A Rational Economic Model of Paygo Tax Rates

Shehsinski, Eytan and de Menil, Georges and Murtin, Fabrice (2014): A Rational Economic Model of Paygo Tax Rates.

Abstract

We argue that a rational-economic model of how societies choose their paygo tax rate can explain the cross section variance of these rates in large, developed OECD economies. Using a two-period OLG framework, we suggest that paygo tax rates are determined by a representative agent and a benevolent government jointly maximizing the expected life-time utility of the representative agent. In order to calculate these expected utilities, we construct probability distributions of life-time labor and capital income by simulating annual models of real wages and the return to capital estimated from data on real GDP and the real return to capital from the end of World War II to 2002. The joint distribution of the error terms is bootstrapped from the estmated errors of the annual equations. Expectations are taken over these distributions. The model predicts that each country chooses the paygo tax rate which maximizes the expected life-time utility of its representative agent. Risk aversion, described by a CRRA utility function, is assumed uniform across countries, such that the variance of the predicted rates is due exclusively to cross-country differences in the objective characteristics of the dynamics of wages and the return to capital in each country. These predicted rates are shown to explain 85% of the variance of observed effective-paygo rates. The calculations show that it is cross-country differences in the level and variability of the return to capital which are the most important source of this variance. We use the model to simulate a hypothetical world in which all countries share a unique, global capital market, and show that this scenario leads to a radical convergence of paygo rates. In a further exercise, we add an estimate of the probability of global crises like that of 2008 to the national distributions computed from post-War data, and examine the potential effect on paygo rates of these previously neglected, low probability events.

• Item Type: MPRA Paper
• Language: English
• Keywords: Pay-as-you-go, Savings, Risk Aversion, OLG, National Capital Markets
• Subjects: H - Public Economics > H0 - General

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