Appendix B: Tax Reform Within Lump Sum Taxes

B1 Introduction

Appendix A of this chapter characterized tax structures that maximize the sum of generational utilities discounted by the social time preference in an overlapping- generations growth model. Because the incentive effects are complicated and sensitive to parametric structure, theory alone cannot provide clear-cut guidance to efficient dynamic tax structures. With the general model, the rates of tax are highly sensitive to the compensated elasticities and covariances. Unfortunately, we have little empirical data on some of these parameters.

At this stage, we have two alternatives. One is to address the quantitative issues of the incentive effects, using numerical simulation models in which agents live for many periods, as explained in the main text of this chapter. The other is to eliminate the incentive effects. It should be stressed that the impact on intergenerational incidence of converting an income tax to either a consumption or wage tax does not depend solely on the difference in such incentive effects on a representative person.

Consumption taxes and labor income taxes are equivalent from the viewpoint of household budget constraint. Both taxes affect the relative price of consumption over time in the same way, as also explained in the main text of this chapter.

The present appendix thus employs the second approach that eliminates the incentive effects. Namely, within the framework of lump sum taxation, this advanced study, Appendix B intends to analyze theoretically the effect of the timing of tax payments on the welfare of earlier generations during the transition process.

The rationale for this approach is not that we believe that such incentive effects of distortionary taxes are unimportant. Rather, the aim of this approach is to demonstrate that even if there are no incentive effects, different taxes generate different intergenerational incidence because consumers differ in their timing of payments of taxes. This is called the tax timing effect. The difference between consumption and labor income taxation is not the incentive effect. The tax reform concerning consumption and labor income taxation may well be evaluated within the framework of lump sum tax reform. It is useful to analyze the implications of lump sum tax reform for intergenerational incidence more fully.

Essentially, if the rate of interest is greater than the rate of population growth, the effect of consumption tax is to reduce the lifetime present value of taxation by postponing tax payments to later in life. This is called the tax postponement effect. Based on Ihori (1987), we theoretically investigate under what circumstances the tax postponement effect is relevant and how the timing of tax payments affects intergenerational incidence.

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