Fraumeni. (1992). “The Output of the Education Sector.” In Griliches, Zvi, 1992, Output Measurement in the Service Sectors. Chicago, IL: University of Chicago Press.

Judd, Kenneth L. (1998). “Taxes, Uncertainty, and Human Capital.” American Economic Association Papers and Proceedings, Vol. 88, 289-292.

Judd, Kenneth L. (1999). “Optimal Taxation and Spending in General Competitive Growth Models.” Journal of Public Economics, Vol. 71, 1-26.

Kaldor, Nicholas. (1961). “Capital Accumulation and Economic Growth.” In Hague, D.C. and F.A. Lutz (Eds.): The Theory of Capital. New York, NY: St. Martins.

Katz, Arnold J. and Shelby W. Herman. (1997). “Improved Estimates of Fixed Reproducible Tangible Wealth.” Survey of Current Business, May 1997, 69-92. Washington, D.C.: U.S. Department of Commerce (Bureau of Economic Analysis).

Kendrick, J.W. (1976). The Formation and Stocks of Total Capital. New York, NY: Columbia University Press.

King, Robert G. and Sergio Rebelo. (1990). “Public Policy and Economic Growth: Developing Neoclassical Implications.” Journal of Political Economy, Vol. 98(5), S126-S150.

Krueger, Dirk and Fabrizio Perri. (2003). “On the Optimal Welfare Consequences of the Increase in Inequality in the United States.” NBER Working Paper, No. 9993, Cambridge, MA: National Bureau of Economic Research (NBER).

Krueger, Dirk and Jessica Tjornhom Donohue. (2003). “On the Distributional Consequences of Child Labor Legislation.” International Economic Review, Vol. 46(3), 785-815.

Kydland, Finn E. and Edward Prescott. (1982). “Time to Build and Aggregate Fluctuations.” Econometrica, Vol. 50(6), 1345-1370.

Lucas, Robert E., Jr. (1988). “On the Mechanics of Economic Development.” Journal of Monetary Economics, Vol. 22(1), 3-42.

Lucas, Robert E., Jr. (1990). “Supply-Side Economics: An Analytical Review.” Oxford Economic Papers, Vol. 42, 293-314.

Lucas, Robert E., Jr. (2003). “Macroeconomic Priorities.” American Economic Review, Vol. 93, 1-14. Lucas, Robert E., Jr. and Prescott, Edward C. (1971). “Investment under Uncertainty.” Econometrica, Vol. 39, 659-681.

MaCurdy, Thomas E. (1981). “An Empirical Model of Labor Supply in a Life-Cycle Setting.” Journal of Political Economy, Vol. 89(6), 1059-1085.

Maddison, Angus. (2007). “World Population, GDP and Per Capita GDP, 1-2003 AD.” Last updated in August 2007. Data set available from: http://www.ggdc.net/maddison/Historical_Statistics/horizontal-file_03-2007.xls

McNulty, John K. (2000). “Flat Tax, Consumption Tax, Consumption-Type Income Tax Proposals in the United States: A Tax Policy Discussion of Fundamental Tax Reform.” California Law Review, Vol. 88(6), 2095-2185.

Moore, David. (2005). “Slovakia’s 2004 Tax and Welfare Reform.” IMF Working Papers. Washington, D.C.: International Monetary Fund.

National Science Foundation (NSF). (2007). National Patterns of R&D Resources: 2006 Data Update. Publication and data available from: http://www.nsf.gov/statistics/nsf07331/pdf/nsf07331.pdf

Nicholson, Walter. (2005). Microeconomic Theory: Basic Principles and Extensions. Ninth Edition. Mason, OH: South-Western.

Organization for Economic Co-operation and Development (OECD). (2006). “Expenditure by Funding Source and Transaction Type.” OECD Statistics. Data set available from: http://stats.oecd.org/wbos/default.aspx?

Paez-Farrell, Juan. (2005). “New Keynesian Models and the Test of Kydland and Prescott.” Macroeconomics series, No. 0411003. St. Louis, MO: Washington University in St. Louis, EconWPA.

Persson, Torsten and Guido Tabellini. (1990). Macroeconomic Policy, Credibility, and Politics. London, UK: Harwood.

Poterba, James M. (1997). “The Rate of Return to Corporate Capital and Factor Shares: New Estimates Using Revised National Income Accounts and Capital Stock Data.” NBER Working Papers, No. 6263. Cambridge, MA: National Bureau of Economic Research.

Rabushka, Alvin. “The Attractions of a Flat-Rate Tax System.” Wall Street Journal, 25 March 1981.

Rabushka, Alvin. (2002). “The Flat Tax at Work in Russia.” Palo Alto, CA: Hoover Institution, Stanford University. Available from: http://www.hoover.org/research/russianecon/essays/5134032.html

Rebelo, Sergio. (2005). “Real Business Cycle Models: Past, Present, and Future.” RCER Working Papers, No. 522. Center for Economic Research, University of Rochester: Rochester, NY.

Romer, Paul M. (1986). “Increasing Returns and Long-Run Growth.” Journal of Political Economy, Vol. 94(5), 1002-1037.

Romer, Paul M. (1990). “Endogenous Technological Change.” Journal of Political Economy, Vol. 98(5), S71-S102. Rosen, Harvey S. (2005). Public Finance. Seventh Edition. New York, NY: McGraw-Hill.

Royal Swedish Academy of the Sciences. (2004). “Finn Kydland’s and Edward Prescott’s Contribution to Dynamic Macroeconomics: The Time Consistency of Economic Policy and the Driving Forces Behind Business Cycles.”

Rupert, Peter, Richard Rogerson and Randall Wright. (2000). “Homework in Labor Economics: Household Production and Intertemporal Substitution.” Journal of Monetary Economics, Vol. 46(3), 557-579.

Solow, Robert M. (1957). “Technical Change and the Aggregate Production Function.“ Review of Economics and Statistics, Vol. 39(3), 312-320.

Stokey, Nancy L. and Sergio Rebelo. (1995). “Growth Effects of Flat-Rate Taxes.” Journal of Political Economy, Vol. 103(3), 519-550.

Temin, Peter. (1998). “The Causes of American Business Cycles: An Essay in Economic Historiography.” NBER Working Paper, No. 6692, Cambridge, MA: National Bureau of Economic Research (NBER).

Turner, Chad, Robert Tamura, Sean E. Mulholland and Scott Baier. (2007). “How Important are Human Capital and Total Factor Productivity for Determining State Economic Growth in the United States.” Working Paper. Available from SSRN: http://ssrn.com/abstract=1004546

United Nations Statistics Division (UNSD). (1992). Handbook of the International Comparison Programme. New York, NY: Department of Economic and Social Development.

Ventura, Gustavo. (1999). “Flat Tax: A Quantitative Exploration.” Journal of Economic Dynamics and Control, Vol. 23, 1425-1458.

Williams, Noah. (Spring 2007). Lecture Notes for ECO 311 – Macroeconomics: A Mathematical Approach. Princeton University, Princeton, New Jersey

Williamson, Stephen D. (2004). Macroeconomics, Second Edition. New York: Addison Wesley.